From Global Risk Management
The Oil Market Quarterly Outlook July'18
From Global Risk Management
In the second quarter of 2018 Brent oil price has moved from $67 reaching $80 and is at time of writing trading around $78. Volatility has been high and global supply has been of great concern.
Changes in oil production is currently of the essence as OPEC+ has agreed to increase production by 1 mbpd and U.S. shale oil production is at its all-time high. However, the sky-rocketing shale oil production have not caused a huge drop in oil prices, likely because U.S. crude oil infrastructure has not been able to keep up with the increased production, landlocking the oil. Furthermore, the crisis in Venezuela is deepening and both the political and the economic state of the country is affecting crude oil output which plummeted from above 2 mbpd to now less than 1.5 mbpd. The U.S. is pulling out of the Iran nuclear deal and pledges to re-impose sanctions, causing more supply concerns – all in all, the next quarter could continue to see supply concerns and volatility is likely to remain high.
U.S. Production, Bottlenecks in exports, WTI-Brent Spread, Chinese demand, Indian demand could decline due to high prices, and OPEC+ alleged production increase.
During Q2 the supply fundamentals looked quite like Q1 with regards to OPEC+ and U.S. production. The average daily U.S. production started out at about 10.5 mbpd and was at the end of Q2 at 10.9 mbpd making the U.S. the second-largest producer after Russia. Though the increase in production was not as large as it was during Q1 it was still a huge increase. The decreasing production growth is likely due to infrastructure bottlenecks starting to arise in the U.S – especially in the Permian Basin. Such bottlenecks suggest that U.S. crude oil will not be available on global markets and therefore not affect the price of Brent (read the extra section for additional information on this topic). Due to these bottlenecks the growth in U.S. production is expected to decrease further during Q3.
As the price of Brent has surged through Q2 the OPEC+ production cut seems to have had an effect. And the oil producers have indeed been highly committed to the deal. However, as the parties recognised that the Venezuelan and Iranian production most likely will decrease further they suggested on increasing production by 1.5 mbpd. at the official OPEC meeting last month. The proposal, however, met heavy resistance by especially Iran and Venezuela resulting in the outcome of the meeting being rather blurry but with Saudi Arabia pledging to increase production by 1 mbpd, nominally. 1 mbpd is a lot and likely not the actual quantity they are going to produce. Such an increase would hit OPEC+’s spare capacity, so a more realistic estimate is that Saudi Arabia is going to increase production by about 600 kbpd –If they increase production by 1 mbpd or more, the global spare capacity would tighten, which would imply oil prices being more sensitive to shocks .
Looking at the U.S. inventories, the decreasing trend has turned, and the U.S. inventories are now building slightly as an effect of the increased production. This trend is expected to continue during Q3 but could possibly be countered partially by increased refinery inputs as the U.S. driving season will continue into Q3 followed by the restocking of heating oil for the winter season.
Looking at the U.S. exports it is observed that the exports of crude on average increased during Q2, but as prices have risen and U.S. inventories building the export capacity is likely reaching a limit somewhere in between 2-2.5 mbpd.
During Q3 the export capacity is not expected to increase meaning that the price of Brent is not going to be dumped by a sudden outflow of the excess U.S. barrels.
What is, however, expected to affect the price of Brent heavily is the output of the OPEC+ countries. Especially Iran and Venezuela will be of focus here. Venezuela’s crude output is decreasing and that would most likely apply for Iran as well due to coming sanctions by the U.S. But also, the counter-weight being Russia and Saudi Arabia is going to affect the Brent price in terms of the quantity they are going to increase the production by.
The major difference between Q2 and Q1 is that the market possibly is starting to worry that the increase in prices is going to affect demand. Already, the U.S. president has been commenting on high gasoline prices. However, relatively speaking gasoline is already more expensive in China and India according to Bloomberg, as below graph shows.
Demand is still strong, but India is especially starting to worry as the country’s latest economic survey suggests that growth will be cut by 0.2-0.3% by every 10$ increase in the crude oil price. This is due to Indian growth being highly dependent on oil consumption. Bloomberg Gadfly released a study suggesting that there currently are two opposing forces. One is that growth in GDP spurs growth in oil demand, but as demand increases the price does as well, and this will counter the demand. If so, the decisive factor will be how much oil is supplied as growth most likely is persistent.
Below graphs display crude oil imports from China and India as a proxy for their demand.
