Back in January 2016, crude oil prices undershot their fundamental values, falling below USD 30 per barrel (bbl).
However, markets have since undergone a major correction and now appear to be moving towards the other end of the price spectrum (see exhibit 1). Our analysis of production data leads us to believe that supply has started to normalise: declines in production are now broader-based in the US and other non-OPEC countries.
Exhibit 1: After plummeting at the start of 2016, oil has since rallied strongly (graph shows real oil price, USD per barrel, for the period from 1975 through 17 May 2016)
Source: Bloomberg, May 2016
However, increasing production by OPEC countries is offsetting falling production elsewhere….
Nonetheless, rising OPEC output continues to pose a challenge for market equilibrium. Production by OPEC countries grew over the course of the last year by twice as much as the volume of declines seen in US oil production: between April 2015 and April 2016, OPEC production rose by about 1.7 million barrels per day, while US output declined by about 0.8 million barrels per day (see exhibit 2).
Exhibit 2: Increasing outages in oil production have brought supply and demand closer to balance (graph shows estimated, historical unforeseen liquid fuel production outages, in millions of barrels per day)
Source: EIA up to April; Citibank, BNPP IP. Figures for May carried over with the exception of Nigeria and Iran, which rely on external resources.
So, while the dynamics of oil supply have improved, it still seems, in our view, that the underlying fundamental market equilibrium – in the absence of temporary disruptions – has not yet been restored. That is, short-term disruptions to supply (i.e. fires in Canada, pipeline sabotages in Nigeria, payment disputes in Iraqi Kurdistan, and an oil-worker strike in Kuwait) have recently influenced prices more than the longer-term adjustments in the dynamics of market equilibrium.
As we have previously stated, markets should not be paying for adding production capacity when none are yet needed. As a consequence, and assuming no temporary supply disruptions, market prices should be anchored at the assumed production cash cost of US shale oil production (currently about USD 35-45/bbl). In addition, we acknowledge that the oversupply issues have improved and should continue to do so and thus we believe that the downside risk of prices to below the cost of production (sub USD 35/bbl) has declined.
In retrospect, the sharp price increases experienced since March 2016 have been linked in particular to two factors: first, a broader ‘reflation’ macroeconomic theme underpinning global asset prices; and second, OPEC and Russia ‘talking up’ oil prices by voicing their plans to limit output.
Regarding the latter, we did not see a tangible risk materialising from the threat of an OPEC output freeze. However, this ‘fundamental void’ created by OPEC’s rhetoric has now been filled by unusually large supply disruptions. Since January, unplanned disruptions rose by about 1.5 million barrels per day, with most of these occurring in May due to the fires in Canada (about 0.8 million barrels per day of output were lost in May).
Headwinds should eventually help cap the rise in oil prices
Based on simple arithmetic, the increase in disruptions should have pushed the physical demand/supply balance into a temporary deficit – supporting markets over the short term.
Markets may temporarily continue to be supported by positive headlines, while current disruptions and a seasonal rise in demand should lead to higher inventory drawdowns. We should also see further falling rig counts as the impact of the lower prices seen in January comes through in the data (rig counts tend to lag prices by three to four months). However, headwinds are expected to build over the coming months, which should eventually help cap the rise in prices or even lead to a new correction.
From a supply perspective, we expect production disruptions to ease in the coming six to eight weeks, mainly from Canada and the North Sea. There is still a large inventory overhang that needs to be worked through by the markets (see exhibit 3). And there is a major risk of continued upside surprises regarding OPEC production.
Exhibit 3: A large inventory overhang still needs to be worked off (graph shows current inventory levels as the number of days of supply available for US crude oil relative to previous periods
Source: Bloomberg, BNP Paribas Investment Partners, May 2016
From a price perspective, should oil rise further above the production cost for shale, we would expect an increase in hedging demand and near-term additional supply. At about USD 50/bbl, there are roughly 200 000 barrels per day of drilled, but unfinished well capacity that could quickly return to markets. But to be clear, we are arguing here from the perspective of normalisation of temporary demand/supply effects, high inventories and hedging demand. We expect some production to return to the markets, but this is not the key driver, in our view.
Speculation on demand-led gains in oil prices might flounder
Unlike some other observers, we do not expect a similar magnitude decline as seen after the price rally in the first half of 2015. Underlying supply has been adjusting and non-OPEC/ex-US production declines have longer lead times to recover. There are also a number of factors that will likely lengthen the response time of shale production, including bringing back labour quickly enough and financing production.
Finally, as already touched upon, a potentially greater short-term risk is the crowding of non-specialised oil investors (i.e. macro/retail investors) into one direction (long the market). Their global ‘reflation’ view – largely based on the perception that demand will drive asset prices higher – may receive a serious knock as the recently more positive perception on economic growth in China is challenged.
In conclusion, there is potential for oil prices to continue to rise in the short term. However, as headwinds start building up, prices should roll over, realigning with our fundamental view that the underlying market has not yet fully rebalanced and needs further gradual adjustments, assuming no further supply disruptions occur. [divider] [/divider]
This article was first published in our Weekly Intelligence Report on 24 May 2016.