The Fuse

Are the Crude Futures Curves Underestimating Longer-Term Risks?

by Matt Piotrowski | January 14, 2016

Reasons for oil coming off for contracts in the immediate term are no secret—rising non-OPEC supply, OPEC pumping all out, a stronger dollar, and a sharp rises in commercial inventories. But the plunge in prices further out on the futures curve is a bit of a mystery.

With the sharp fall in the prompt oil price, contracts along the futures curves have also taken major hits. Reasons that oil has come off for contracts in the immediate term are no secret—rising non-OPEC supply, OPEC pumping all out, a stronger dollar, and a sharp rises in commercial inventories. But the plunge in crude futures prices further out on the curve is a bit of a mystery. It could simply be a case of the momentum of the front part of the curve, which is in steep contango, with prompt prices weaker than deferred contracts amid the supply surplus, pulling down longer-term contracts and traders projecting the current sentiment on the future.

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The fall in the entire curve, however, may instead represent a structural shift in a sharply changing perception surrounding long-term fundamentals, compared to what was seen just several months ago. This perception, based on the weakening contracts all along the futures curves, is that fundamentals will continue to weigh on prices and that, even if the supply-demand balances tighten, prices will still remain in a long-term bear market and not return to previous high levels seen from 2011-14.

While the forward contracts are not predictors of future prices, they do reflect what buyers will pay for tomorrow’s oil in today’s market. For contracts through the end of this decade, prices are under $50 for both NYMEX West Texas Intermediate and ICE Brent, while further out to December 2023, the price reaches only about $52.

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With front-month oil currently sitting around $30, it seems far-fetched that prices could rebound to triple digits again, or even $75-$80, but commodity markets have a history of moving with rapid velocity. After all, through the period of 2011-14, it was then unthinkable that prices would retreat to $30. Yet, here we are, with analysts gripping onto the “lower for longer” cliché. Could the market rebound, at some point, as sharply as it fell?

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Going forward, one possibility is that the futures curve is underestimating risks from both geopolitics and deferred investment. On the flip side, the other possibility is that the rapid descent of the curve does in fact indicate the market is in for longer-term structural weakness, similar to what Goldman Sachs analysts noted last year when they suggested that the market could be bracing for 15 years of low prices.

Geopolitics to once again matter?

The argument that the futures curve is underestimating risk is relatively straightforward, and is the reason why many analysts, the International Energy Agency (IEA) included, see prices bottoming out this year and rising through the second part of the decade. The current low price environment is choking off future investment in a dramatic fashion.

The argument that the futures curve is underestimating risk is relatively straightforward, and is the reason why many analysts, the International Energy Agency (IEA) included, see prices bottoming out this year and rising through the second part of the decade. The current low price environment is choking off future investment in a dramatic fashion. Based on recent estimates from consultancy Wood Mackenzie, some 68 upstream projects, totaling $380 billion of capital expenditures, have been deferred, with deepwater outlays being undermined the most. This means some 2.9 million barrels per day (mbd) that was expected to come on line this decade will not hit the market until the 2020s, says Woodmac. “By 2021 deferred volumes will reach 1.5 mbd, rising sharply to 2.9 mbd by 2025,” said Angus Rodger, principal analyst with Woodmac. Projects could be pushed back even further, depending on multiple factors that may complicate companies’ plans. “Against a backdrop of overwhelming corporate pressure to free-up capital and reduce future spend—to the detriment of production growth—there is considerable scope for this wall of output to get pushed back further if prices do not recover and/or costs do not fall enough,” said Woodmac.

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At the same time, low oil prices are stimulating demand, particularly for gasoline in the U.S. Against this backdrop, supply-demand balances could shift from a surplus, which averages close to 1 mbd today, to a deficit rather quickly. While 1 mbd is a significant oversupply, it is down from 2.4 mbd in Q2 2015, according to EIA. As the result of a swing into deficit, prices would naturally rise, perhaps at a fast clip. The collapse over the past 18 months was preceded by high prices stimulating overproduction and limiting demand growth. The oversupply swamped the market, causing today’s imbalance.

