Uncertainty looms for the energy market
Traders believe the market may balance by the end of 2016, but until then the future is uncertain
Is the worst over? Market sentiment may be shifting, even before the fundamentals really have their say. For the past two years, the prevailing wind has been bearish. Demand growth has been weak, thanks to economic problems in Europe and the transition from an investment-led to consumer-led economy in China. The supply side has reinforced this picture of market weakness. The phenomenal growth of light tight oil production in the US, rising oil sands output from Canada and, since autumn 2014, Saudi Arabia’s reluctance to withhold supply have all pushed oil lower.
Now the perception is starting to change. The futures curve no longer shows the steep contango that was seen earlier this year, suggesting traders believe the market will balance towards the end of 2016. If the fundamentals play out as the market now seems to think they will, $60 a barrel Brent might just be the start of a gentle rally that will leave prices at a new “Goldilocks” level: not too hot, not too cold, but just right; a price that keeps both demand and supply ticking higher, pretty much in balance.
At least that’s what producers might hope. There’s still plenty of uncertainty that might muddy the waters.
Start with consumption. The International Energy Agency (IEA) says “unexpected pockets of demand strength have emerged”, most likely in response to the falling price. Demand data lag supply data by several months, so the full picture isn’t visible yet, and some of the demand isn’t consumption, but stock building. But India and Russia, for example, are showing bigger-than-expected consumption growth.
Cheaper fuel and a healthier economy have helped push US demand higher, too. There is some evidence – including a slight fall in fuel economy, according to the University of Michigan – of SUVs and light trucks coming back into fashion. The IEA expects demand to rise by 1.1m barrels a day (b/d) this year, helped along by the improving macroeconomic picture (that is, more travel and more goods being bought, made and sent around the world). It is a big lift from the 0.7m b/d seen for 2014, but hardly gangbusters. Above all, note that we really won’t know how quickly (or slowly) demand is growing until much later this year.
If the picture is mixed on the demand side, it’s even more so where supply is concerned. In North America, where the rig count continues to fall, the peak in output may finally be imminent (again) – but it probably won’t last. That’s the forecast from the Energy Informational Administration (EIA), which says that US crude oil output will hit 9.4m b/d in the second quarter of 2015, then decline by 210,000 b/d in the third quarter. Yet, once the market balances later in the year, prices will rise, says the EIA, and US oil output will resume its upwards path. In short, the US supply numbers leave something there for the bulls … and something for the bears. It’s the same in Canada.
Projects already under way could add another 500,00 b/d or so of supply in the next two years, but then the growth peters out – unless prices firm in the meantime, in which case the pause in supply growth may be relatively short. Either way, for now output is going to keep rising, whatever the price.
Then there’s Opec, where the signals are even less clear. The group’s output leapt 900,000 b/d higher in March, to more than 31m b/d. The latest forecasts for the call on Opec now show a significant gap between the year average (29.5 million b/d) versus the average for the second half of the year (30.35m b/d). Either way, Opec is overproducing. If Libya’s output continues to recover – a big if – or Iran’s rises in the wake of a full nuclear deal, things will come to a head. It is possible that in the second half of the year, Opec will have got what it wanted – a slow down in non-Opec supply growth – but face a supply overhang from its own production. At some point, it would have to cut to account for that and face the prospect of non-Opec supply coming back into play to fill in what it had removed.
Reading Saudi Arabia’s motives in all this is difficult, too. For now it’s even pumping greater volumes of oil onto the market. Output reached 10.1m b/d in March, a whopping 390,000 b/d higher than in February, according to the IEA. Oil minister Ali Naimi says output was even higher, at 10.3m b/d (which was the number the kingdom reported directly to Opec). Exports have been rising steeply.
But all may not be as it seems. Some Opec watchers remain convinced that the kingdom, under pressure from fellow group members, is already preparing to shift strategy. “They will cut, but only into a firming market, perhaps later this year,” says one senior analyst close to the Saudi ministry. Certainly, recent speeches from Naimi and Ibrahim Muhanna, an advisor to the minister, have left open the prospect of cuts – but only if key non-Opec producers (for which, read Russia, Mexico and possibly Norway) agree.
Indeed, Muhanna confirmed what Petroleum Economist exclusively reported just after the Opec meeting in November: that the kingdom had been ready to agree cuts with Russia and Mexico, but failed. “Neither non-Opec producer was prepared to cut. They have their own reasons. So Opec took a bold decision. In the current circumstances, it could not act alone. It agreed to keep the same production level and to let the market balance itself.”
In other words, it was only after Saudi Arabia could not get the cuts it wanted that it decided on Plan B, the market-share strategy. It means that Plan A remains viable. Seen in that context, Saudi Arabia’s increased production in recent weeks could be tactical, not strategic: a ploy to cajole others into cutting by threatening a period of high production if they don’t. Supporting this theory are rumours from within the kingdom that its spare capacity is now in play – that is, no longer to be used as an emergency buffer, but as a tool. At 3m b/d, that spare capacity is a “huge weight” hanging over the market, says Seth Kleinman, an analyst at Citi.
Furthermore, if a cut is to be had then it makes sense for the kingdom to establish the kind of baseline it wants to be cutting from. If it can claim output of 10.3m or 10.5m b/d when the cuts happen, then a 0.5mb/d cut will leave it with plenty of market share.
Iran is also likely a factor in this. Despite their hostility to a deal, the Gulf Arab producers may now be reluctantly accepting the likelihood of one. Iran’s exports are already on the rise – the IEA says heavy buying from China lifted the number to 1.27m b/d in March, compared with 1.1m b/d or so in recent months. (Before sanctions, Iran exported about 2.2m b/d). A swift 600,000 b/d production jump could come within months of sanctions being lifted, says the agency.
That’s a lot of oil for Iran’s fellow Opec members to accommodate. So, if they think a deal likely, it probably makes sense for them to lock in as much of the market as they can before Iranian oil starts hitting a market that still can’t decide its direction.