Since hitting bottom at $42 in June, there had been some signs of life for crude (WTI) as prices crept back up to above $50 with little fanfare. Is this the end of the tunnel for the 3-year oil slump?
Oil markets have reacted calmly in the past two years to various geopolitical events that historically would have caused price spikes. From the escalation of Syrian civil war, the attack on Saudi embassy in Tehran, the Iran-Saudi feud and the related Qatari embargo, to the independence referendum in Iraqi Kurdistan. Nothing seems to move the needle. Many wonder if this is the new norm.
First thing first. In commodity markets, one always has to remember the second-order effect – all the headlines of conflicts, strikes, and natural disasters matter, but only to the extent of how they affect the underlying trends in supply and demand. Commodities have end users, so when the fundamentals exert themselves, especially on the margin, minor events can create shocks. When sentiment runs ahead of fundamentals, even minor positive news are exaggerated; when sentiment sours, every minor bad news brings intense selling pressure. Recent events did not move the market individually not because they don’t matter. Rather, conditions were just not ripe for them to overcome the fundamental forces. They, however, give clues to the direction of travel. We argue that the collective and cumulative effects can set the foundation for conditions for a breakout to the upside later. Consider the following:
- The general sentiment for oil among analysts and investors has improved vastly since the summer. Crude oil volatility index OVX is now at the lowest point since the summer of 2014.
- Hurricane Harvey’s effect is largely in the rearview mirror as refineries are recovering and stockpile is being drawn down again.
- Seasonality is a headwind as we head into winter low demand season but crude inventory levels are trending decidedly lower.
- North American rig count is rising but stabilizing; rig productivity should be lower from here on out. Gains from the first wave of 2017 rig addition are running out.
- Shale producers have largely hedged out 2018 production so selling pressure should abate. The term structure from mid-2018 out is in backwardation, reducing incentives to hedge and signaling short term bullishness.
- New production from past investments (oil sands, offshore) is coming online but the pace is still modest.
- Iraq-Kurdistan-Turkey feud is cooling but can still escalate, threatening 500kbpd supply disruption.
- Libyan/Nigerian production ramp has been inconsistent. Venezuelan sanction is on the table.
- Iranian sanction uncertainty could prove bullish, though a unilateral sanction from the U.S. would only have partial effect by just shifting some barrels around.
- OPEC rhetoric about production cut extension through 2018 is positive, especially after recent Saudi-Russia’s gesture toward joint venture and managed output.
The last point about Saudi-Russia coordination is not trivial. There is a sense of urgency on the Saudis’ part to lean away from the U.S., diversify their economy, set the stage for Aramco IPO, and race ahead of peak oil (demand) in the coming decades.
Upon examining the data, we believe the short term (rest of 2017) net effect of these factors is bullish for oil prices, but medium term outlook is murky as worldwide inventory level may resume its climb in the latter half of 2018, especially if the synchronized global growth stumbles. Consensus world oil demand projections at this point are pretty rosy and perfection has been largely baked in to prices. Any signs of a general economic slowdown are bound to have an outsize effect.
Political tension in the middle east is worrisome. With Russia re-establishing influence across the region at the expense of America, Saudi power transition, Sunni-Shia competition intensifying, pressure is building up for a sudden crisis. The structural decline in oil price volatility, as discussed in our previous article, is likely to persist due to the fine balancing acts from American shale producers. However, the return of risk premium due to geopolitics is a distinct possibility in 2018. Amidst a tightening market, it could provide a floor for oil prices in case of an economic shock.
Kronos Management, LLC
October 24, 2017
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