The Fuse

Bullish Comments from the Saudis Appear Premature, Glut Likely to Persist

by Matt Piotrowski | October 25, 2016

The world’s most watched oil minister and some big-name CEOs last week asserted the global oil market is now quickly moving into balance, with supply declines and solid demand bringing about the needed adjustment that producers have been waiting for over the past couple of years. “Market forces are working. After testing a period of sub-$30 prices, the fundamentals are improving and the market is clearly balancing,” said Saudi Energy Minister Khalid Al-Falih last week at a conference in London. “On the supply side, non-OPEC supply growth has reversed into declines due to major cuts in upstream investments and the steepening of decline rates.”

Oil prices and forward curve structures are teetering, indicating that recent bullish sentiment from oil CEOs and OPEC ministers may be premature.

Others are trying to talk up the market, too, despite fundamentals suggesting otherwise. For instance, the Total CEO, Patrick Pouyanne, said the underinvestment of today could bring about a 5 million to 10 million barrels per day shortfall by the end of the decade. But oil prices and the forward curve structures are teetering, indicating that Al-Falih’s and Pouyanne’s bullish sentiment may be premature. In fact, since oil prices tanked a little more than two years ago, a number of traders, pundits, CEOs, and oil ministers have unsuccessfully called the bottom for oil and suggested that the market had rebalanced. This time might be no different. Over the past couple of years, there’s been a string of comments from executives and ministers who want and need higher prices making the case for a tighter market, even though there’s little to no evidence of that reflected in the fundamentals.

callingtheoilbottome

Brent, spreading the pain

There are a number of signs that contradict what Al-Falih said. For one, the Brent futures curve is weakening. The contango has widened recently, giving steep discounts to buyers. When the contango grows, a buyer’s market ensues as front-month prices become steeper compared to forward contracts. In the past month, the December-January Brent spread has doubled to $1. This widening reflects how much stronger supply is than demand. New volumes from the North Sea, Libya, Nigeria, Iraq, and Kazakhstan have overwhelmed the market, causing December Brent to lose about $2, or about 4 percent, in the past couple of weeks to trade just above $50.

There are a number of signs that contradict what Al-Falih said. For one, the Brent futures curve is weakening.

The glut in the Atlantic basin is most evident in distressed Nigerian volumes. Nigeria recently slashed its official selling prices (OSPs) by about $1 in order to clear its extra volumes, with some grades now trading under Brent. Heading into the OPEC meeting next month, the West African member will be one challenge for the group. It will likely be exempt of any production quota since it has dealt with repeated violence against its oil installations all year. The country has the potential to increase production as others—most notably Saudi Arabia—would cut. If current conditions are any guide, Nigeria will have to continue to slice its OSPs to get rid of cargoes, pulling Brent down, too.

There are also issues with Libya and Iran, both of whom are in similar positions to Nigeria. After dealing with outages, they seek to increase production to their maximum levels. But the twist that could scuttle an OPEC deal is Iraq’s stubbornness to go along with a cut. This week, Iraq said it wants to keep its own output level elevated, even if OPEC inks an agreement. Iraqi Oil Minister Jabar al-Luaibi said Tuesday that Iraq would seek the same exemptions as Iran, Nigeria and Libya as it needs revenue to fight ISIS. Crude output in Iraq, which has not been subject to an OPEC quota since 1991, averaged just under 4.5 mbd last month, up roughly 1 mbd from this time last year, a reflection of its aspirations to continue to up output even in the low price environment. The problem of increasing beyond the current level is two-fold. For one, it would simply add to the current glut. Second, as noted above, Iraq’s determination could threaten the entire OPEC deal.

Shale will shine again?

Al-Falih and Pouyanne could also be misreading the U.S. market. There is a form of rebalancing taking place, but it’s happening slowly, and it’s, ironically, likely to add to the oversupply in the longer run. The U.S. crude benchmark West Texas Intermediate (WTI) has closed some of the gap on its counterpart Brent. Front-month WTI futures are trading just 88 cents per barrel under Brent, versus a spread of $1.50 about two weeks ago. The narrower differential reflects both changes in the U.S. and a weaker global market.

Against the backdrop of slimmer inventories, stagnant production, and opportunistic export cargoes, the U.S. market—which used to be the center of oversupply—has tightened relative to the rest of the world.

Against the backdrop of slimmer inventories, stagnant production, and opportunistic export cargoes, the U.S. market—which used to be the center of oversupply—has tightened relative to the rest of the world. The comparative strength of the U.S. is reflected in physical prices, with Light Louisiana Sweet selling for roughly $1.65 over Dated Brent. However, it’s not all bullish in the American market. Although there may be less oil in storage, there’s more available in the spot market, which could eventually weaken prices and cause the contango to blow out again. Moreover, the recent bump in prices has increased the amount of forward hedging and helped boost the rig count for 17 of the last 20 weeks. The recent price rally will test how flexible shale is. “I think it is going to be a swing producer. It can react much faster than the typical cycles in our business over the last 10, 20, 30 years. And that is what is unique about what is going on. We have to think about this business differently today than we did just a decade ago,” said ConocoPhillips’ Ryan Lance last week.

These developments are certainly not bullish heading forward. The bearish outlook is reflected in physical players, producers and merchants, holding the largest net short position in nine years—an indicator of intense hedging.

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Back to square one?

Despite Al-Falih’s latest contention that the global market is rebalancing, the Saudi-led policy of November 2014 did not achieve its goal fast enough, since OPEC is now attempting to come together to rein in output.

In November 2014, OPEC decided not to cut production and instead allow lower oil prices to choke off non-OPEC supply. The plan, led by the Saudis, made sense. Otherwise, an OPEC cut would have underpinned U.S. shale. It’s apparent that despite Al-Falih’s latest contention that the global market is rebalancing, the Saudi-led policy of November 2014 did not achieve its goal fast enough, since OPEC is now attempting to come together to rein in output. The oil market essentially has only one participant that can voluntarily cut, and that’s Saudi Arabia. Shale will be driven by economics, and it’s clear that $40-$50 can sustain U.S. output, while $60 will likely allow it to grow. All OPEC producers besides the Kingdom will produce as much as possible, and Russia, despite bullish rhetoric, will also pump all out. Saudi Arabia will have to determine if it wants to cut back on its own or if it wants to ride out the November 2014 strategy. Al-Falih says it has been working but just needs a push with a supply cut. We’ll soon find out whether he’s right or if his analysis was another incorrect call that we’ve seen so frequently in the past couple of years.

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