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Oil goes into the red zone

The market is primed for another price rally. The industry needs to update its outlook

Another phase in the oil market's cycle—the bottom half of the circle, when prices slumped, reached their nadir, and recovered—is over. The next phase, which will take prices up around the arc to their peak, is beginning. The industry, still gun-shy after years of price weakness, seems no longer to believe in oil's cyclicality. But this will only reinforce it.

Forget the conference-circuit jargon of "lower-for-longer" and "low-oil-price environment". Scrap notions that American tight oil acting as a swing producer or the "shale band" that would evermore keep prices within a Goldilocks range of $45 to $65 a barrel. Ignore, too, the forward curve—never a predictor of shocks—where summer 2019's oil can be bought for $4-5/b less than mid-May's spot price of around $80.

A surge in oil prices is now odds on. Yes, American tight oil production is surging. But it remains a small corner of the light end of the crude market, unable on its own to meet the soaring middle-distillate needs elsewhere. And yes, oil-demand growth will take a hit at $80/b Brent. But only over time. For now, it's still rising fast—China alone consumed almost 500,000 barrels a day more in March than a year earlier, and India more than 300,000 b/d. Other bullish forces—new US sanctions on Iran, Venezuela's collapse, the risk of a sharp escalation in the Middle East, and chronic underinvestment—are all pushing at once.

Start with Opec and its partners' cuts, which, unless adjusted now, threaten to over-tighten the market. The effort to rebalance supply and demand has succeeded under Saudi Arabia's own terms. The surplus in OECD stocks has now gone—the IEA said in mid-May that the inventory was 1m barrels beneath the five-year average. It's unquestionably the most successful deal Opec has executed.

Mission extended?

Its mission may have been accomplished, but Opec is unlikely to change course in June, for several reasons. First, the group is loath to risk a price drop by announcing an end to its cuts. Saudi Arabia, with an Aramco IPO to launch and costly economic reforms to undertake, is understood to want prices above $80/b. Energy minister Khalid al-Falih says the world has "capacity to absorb higher prices", and the kingdom seems ready to test the thesis. It will take something extraordinary and unpredictable—like an angry intervention from Donald Trump—for an abrupt change in policy.

Second, Opec's cuts will be far harder to unwind this time than in the past. The collapse of Venezuela's output means it's now producing 500,000 b/d less than it agreed in November 2016. Mexico, an outsider that joined the cuts in December 2016, is producing 280,000 b/d less than it pledged. Angola's cuts amount to 150,000 b/d more than it agreed to remove. All told, an abrupt end to the Opec+ deal would, at best, restore just 1.4m b/d or so of the 2.4m b/d withheld from the market. 

Forget the conference-circuit jargon of "lower-for-longer" and "low-oil-price environment"

 

Instead of an end to the cuts, expect Opec and partners to announce in June their intention to keep monitoring the market, and their readiness to supply more if necessary. They might even promise to achieve 100% compliance. This would mean more oil, but only from those that could produce it: Saudi Arabia, Iraq, Kuwait, UAE and Russia. The cuts would effectively change from voluntary ones to involuntary ones (Venezuela leading the charge).

Even then, Venezuela and Iran's fates will hang over the market. Nicolás Maduro's victory in the presidential elections in Venezuela on 20 May seems likely to be the cause of the next phase of rapid deterioration in oil supply. Production in April was just above 1.4m b/d, about 500,000 b/d less than a year ago. But the unravelling of the economic system is about to become more severe.

American sanctions targeting imports of Venezuelan crude into the US and exports of US products to Venezuela, for use as a diluent in the Orinoco heavy oil projects, may follow the elections. This could disrupt up to 500,000 b/d of supply, believe some analysts. The loss of the US market—the main cash buyer of Venezuelan crude—would be devastating to state company PdV's cash flow.

And when PdV and the government fail again to meet repayment obligations later this year on $52bn worth of debt, creditors will pounce. Further asset seizures, following the example of ConocoPhillips, which recently took control of products from PdV's Isla refinery on Curacao, seem likely. Even PdV's Citgo operations in the US—49.9% of which was used as collateral for loans from Russia's Rosneft—could be targeted. It seems plausible that Venezuela's oil output could drop beneath 1.3m b/d in the next few months. Some analysts talk of it plunging beneath 1m b/d or collapsing altogether.

Iran and sulphur

No one can say yet what the impact of new US sanctions on Iran's oil sector will be. The Obama-era restrictions removed 1.2m b/d of exports, but also depended on EU sanctions—which don't seem likely to be re-applied—and the cooperation of Asian importers. Whether Trump will be satisfied with a less-punishing cut in Iranian supply (perhaps up to 400,000 b/d) than Obama achieved, and what he could do if he wasn't, is debatable.

Even factors that were thought bearish before may now be bullish. New regulations to cut sulphur emissions from the global shipping fleet, for example, were presumed to mean less oil demand—especially if liquefied natural gas became the go-to bunkering fuel. Instead, says Morgan Stanley, an investment bank, a scramble from shippers to find gasoil and diesel ahead of the rule change in 2020 will boost demand for crude. Rising supplies of light tight oil don't have the chemical characteristics to meet the new need for middle distillates.

 

Environmental controls on shipping emissions are set to impact the market

 

All this creeping tightness in the fundamentals will only sharpen the price sensitivity to geopolitically induced risk. Indeed, for all the focus on the impact of new US sanctions on Iran—and the EU's attempt to keep the nuclear deal and Iranian oil exports in tact—the underlying worry is that Trump's withdrawal from the treaty is the first major step towards a broader confrontation with Iran, or one between Iran and its regional rivals.

Events in May hardly tempered those concerns. The opening of the US embassy in Jerusalem and the killing of Palestinians in Gaza, Israeli bombardment of Iranian positions in Syria, Hizbollah's rocket attacks on the Israeli-occupied Golan Heights, and the continued missiles launched at Saudi Arabian energy assets by Iranian-backed Houthis in Yemen suggest things are fast spiralling out of control. 

Demand response

If further prices inflation now looks likely, so does a demand response. The IEA has trimmed its forecast for demand growth this year, from 1.5m to 1.4m b/d. Patrick Pouyanne, Total's boss, says $80/b will inevitably start to cut into demand, which was only so strong because the price was so low for so long. It's sound economic logic.

But the problem with demand is the data take several quarters to emerge. In the meantime, later this year the world will consume 100m b/d for the first time, according to the IEA—in the fourth quarter, just when any impact from new Iran sanctions will start to be felt and other supply-side risks could be reaching their boiling point.

All the while, outside Texas few companies are willing yet to start sanctioning new projects. Opec, citing Rystad Energy, says upstream spending outside the group will rise by just 3.5% this year and 8.1% in 2019. Capex, including exploration, remains 42% beneath the level in 2014. That's despite a 75% increase in oil prices since mid-June.

"No one wants to do anything that doesn't work at $50/b," says an executive at one independent. That's a sentiment held across the industry's c-suite, where gloomy price assumptions are still gripping like it's 2016. Unless demand really starts to drop off—or producers start soon to believe in the price rally—the industry's bearish fears will become one of the market's most bullish forces.

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