Having been bullish for nearly half a year, yesterday Goldman’s flipped again, when it cut its Q4 oil price target from $50 to $43, admitting the previously anticipated rebalancing will take longer to achieve, and now expects “a global surplus of 400 kb/d in 4Q16 vs. a 300 kb/d draw previously.” Moments ago, the same Goldman analyst released a follow up note, confirming what we have been saying for the past year, namely that OPEC is increasingly irrelevant as a marginal supply-setter in a world in which it is the lack of demand that is a far bigger threat.
In “OPEC won’t stop oil going”, Damien Courvalin writes that “an OPEC deal to curb oil production, either today or at the November meeting, is thought more likely than at any point in the past two years.” That said, he notes, “we remain sceptical of its impact. For one, our production forecast continues to reflect a seasonal Saudi production decline into year-end, with no growth elsewhere. Second, even with this OPEC help, our updated oil supply-demand forecast now points to a renewed build in inventories in 4Q 2016 vs. a forecast for a draw only last month. This weaker oil outlook into year-end led us yesterday to lower our year-end WTI oil price forecast to $43/bbl, from $51/bbl previously. Given a well-supplied market and a crude curve in contango (with limited spot upside).”
Here are the details behind Goldman’s pessimism:
Intraday oil price volatility has picked up over the past week and ahead of today’s OPEC advisory meeting in Algiers. Statements by participants suggest a deal to curb production today or at the next meeting in November is more likely than at any point over the past two years. We remain sceptical of its impact, for two reasons: (1) independent of today’s outcome, our production forecast continues to reflect a seasonal Saudi production decline into year-end and no growth elsewhere, the equivalent of a deal; and (2) even with this OPEC help, our updated oil supply-demand forecast now points to a renewed build in inventories in 4Q 2016 vs. a forecast for a draw only last month.
This weaker oil outlook into year-end led us yesterday to lower our year-end WTI oil price forecast to $43/bbl, from $51/bbl previously, and still below the forward curve even after yesterday’s sell-off (“Beyond Algiers, weakening oil fundamentals,” September 27, 2016). While a potential OPEC deal today could support prices in the short term, we find that the potential for fewer disruptions and the relatively high speculative net long positioning instead leave risks to our forecast squarely skewed to the downside. Given the uncertainty on forward supply-demand balances, we reiterate our view that oil prices need to reflect near-term fundamentals – which are weaker – with a lower emphasis on the more uncertain longer-term fundamentals.
This renewed weakness in fundamentals reflects the three key drivers of the ongoing oil market rebalancing:
- New Oil Order: Low cost production continues to surprise to the upside, most recently in Saudi Arabia and the UAE, previously in Iraq and Iran, and next in Russia. This relentless production growth reflects the core of the New Oil Order, where the flattening of the oil cost curve created by shale leads to a loss of pricing power by low-cost producers, leaving them with only volume growth to sustain fiscal revenues (“OPEC loses pricing power, shale shifts to the margin,” October 26, 2014).
- Wall of Supply: The ramp up in new production capacity outside of OPEC is set to accelerate into year-end, with 2017 additions of projects started up to 2014 expected to be 30% higher than in 2016 (“The Battle for Capital: A Flatter Cost Curve Drives OPEC Growth and Non-OPEC Deflation,” Top Projects 2016, May 20, 2016). In turn, the US production declines are set to slow even at the current low rig count given the rising age of producing wells (less drilling of new wells) and the much smaller decline rates of mature shale oil wells.
- Détente: Collapsed fiscal revenues are incentivising both a ‘detente’ in areas where geopolitical conflicts have disrupted production as well as a deflationary reduction in local taxation as countries fight to compete with US shale for revenues and capital (“More worried about a thaw than a freeze,” Commodities Research, August 22, 2016). As a result, the surge in short-term production disruptions that balanced the oil market unexpectedly in 2Q 2016 is slowly starting to reverse.
Importantly, even if disruptions remain at current levels in Libya and Nigeria, and Saudi reduces production into year-end, we project that global oil supply will continue to rise in coming months driven by low cost production growth and new project deliveries. We continue to view such supply shifts as the key drivers to oil prices through 2017, especially given today’s high level of inventories. Oil demand growth, and in particular China’s, has remained the bright spot of the oil market over the past two years. This strong demand growth has been supported by both low prices as well as the ongoing rotation from investment to consumption which put downward pressure on demand for CapEx commodities used in infrastructure and manufacturing, such as steel, relative to OpEx commodities exposed to consumer spending, such as oil.
Medium term, we believe that the decline in drilling activity around the world is still setting the stage for an eventual recovery in prices. For now, our 2017 outlook remains unchanged, with demand and supply projected to remain in balance and WTI oil prices to average $53/bbl, with a 1H 2017 expected trading range of $45-$50/bbl. The risks around this forecast remain high, however, with our forecasts conservative on both further low cost production growth and further disruption reversals, which combined represent today 1.6% of global supply, the equivalent of the average global oil surplus observed during 1Q 2015 – 1Q 2016.
Assuming, for example, that global supply exceeds our forecasts by 400 kb/d (0.4%), our models imply that oil prices would need to average $43/bbl on average next year. Such a scenario is not that unlikely as it could be reached either (1) with half of Libya’s and Nigeria’s current disruptions reversing, (2) 2017 non-OPEC new projects coming online in line with company guidance instead of our lower ‘risked’ forecasts, or finally (3) Iran and Iraq delivering on their advertised production growth instead of our more conservative expectations.
Given our outlook for a well supplied market and a crude curve in contango with limited spot upside, we continue to recommend being short the S&P GSCI Crude Oil index, especially paired with positive yielding oil-exposed assets such as HY E&P credit, which is our recommended Top Trade #8.
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