Reassessing common (mis)perceptions about the oil market
By Larry Goldstein, Adam Sieminski and Frank A. Verrastro| June 30, 2017 on CSIS.org
For the past two years, we have tended to be aligned with the pessimists camp relative to the timing of oil market rebalance and the ability of the Organization of the Petroleum Exporting Countries (OPEC) or anyone else — absent a significant market disruption — to materially accelerate the turnaround and hold prices above $60 per barrel. At the same time, however, we have reiterated the perils of failing to invest in new large-scale projects. We have also expressed concerns that sentiment was misinterpreting or selectively ignoring a more complete picture of market activity and instead choosing to focus narrowly on and overemphasize individual metrics and data points in that analysis.
With that as backdrop, even the most casual observer would be hard pressed not to notice that market momentum supportive of the “rebalance is almost here” narrative took a decided hit this month as a confluence of data and sentiment drove crude oil prices to their lowest level since OPEC decided to cut production last fall. By mid-month, both Brent and West Texas Intermediate (WTI) crude oil prices had dipped below $45 per barrel (bbl), reaching lows not seen since November of last year. The sentiment change was driven by rising production (OPEC and non-OPEC), stubbornly resilient stock levels in both crude and refined products, and questions surrounding the pace of future demand growth. From a pure investment perspective, the downward price cascade was exacerbated by long positions being liquidated on the spate of bearish news.
As the month progressed, however, a weaker dollar, geopolitical concerns, and the threat of a potentially long and disruptive tropical storm Cindy had market watchers poised to interpret bullishly the “inevitable” inventory draws expected in light of off-line production (the storm temporarily shut in about a sixth of the Gulf of Mexico’s total production) and delayed unloading of imports in the Gulf. On the international risk front, the month of June also evidenced new tensions within the Middle East — Iran launched missiles into Syria, the United States and Russia sparred over airspace, and several Gulf Cooperation Council (GCC) nations took targeted action against Qatar.
With prices at nine-month lows and the prospect of a further decrease (into the high $30–low $40s/bbl range), speculative positioning (the ratio of long to short positions) dropped from 12–1 to closer to 2–1. Over the past week, oil prices have rallied back above $45/bbl, as buyers repositioned to take advantage of the lower prices. Yet questions still remain about the timing and strength of the rebalance.
On the supply side, mid-month projections by the U.S. Energy Information Administration (EIA), the International Energy Agency (IEA), and OPEC all point to substantial non-OPEC oil growth this year as well as for 2018. In addition, with the resurgence of output in Nigeria, Libya, and Iraq, even OPEC’s volumes increased last month. Added to that, OECD oil stocks reportedly rose by some 18 million barrels in April — reaching levels above those in place when the OPEC “freeze” was announced last year. Reports of an uptick in floating storage have also eroded investor confidence.
Perhaps more importantly for market watchers, both the IEA and OPEC monthly reports projected growing supplies into next year and stock draws smaller than originally forecasted, thereby delaying — absent additional action by OPEC — the timing of the anticipated “rebalance” further into 2018.
With large swaths of U.S. production currently hedged this year at prices above $50/bbl, cash flow should be available, at least for now, for producers to add rigs and drill wells if they should choose to do so. Recent concerns over declining productivity in places like the Permian may signal a corner being turned, but these may also be reflective of some producers adding less efficient (and cheaper) rigs or either choking back production (to meet lease hold obligations without further flooding the market) or drilling but not completing wells. EIA data also suggest an increase in the volume of drilled but uncompleted (DUCs) wells added.
In our minds, market misperceptions or misinterpretations are also having an impact, and on this front, at least two items stand out. One is the obsessive fascination with weekly U.S. stock adds or draws (especially without properly analyzing the relationship between crude and refined products, refinery runs and import crude quality needs, price differentials, and export trends). Despite the best efforts of statistical groups like EIA and the American Petroleum Institute, weekly data tends to be noisy and is often revised. It clearly provides some guidance, but it can also be misleading.
A second issue relates to the overemphasis on needing to reach the five-year average on total stock levels as a decisive signal that the elusive rebalance point has been reached. In a growing market, the five-year average is always going to be skewed to the low side. And as storage has grown globally, one can safely assume that, for example, China’s “strategic” stocks (though not highly transparent) are unlikely to be depleted solely to benefit from opportunistic price movements. Similarly, as U.S. production has increased, takeaway infrastructure and changing refinery feeds have necessitated the construction of additional storage along the entire supply chain. In addition, the global oversupply situation (coupled with OPEC’s cutbacks) has produced a variety of arbitrage opportunities and tanker movements throughout the world (and here the price spread between WTI and Brent impacts the extent to which U.S. crude exports are likely to increase or not). So even in the most transparent system, underlying system changes tend to mask what’s taking place on a real-time basis, making estimates even more complicated.
What is abundantly clear is that OPEC’s decision last fall to remove in excess of 1.5 mmb/d of oil from the market in order to accelerate the depletion of the enormous supply overhang “succeeded” in temporarily raising prices, but it simultaneously coaxed out additional new volumes (especially with respect to quick-cycle U.S. unconventionals production) as well, thereby diluting/offsetting the impact of the earlier cuts.
What remains unclear, however, is OPEC’s next move and more, importantly, its “exit strategy” should the current compliance scheme fail to produce its intended result of ridding the world of the vast oil inventory overhang anytime soon. The group will meet next month to reassess its plan for extending the current freeze through March of next year. In the interim, international events — boycotts, trade wars, escalation in regional conflicts, a failed state or two, and the investment choices of the financial community as sentiment waxes and wanes with these events — could alter the market trajectory. OPEC may discuss imposing production limits on previously exempted members. Or perhaps selected members will opt for additional restrictions (at the peril of losing further market share). Less likely in our view — at least at this juncture — is an outcome based on despair in the face of lower prices, with producers abandoning output targets in favor of increasing revenue, as such an unwinding would unquestionably send prices plummeting. Until either geopolitical or supply/demand events provide a stronger signal, we expect an undulating pattern of fluctuating prices to characterize the oil market — for at least the next few quarters, and potentially well into 2018.
Frank Verrastro is a senior vice president and trustee fellow at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Adam Sieminski holds the James R. Schlesinger Chair for Energy and Geopolitics at CSIS. Larry Goldstein is a senior associate of the CSIS Energy and National Security Program. Albert Helmig is CEO of Grey House, a private management consultancy in New York City.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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Originally published at www.csis.org.
