Investment Strategy  

09/06/2017

Towards a range-bound, yet volatile oil price

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The Organization of Petroleum Exporting Countries’ (OPEC) decision to extend its production cut for a further 9 months came as a relative disappointment to markets, that had been hoping for a more aggressive outcome (deepened cuts and/or more detail on the exit strategy). But it comforted our baseline scenario of a gradual rebalancing of the oil market over the course of the year.

In this Bulletin, we take the opportunity of the recent OPEC news to delve deeper into the details of our scenario of a range-bound yet volatile oil price for several years to come. We see actions taken both by the OPEC and the US shale industry as likely to keep the barrel within a USD 45-60 range, with an average price of around USD 55/bbl in 2017 and 2018 (Brent).

Indeed, with OPEC facing no other rational choice but to stay committed to its “rebalancing act” and maintain a floor on the oil price by restraining production, the most sensitive variable in the equation remains the production cost of the US shale industry or, put differently, the oil price level that triggers investment in new production capacities / production shutdowns.

With the oil price currently at the lower end of this range, we would recommend maintaining exposure to commodities and relative assets. Not only does the downside appear limited, but favorable seasonality also lies ahead. Yet, expect prices to remain volatile as long as the physical market is oversupplied.

OPEC vs shale industry: if you can’t beat them then learn to live with them.
On May 25 the cartel announced that the output curbs set at its prior meeting will be prolonged for nine months, in attempt to end the oil glut in place since end 2014 and rebalance the global market, after the halving of oil prices decimated oil-dependent producers’ budgets. The output cuts by the 12 OPEC and 10 non-OPEC countries (led by Russia) were extended with unchanged volumes and continued Libya/Nigeria exemptions. While compliance will be scrutinized given OPEC’s long history of underperformance, it has actually proved high during the first five months of agreement.

The five-year rolling average of OECD1 inventory was referred to as a key performance indicator, the normalisation of stocks being a required first step for market stabilisation. In this respect, first signs of improvement materialized a few weeks ago in high-frequency data provided by the EIA on US stocks. Interestingly, the latter started to fall even before the start of the driving season. Markets will be keeping a close watch though, due to i/ the still high level of OPEC exports to OECD countries, and ii/ the surprisingly healthy return of US production (more below).

Although some OPEC members (notably Saudi Arabia) still have fiscal breakevens well above USD 60/bbl, they seem relatively satisfied with the oil price improvement since 2016. Indeed, the prospect of only a small production cut resulting in a revenue increase thanks to higher prices has succeeded in keeping all countries, even Iraq and Russia, on board so far.

As the main contributor to the deal, the situation of the Kingdom of Saudi Arabia is key. With its reserves having dropped another 5% in 1Q17 and now standing just above USD 500 bn (down 32% from their mid-2014 peak), financial stress remains elevated. And while efforts are being made on the fiscal front to adapt to the new oil price paradigm, the current fiscal breakeven (USD 74/bbl in 2018 according to the International Monetary Fund -IMF) suggests that reserve drawdown should continue in coming years. That said, the use of Saudi financial reserves can be seen in a more structural perspective. Indeed, medium term, Saudi Arabia’s ambitious annual budget depicted in the National Transformation Plan aims to more than double non-oil revenue. Should this adjustment process prove successful, the Kingdom would be able to reduce its oil breakeven below USD 50/bbl by 2020, assuming production remains stable at 10 million barrels per day.

This year’s resurgence of US shale production has already well exceeded main agencies’ expectations. As such, the US Energy Information Administration (IEA) has revised its 2017 and 2018 year-end shale output forecasts up by respectively more than 450’000 and almost 900’000 barrels per day, whilst keeping its price assumptions unchanged. Implicitly, this suggests that the marginal cost of the US shale industry, i.e. the price level that makes investment in new fields possible and triggers additional production, is lower than originally thought. Most recent estimates2 suggest that after several quarters of cost-cutting and bankruptcies (the default rate reached 25% last year), the shale industry is now more homogenous, with marginal costs ranging between USD 52 and USD 59/bbl – as compared to a higher and much wider USD 57 to 90/bbl just five years ago. Any long-lasting period of 12- to 24-month forward WTI contracts above USD 60/bbl would thus result in additional US supply within 6-9 months.

To contain OPEC member frustration and avoid that their efforts ultimately only help to accelerate the US shale comeback at the expense of their own market share, it will be crucial for the organization to monitor the shape of the forward curve. Once inventory drawdowns are well engaged, the threat posed by OPEC spare capacities should help sustain forward curve backwardation and, in turn, restrain US shale companies’ financing.
For now, while recognising that there is a risk that quotas be relaxed, whether due to geopolitical tensions between OPEC members or mounting frustration regarding the US shale recovery, our baseline scenario is that the OPEC agreement – and, maybe more importantly, the Saudi Arabia – Russia coordination - will hold at least until 2018.

On the demand side, an upside surprise looks possible as emerging market consumption rebounds after several quarter of sluggish economic growth. Combining the forecasts of the three main agencies (IEA, EIA and OPEC) suggests that global 2017 oil demand should be roughly in line with its historical average. Unsurprisingly, most of the incremental demand is to come from non-OECD countries (over 1.2 million barrels per day). Yet, this estimate remains quite conservative in our view. The recovery in emerging markets should really gain traction this year, notably in Brazil and Russia. We would thus not be surprised to see actual data overshooting forecasts. But as long as inventories have not been drained, this would only translate into an acceleration of the oil market rebalancing. We do not think it is liable to push oil prices durably above USD 60/bbl.

Bottom line, we expect Brent to average USD 55/bbl in 2017-2018. For the second half of this year, this means significant upside to the spot price. With the driving season just beginning, seasonality should also prove supportive, while the slope of the forward curve should no longer be a deterrent. Sentiment could also turn more positive with money just starting to flow back into commodity funds and multi-asset portfolios still broadly underweight. Finally, after several attempts since mid-2016, the neutral speculative positioning, close to its long-term average, could also support oil prices. But the volatility of this asset class calls for nimbleness and a close monitoring of trades as a USD 10/bbl rise might be achieved in only a few weeks.

More generally, our baseline scenario of an oil price floored by the OPEC and capped by the US shale industry, along with the stability of the Chinese economy, is an important support factor for the emerging world initiated a year ago.


1 Organisation for Economic Co-operation and Development
2 See “Top Projects 2017”, Goldman Sachs Equity Research

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