Commodities | May 09 2017
Brokers investigate the impact for oil prices from the surge in US drilling activity and the clamping down on supply by OPEC. Where will the balance lie?
-At what oil prices will US oil-directed rig activity slow down?
-Concerns re oil prices in 2018 and 2019 based on easy growth in production
-What if OPEC production reductions fail to generate an undersupplied market?
By Eva Brocklehurst
After a sharp sell-off in oil prices in recent days brokers are questioning what it means for the direction of crude into 2018. US drilling activity continues to surge while OPEC is observed to be maintaining its supply discipline. Where will the balance lie?
Deutsche Bank asserts that prices for oil in the mid US$50/bbl are stimulating US drilling activity at a greater rate than demand is growing for oil globally in 2018. This suggests a period of prices below US$50/bbl, combined with the possibility of cost reflation and capacity constraints, which may lead to a plateau in the oil-directed rig count sooner rather than later.
There may be other explanations for oil price movements, such as hedging, failure of technical support levels or weakening sentiment, to account for the recent sell-off but, if these are the only explanation, then the sell-off is better treated as an aberration in the broker's opinion.
Besides the upside to US production, other fundamentals elsewhere appear steady. Moreover, Deutsche Bank notes although OPEC is a key driver of the oil price, the sell-off was not convincingly related to any particular announcement from that cartel. Hence, a delayed response to the unrelenting rise in US crude oil production, and what that signals for 2018, is the broker's explanation for the sudden downward shift in oil prices.
On the other hand, OPEC retains a policy goal to shrink inventories and, if this is the case, this suggests to the broker the market is in the middle of a period of extended supply discipline. Unless there is a slump in overall demand growth – and Deutsche Bank finds no evidence of this as yet – a sustained downtrend in oil prices is, therefore, unlikely.
That may be the case but Citi believes the market is too complacent about a recovery in the oil price. US shale production appears to be coming back quicker than models predicted last year. The broker envisages growth in the US of 1.2-1.5m bopd in 2018 threatens the OPEC drive to re-balance the market. This suggests inflation in oil prices is increasingly unlikely, although the market appears reluctant to accept it. The broker suspects this scenario provides an investment opportunity.
Macquarie concurs regarding the buying opportunity and tackles the question of prices from a different angle, believing better fundamentals should become apparent in the next few weeks. This broker is inclined to the technical explanation for the recent sell-off because fundamentals are improving.
OPEC is expected to extend its cuts through the second half as inventory reduction goals have not been met. The broker calculates that the global oil market is on track for deficits in the September and December quarters of 450,000 and 1m barrels per day respectively. Refined product drawdown should also be supported by strong underlying demand. Macquarie remains constructive on the balance of the year for prices, but bearish about 2018 and 2019, and believes depletion rates will matter for 2020 and beyond.
Concerns regarding 2018 and 2019 are based on the potential for easy growth in production. Macquarie expects OPEC cuts will reverse in 2018 but at around 1.5 barrels gained for every one barrel reduced, because of expansions across the Middle East OPEC members. Additionally, Macquarie also believes 2018 and 2019 prices will be affected by outsized growth in US production.
US Shale
Citi suspects the industry/market is missing several aspects of the US shale resource. Firstly, the shale learning rate – the rate of change in unit costs every time capacity is doubled – remains phenomenal, and price bulls tend to cite supply chain inflation as a threat to shale economics. Yet, Citi believes these high learning rates leave a lot of scope for shale to absorb inflation. High learning rates translate into an availability of cheap money as well. The broker estimates that shale is able to fund itself around 200 basis points cheaper than the global industry.
This distortion enables 15% more shale production and lowers the cost curve by US$5/bbl. The net result is that global demand appears to be met at oil prices that are not too far away from current levels. Citi suspects 2017 is also the year such realisation will dawn on the market. Business models that require oil price inflation to underpin investment options and/or returns should be carrying more risk than they do today, in the broker's opinion.
Inventory Drawdown
Morgan Stanley acknowledges investors could be a little underwhelmed by the production cuts by OPEC so far, although compliance is widely reported. Furthermore, imports of OPEC oil in key countries such as the US and China show little sign of slowing. Morgan Stanley believes timing is the key and the conundrum can be explained by the difference between arrivals and imports on the one hand and loadings and exports on the other.
In coming weeks imports and arrivals should start to reflect the recent cuts to loadings. This implies a tightening market. Whether loadings and exports will catch up with the decline in OPEC production, remains harder to identify.
Still, the broker highlights visible OPEC inventory which suggests stocks are already getting back to normal levels and this means the balance of 2017 should witness meaningful drawing down, which should support oil prices in turn. Although demand has gone through a soft patch early in the year it should strengthen seasonally into the second half, the broker concludes. Combined with lower OPEC production this should mean a period of drawdowns is on the cards.
Morgan Stanley forecasts a balanced market in 2018 with prices broadly in line with the end of 2017. The broker recognises that US drilling activity is growing faster in recent weeks and, if this continues, could be a downside risk to forecasts. The broker calculates that with around 390 rigs added to the trough levels of May 2016, the US is set up for strong supply growth next year. Morgan Stanley suspects, if OPEC's production cuts failed to generate an undersupplied market by the end of this year, the market may then be oversupplied in 2018, and acknowledges this scenario appears to be creeping into expectations and time horizons.
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