The U.S. crude oil production is starting to bump into infrastructure problems. Intra state excess pipeline capacity is starting to become a shortcoming and so is global export capacity. These have been two crucial factors for Q2. In Q3 this is expected to be even more influential as production is likely to increase further, though in a slower pace than Q1 and Q2. This is, however, leaving OPEC with the upper hand in determining the crude price especially as supply from Venezuela and Iran is expected to decrease. If OPEC+ are unable to offset more than the alleged production decrease from Iran and Venezuela and if the U.S. does not expand domestic pipelines and export capacity fast (which is not expected until 2019), the Brent crude price could be further affected.
Dollar strength and U.S. financial markets, accelerating Indian growth and China strong positioned
U.S. - faith restored in the U.S. financial markets?
The most remarkable development regarding U.S. financials is the strength returning to the dollar. It has now reached levels not seen since the end of 2017. Controversially, as the dollar index started to surge in April the Brent price did as well. Usually a rising dollar results in the oil price declining. However, that trend has turned since end May as the dollar index seems to be in a bullish stance and the Brent price has decreased since end of May. If the dollar index continues its bullish trend during Q3 it could have a bearish effect on Brent.
The Fed interest rate during Q2 increased from 1.75% to 2% which is the highest since 2008. As the rate is higher, the dollar is more profitable to hold. However, in Q1 the market didn’t really seem to have faith in the dollar even though the interest rate was planned to increase. The S&P500 and Dow Jones have been struggling through Q1, but trending upwards through Q2 to take another beating in the last part of Q2. The dollar index is, however, up during Q2 which could be a sign of a stronger economy and that faith in it is starting to return.
Looking at the GDP growth figures in terms of YoY the U.S. economy does look increasingly healthy which is in accordance with the dollar index.
The increase of interest rates is a strategy suggesting that the economy is heating up and is usually a means to prevent it from getting out of hand. But lowering it could as well be a tool for accelerating the economy if it crashes – in 2008 when the great recession kicked in most economies around the world were able to get the wheels turning again as interest rates were lowered substantially, in some countries reaching 0%. But if lowering the interest rate is not a possibility, getting the wheels of the economy turning is more difficult.
Q3 could turn out as a bit of a joker. As the U.S. president is stirring up foreign politics and old trade agreements in the name of protectionism, the economy could be affected if counterparties react drastically.
U.S. financials are assessed slightly bearish.
China - status quo - strong!
In Q1 the market was nervous that a trade war would break out between China and the U.S. resulting in a full-blown global trade war. Officially it is not a trade war, but the U.S. is likely imposing more tariffs on China from 6 July.
The Chinese economy is still exporting and importing a lot and both the PMI and GDP Q2 figures seem decent and pretty much in line with those of Q1. The Chinese economy does not seem more bullish or bearish than Q1 but has been in a constant strong position during Q2.
As the growth path seems steady Q3 is not assessed to add further momentum to the Chinese oil demand, neither is it assessed to slow remarkably. The current growth does, however, ensure a steady growing oil consumption as seen through the last couple of years which is expected to continue during Q3 – with a possibility of being a bit stronger in H2 due to seasonality.
Chinese financials are assessed neutral.
India - economy back in the race!
India’s GDP growth is now back in the race after the downturn of Q2 2017, where the YoY GPD growth fell to 5.6% from a high of 9.2% in Q1 2016. The GDP in the first quarter of 2018 turned out to be 7.7%, indicating that the Indian economy likely is over the monetary and taxational reforms which debilitated the economy temporarily. Also,, the IMF expects the growth rate of the Indian economy to increase further during 2019 and 2020 meaning that the future is bright and that Indian financials most likely will drive the oil demand further during this year and the ones to come.
With regards to the increasing price of oil a report released by the UN said that every 10$ increase in the price of oil could harm GDP growth by about 0.2-0.3 percentage points.
India’s financials are assessed bullish.
Through Q2 Chinese financials have been steady and spurred a higher average oil demand. India has followed and even exceeded the growth of Q1, and Q2 has been the quarter for India emphasising that the 2017 slowdown of economic growth was just a bump on the way and Q3 is looking promising. The dollar index turned out not to be a primary parameter affecting oil prices but is, however, still essential in the long run. U.S. financials for Q3 start off from a slightly bullish foundation from Q2, but could turn out to be disrupted by foreign trade politics. And exactly the foreign trade politics is a joker on the financial front during Q3 and for the rest of the year for that matter. If the trade war between U.S. and China actually unfolds and escalates further, and trade between the EU and U.S. deteriorates then the global financial front could turn out bearish for oil prices.
Chinese and especially Indian financials are assessed primary drivers of demand and therefore influential on prices.