Underinvestment and geopolitical risks, simply put, go hand in hand. Once the market tightens, geopolitical risks reassert themselves, becoming a top priority among traders again, as the inventory cushion to guard against supply disruption becomes thinner. Currently, there is plenty of geopolitical risk that has taken supply offline or threatens production in unstable countries. Libya, Yemen, Syria, Iran, and Sudan are examples of oil-producing countries now experiencing long-term outages due to conflict or sanctions. Other geopolitical hotspots such as Venezuela, Saudi Arabia, Iraq, Nigeria, and Brazil are not dealing with outages, but they are experiencing political volatility, whether from external for internal forces, that could eventually take a massive amount of supply offline. The market is, for the most part, however, ignoring these risks because of what is immediately in front of them: A massive glut of crude in storage and non-OPEC and OPEC supply still rising despite prices falling. But the geopolitical issues are not going away any time soon. President Obama noted as much the other night in his State of the Union speech: “The Middle East is going through a transformation that will play out for a generation, rooted in conflicts that date back millennia.”

It’s safe to assume that geopolitical instability in the Middle East and North Africa will still be there, and could even worsen, when fundamentals do eventually tighten. Which means today’s futures curve is not adequately pricing in long-term instability. Included in the mix is the fact that OPEC’s market share is expected to rise from 2020 to 2040 as non-OPEC supply declines dramatically and demand continues to grow in emerging markets. Under these circumstances, buying long-term contracts at the $50 level appears like a good bargain. By contrast, anyone who bought contracts for 2015-16 during 2014 overpaid immensely, while anyone who unloaded contracts for 2015-16 months during that timeframe was no doubt ahead of the curve, so to speak.

Might the curve represent a structural shift downward?

While the long-term bearish case is certainly reasonable, the oil markets are inherently volatile and unpredictable. It’s unclear how long current bearish sentiment will last, and how much effect geopolitical and deferred investment will have in the longer run. But one thing is for sure: Oil prices are in store for a bumpy ride.

There is the possibility, however, that the curve is a correct indicator of the market’s future weakness and reflects a remarkable structural shift that could last for years, if not decades. Prices may, in fact, have difficulty rebounding back to $50, and when they do, the market may be capped at that level. Despite industry turmoil, supply is still holding up and the massive stock overhang provides a sufficient cushion against tighter supply-demand balances and outages due to geopolitical risks. There’s also the issue that even though threats to supply abound, production among OPEC producers will continue to increase. Iraq and Iran are the two best examples. Iraq is ramping up production despite war-torn conditions, while Iran has mostly upside potential now that sanctions are about to be lifted. Furthermore, while growth in shale is not sustainable at current levels, a rebound in prices, even a modest one to the $50-$60 level, along with more access to capital, could bring a good bit of supply back online.

The U.S. natural gas market may serve as a guide to what will occur in oil. The natural gas shale boom, which took off slightly ahead of the spurt in oil production, caused a massive price collapse. And with the exception of a few blips, prices have been falling since the beginning of this decade, with the market now at the lowest level in about twenty years. The oil market is different than natural gas, of course. Oil prices are reflective of global fundamentals, while natural gas deals with domestic supply-demand balances. Oil has to wrestle with geopolitical risk, particularly the aforementioned threats in the MENA region, and economic and demand growth in emerging markets. While those two factors were key in lifting oil prices from 2004-08 and 2011-2014, they are not as supportive now, making the oversaturated oil market just like natural gas. Amid a market drowning in oil, geopolitical unrest does not register on traders’ radars, and may not for some time if current fundamentals persist or deteriorate further—hence, the weak futures curve. Moreover, emerging market demand growth has been mitigated by declining oil intensity as a share of GDP. What demand growth in markets like China gives to the oil market, it also takes away. Case in point, one of the reasons of the selloff to start 2016 has been turbulence in the Chinese stock market. Even if physical oil demand does not take much of hit from economic troubles, growth has moderated from blistering levels seen last decade, and therefore easing one bullish factor for global prices. Which points to the price levels for contracts far out along the curve as possibly not being too off-target.

While the long-term bearish case is certainly reasonable, the oil markets are inherently volatile and unpredictable. It’s unclear how long current bearish sentiment will last, and how much effect geopolitical and deferred investment will have in the longer run. But one thing is for sure: Oil prices are in store for a bumpy ride.