Now what for the Opec deal?
Opec has brought global crude stocks to heel. But its job is far from over
Opec and other willing producers are engaged in a delicate balancing act and their task is not complete. The producer group seeks to remove excess inventories in the hopes of regaining more control and fostering more stability in the oil market. Yet demand growth is fluctuating by 1m barrels a day. Venezuela stands on the brink of collapse and other Opec countries could witness significant disruptions in 2018. Though market signals in the closing months of 2017 show that its task might be complete, heightened geopolitical uncertainty and a desire for price stability are likely to keep Opec at the market-management table, in some form at least, beyond March 2018.
So what is Opec to do? Dismount in the hopes of sticking a perfect landing, or risk staying on the balance beam only to be pushed off by some unforeseen circumstance? The answer to that question depends on the meaning of the word "rebalancing". Since November 2014, no single concept has driven prices and market sentiment as much as the question of the rebalancing. A term applied to the oil market in the initial months of 2015, "rebalancing" has come to mean two things. First, whether supply and demand levels are back in equilibrium; and, second, whether current inventory levels have decreased to "normal". Where we are in the process of rebalancing is the unifying question for short-term focused analysts who are trying to assess the direction of prices.
For most of 2015 and 2016, the market remained in a state of surplus. Global supplies ramped up by more than 3m b/d, year-on-year, in some quarters, as low prices generated a lagged effect on US tight oil, and drove Opec to prioritise quantity over price. That was before the deal to cut, which came in late 2016. On the other side of the equation, demand growth also received a jolt, but it was not enough to bring the fundamentals in to line. Only after Opec and its non-Opec partners started cutting
—the quotas took effect in January 2017 —was supply finally brought to heel. It brought the first quarter in three years where supply and demand were in balance.
Yet only a protracted period of supply deficits would be able to draw down the inventory overhang. And despite Opec's new policy, inventories did not draw until the second half of 2017. Furthermore, Opec undercut itself by exporting at a higher level leading up to the cuts taking effect. And, as prices teetered close to $60 a barrel, on the high hopes of compliance and expected rebalancing, demand growth took a hit and grew by just 1m b/d in the first quarter.
Now that the market is in draw mode again, rebalancing takes on a new meaning with the focus on inventories. As recently as early November, Saudi oil minister Khalid al-Falih told
Reuters: "Everybody recognises that (the) job is not done yet by any means. We still have significant amount of work to do to bring inventories down. Mission is not yet complete, more needs to be done."
The problem is that with oil back at $60/b and the structure of the Brent futures curve steadily becoming more backwardated (deferred prices lower than prompt prices), the market may be signaling that enough has been done. Granted, some of the improvement is linked to hopes of an extension beyond 2018, but outperforming demand and new disruptions are certainly accelerating Opec's job.
So why the discrepancy? How can the energy minister of the world's largest oil exporter, who, of anyone, ought to have a finger on the pulse of the market, believe more "rebalancing" is necessary when the market is giving the opposite message?
At face value, the reduction in inventories since the second quarter of 2017 has been impressive. Measured on either an absolute basis or in terms of days of forward-demand cover, about half of the stock excess in OECD countries was eroded between January 2017 to the end of August, and now sits at 160m-170m. If the flow of inventories in the OECD takes its cue from the global balance, which most estimates expect to show continued deficit through 1Q18, the inventory draws in the OECD should continue through that quarter. Of course, this assumes no change in Opec policy
—or compliance —in the interim.
In the US, where most of the crude overhang accumulated, crude inventories were 12% above the five-year average at the start of the year and now sit just 3% above. On a days-forward-cover basis, crude inventories are almost exactly in line with the five-year average. On the product side, fuel oil, ultra-low sulphur diesel, and gasoline all sit in line with or below the five-year range. A strong refining-margin environment, flat product structure, and crude-export arbitrage will ensure that crude does not continue to stockpile on a net basis.
But should "normal" be based on a five-year average? Should it be an index to the beginning of the downturn? Should it include the years of excess? Or should "normal" rebase, now that demand is rising more quickly than before? Essentially, "normal" really depends on which metric one uses. OECD crude stocks on an absolute and demand-adjusted basis still remain at roughly last year's average as of August. And, most importantly, we find that roughly two thirds of the drawdown in OECD countries has been due to the five-year range moving higher, and only one third has come from truly lower absolute levels of inventories. Seen this way, the progress on crude inventories looked less impressive through August but still improved dramatically in the fall.
Does location matter? While it is tempting to keep the question simple and focus on the US and the OECD, a non-partisan view would look at how other regions fare as well. Outside the OECD, data from the Joint Oil Data Initiative, or Jodi, and from tanker-tracking companies also show a sharp downturn in oil inventories held in some non-OECD countries: from both oil-in-transit and from floating storage. The International Energy Agency calculated in October that over 60% of the drawdown in inventories globally from 2Q17 to 3Q17 (excluding China) has come from a reduction in oil held in floating storage (concurrent with the curve moving out of contango) and from tighter supply dynamics that reduced the need for oil to be transited.
The stocks picture in China remains foggy, yet it remains essential to the question of the rebalancing process. By Barclays' calculations based on Ursa data, much of the build in inventories implied by other components (production, net imports, refinery runs) seems not to be borne out in the observed build in storage. That means that the extent of the stock build and unexplained oil that global balances implied was probably never as acute as thought. If Chinese consumption figures are stronger than most agency balances imply, the draws that are occurring now on a global basis might be even more dramatic. The future would look far brighter if, all of a sudden, the Chinese oil-consumption baseline were 300,000 b/d or so stronger.
In sum, although a significant inventory drawdown has occurred by most metrics and in most regions, the fog of Chinese data; the subjective definition of what rebalancing is; subjective definitions of "normal"; and the market's tendency to shift focus on the fundamentals of the past, present, or future make the question of "rebalancing" a constant issue of debate.
In our view, Falih's concerns stem not from the subjective definitions of "rebalancing" but simply from what the future might hold. Without clarity on Opec's policy or how American tight oil will react to the higher price levels of Q4 2017, underperforming demand and outperforming shale oil might result in significant builds. Most projections still expect supply to exceed demand again in 2018. We expect the inventory drawdown to be temporary, and our balances (as well as those of the US Energy Information Administration) indicate it will reverse even if Opec extends its policy in some form through to the end of 2018.
Yet Opec's conundrum is that if prices are above $60/b and market participants believe the rebalancing is close to complete, market forces could spur more tight oil and reduce long-term demand. Such imbalances might happen even more quickly if one constructs an even more bullish market balance next year than our estimates and others are currently applying. Opec has achieved its course correction, and the ball is in its court to calibrate the timing and magnitude of its response. Is it prepared to let prices migrate higher, thereby releasing a pandora's box of shale output and structural long-term demand erosion? With low near-term data visibility on demand, global inventories, and US tight oil dynamics, sticking the landing will be difficult.
Opec's conundrum is that if prices are above $60/b and market participants believe the rebalancing is complete, this could spur more tight oil and reduce long-term demand. Such imbalances might happen even more quickly if one constructs an even more bullish market balance next year than our estimates and others are currently applying. Opec has achieved its course correction, and the ball is in its court to calibrate the timing and magnitude of its response. Is it prepared to let prices migrate higher, thereby releasing a pandora's box of shale output and structural long-term demand erosion? With low near-term data visibility on demand, global inventories, and US tight oil dynamics, sticking the landing will be difficult.
Michael Cohen is head of Energy Markets Research at Barclays.
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