U.S. foreign policy, Iran, Venezuela, Yemen
The U.S. president has taken centre stage on the international political scene during Q2. The quarter started out with the U.S. being in a potential trade war with China which was initially avoided but is still spurring uncertainty.
In May, the U.S. backed out of the Iranian nuclear deal. The deal was introduced in 2015 as a collaboration between the EU and U.S. to cooperate with Iran in destroying their nuclear and ballistic missile program in return for removing the sanctions. When the sanctions were introduced back in 2012 by EU and the U.S. the Iranian oil production fell about 1 mbpd as a lot of countries boycotted their exports. The production rose about the same amount following 2015 when sanctions were lifted as a deal was made with Iran. At the start of May, the U.S. then pulled out of the deal saying that it was “the worst deal ever”. Furthermore, the U.S. committed to re-impose the sanctions from 2012 on Iran and everyone trading with them unless very special arrangements were approved.. The sanctions will be in full effect as of 4 November. The pulling out of the deal was the first sign of the U.S. adapting a more protectionist stance to geopolitics. The sanctions could remove somewhere between 0.5 and 1 mbpd from the market, but as it is only the U.S. who withdrew from the deal Iran’s exports are probably not going to drop as much as it did in 2012 i.e. less than 1 mbpd.
Furthermore, the U.S. emphasised the critical attitude towards historic trade partners during the June G7 summit. Leaving the meeting with nothing signed and a further hostile stance towards Europe and especially their primary ally, Canada.
Following the G7 summit U.S. President Trump went to Singapore to meet with the North Korean leader Kim Jong-un, with an agenda of getting North Korea to destroy its nuclear program. The meeting was a huge political and historical event, but economically speaking it did not turn out to have a significant effect. From here the relationship is not expected to affect the oil market remarkably, but it does, however, remove a potential risk premium from the alternative scenario where the situation could have escalated.
Venezuela has for long been challenged both politically and economically speaking. The state of the country has had a huge effect on crude oil output which plummeted from more than 2 mbpd to now less than 1.5 mbpd.
The situation has been critical for quite a while and media is speaking of a humanitarian crisis with more than half a million having left the country. Venezuela has defaulted on debt and has paid creditors in crude oil instead of currency which resulted in Russia receiving 225 kbpd of Venezuelan oil. Furthermore the U.S. has prevented domestic financial institutions from investing in Venezuelan and PDVSA (the state-owned oil company) bonds. Even large international companies withdrew interests from the country.
Venezuela is highly dependent on its oil production and therefore it is important to maintain present equipment and make new investments when old wells run dry. Allegedly both have been a shortcoming. As oil assets are degrading and a limited amount of money is flowing in across its borders future investments in the oil sector seem limited; further degrading the output. Additionally, the labour force is likely exhausted and not motivated to work as the country experiences severe shortages of medicine and food.
Currently there is no signs of improvement which is why the crude output from Venezuela is expected to drop even further.
Yemen is still a fighting ground backed by Saudi Arabia on one side and Iran on the other. Missiles from rebels have been fired at Saudi Arabia. However, it is not the direct attacks that spurs geopolitical risk in the oil market. The risk/uncertainty arises from Saudi Arabia and Iran both being in OPEC. If disputes escalate further across the Yemen borders, disputes could be taken as high as on OPEC level.
The crisis in Venezuela is nothing new to the market and neither is its decreasing output. Disputes between Saudi Arabia and Iran are old news as well, and OPEC has thrived with the production cut even though a war in Yemen broke out. But the market reacts to geopolitics and right now some of these situations are affecting the market. Especially in Venezuela in terms of lack of investments in oil assets. The most remarkable event on the geopolitical scene during Q2 is, however, the U.S. backing out of the Iran nuclear deal and the pledge to re-impose sanctions. As sanctions removed a lot of Iranian barrels between 2012 and 2015, at least some of those are expected to be removed in the time to come.
Oil price forecast (average)
Please note that the forecast is the AVERAGE price per quarter. Thus, prices during the quarter will likely be both higher and lower.
Brent forecast and prices (USD per barrel)
How is the report structured?
The report is divided into three parts – each part elaborates on three main topics which are influencing the oil prices:
The GOSI is the background for the medium term forecast on oil prices. The last pages in the report are our forecast and company news.
Contact the Global research team
About Global Risk Management:
Global Risk Management is a leading provider of customised hedging solutions for the management of price risk on fuel expenses. Combining in-depth knowledge of the oil market, finance and transport, we help clients protect their margins from the risk posed by notoriously volatile fuel prices.
This publication has been published by the research department of Global Risk Management for information purposes only. Global Risk Management is not liable for its content and disclaim liability if it is used for trading or other purposes. The publication is protected by copyright and may not be reproduced in whole or in part without a proper source description.
The contents of this document are not intended to provide investment advice nor any other investment service, and the document does not constitute and under no circumstances should it be considered in whole or in part as an offer, a solicitation, advice, a personal recommendation to purchase or subscribe for an investment service and/or product, nor an invitation to invest in the class of assets mentioned herein. The information indicated in this document shall not be considered as legal or tax or accounting advice. Furthermore, accessing some of these products, services and solutions might be subject to conditions, amongst which eligibility. Our Oil Risk Managers are available to discuss with you on these products, services and solutions to check if they can respond to your needs and are suitable to your investor profile.
The full understanding and agreement to the related contractual and informative documentation including the documentation relating to the relevant risks is required from the potential investor prior to any subscription of products/investment services. The potential investor has to remember that he should not base any investment decision and/or instructions solely on the basis of this document.
This document is not intended to be distributed to a person or in a jurisdiction where such distribution would be restricted or illegal. It is the responsibility of any person in possession of this document to inform himself of and to observe all applicable laws and regulations of relevant jurisdictions.
The simulations and examples included in this document are provided only for indicative and illustration purposes. The present information may change depending on the market fluctuations and the information and views reflected in this document may change.
A/S Global Risk Management Ltd. Fondsmaeglerselskab disclaims any responsibility to update or make any revisions to this document. The purpose of this document is to inform companies who shall make their investment decisions without overly relying on the document. A/S Global Risk Management Ltd. Fondsmaeglerselskab does not offer any guarantee, express or implied, as to the accuracy or exhaustivity of the information or as to the profitability or performance of class of assets, counties, markets.
This document does not intend to list or summarise all the financial products’ terms and conditions, nor to identify or define all or any of the risks that would be associated with the purchase or sale of the investment product(s)/asset class(es) described herein.
The historical data and information herein, including any quoted expression of opinion, have been obtained from, or are based upon, external sources that our company believes to be reliable but have not been independently verified and are not guaranteed as to their accuracy or completeness. Our company shall not be liable for the accuracy, relevance or exhaustiveness of this information. Past performance is not a guide to future performance and may not be repeated. Investment value is not guaranteed and the value of investments may fluctuate. Estimates of future performance are based on assumptions that may not be realised, and should not be deemed an assurance or guarantee as to the expected results of investment in such asset class(es).
This document is confidential, intended exclusively to the person to whom it is given, and may not be communicated nor notified to any third party and may not be copied in whole or in part, without the prior written consent of A/S Global Risk Management Ltd. Fondsmaeglerselskab.
With increasing U.S. crude oil production, why have oil prices not plummeted?
The Permian Basin in Texas, U.S. is the largest shale play in the U.S. and has within this decade become the by far most productive in the U.S. Currently the field produces around 3.3 mbpd of a total U.S. production of 10.9 mbpd. But even though the American production has skyrocketed, the price of Brent has not decreased accordingly. In fact it recently reached the highest level since 2014. So why did these American barrels not force prices down – the answer is found in the pipeline infrastructure.
As the production from the Permian has exploded within the last two years the transport infrastructure such as pipelines has not been able to keep up. The consequence is that oil in the area is starting to become land-locked – meaning that the oil cannot get out of the production area. When it cannot get out of there it cannot reach the global market and therefore it does not affect global oil prices.
The way to examine if bottlenecks are arising is to look at the locally priced oils. For the Permian Basin that would be the WTI Midland grade which is priced in Midland, Texas. When WTI Midland becomes way cheaper than the regular WTI crude the probability of a bottleneck is high or it is imminent.
To sum up: when an area is producing more oil than what can be transported away from there (the takeaway capacity), the oil will be stuck and its price will decline.
In the beginning of Q2 the difference from WTI to WTI Midland increased rapidly resulting in the regular WTI being priced as much as 13$ higher. This was an indication of oil being plenty in that area. By looking at the takeaway capacity from the Permian Basin it is found to be just below 3.3 mbpd. The production was at the moment as well just about 3.3 mbpd meaning that there was no spare pipeline capacity.
If production in the Permian continues to increase this spread is very likely to rapidly expand again. It is not until during 2019 that extra capacity is planned to be available. However, the capacity is expected to reach about 5 mbpd within 2019/2020. The more capacity, the more crude will reach the market and the more global prices could be affected.