So much has been thrown at the oil market so far this year: Concerted cuts from OPEC+ along with almost daily headlines from officials talking the market up. Geopolitical tension and equity markets rising and the narrative from sell side research on a bullish tone.
Still, Brent is hitting a wall at the ~$68/bbl level. The physical market is improving, which is significant for Brent related crudes. Assuming “macro holds”, Brent looks on target for a leg up to the low $70s/bbl.
Producers are lined-up, actively hedging at current levels, which represent decent risk/reward. This is having important consequences for producers’ hedge books with the value of optimal hedge structures has shifted rapidly.
Consensus demand growth expectations for 2019 remain unrealistic. Overall, the market seems to be sleepwalking into a growing uncertain and unstable market environment with game-changing developments unfolding for both the oil bulls and bears on geopolitics and macro-economics.
*Contact us for detailed analysis on CTC’s Brent-linked hedging survey
CLEAR TIGHTENING IN BRENT
The supply side is improving: Expectations for 1Q 2019 were that it was going to be the weakest quarter with initial stock build forecasts ranging between 0.5-1.0mb/d. However, Saudi Arabia’s compliance to production cuts and unplanned supply outages near 5-year highs throughout most of 1Q19 averted the worst case scenario.
There is no more financial incentive to store Brent with the front-end of the curve in steep backwardation now – SEE CHART 1 – and balances will improve as a result.
There are a multitude of reasons for this but we will point to the main one which is the that Saudi is cutting hard (and willing to compensate for laggards). Further, OPEC is talking the market up in a way we do not recall seeing with a focus on price metrics which is also, on the face of it, at opposite with President Trump tweets (latest one on the subject: “‘OPEC should increase the flow of oil”).
On this, we found the interview of Saudi Energy Minister Khalid al-Falih and analysis in EIG’s Petroleum Intelligence Weekly as most instructive: As they point out “Saudi oil policy this year will focus first on steering Brent crude into a $70-$80 range, and then on keeping it there” and that Saudi’s intentions are of a permanent management of oil stocks. That we have never seen before, intentions are far-reaching indeed.
The challenge with OPEC essentially building spare capacity is that historically it has always ended badly and to us, is the driver behind the 2014 & 2016 plunge in prices.
Historically, OPEC has been adept in managing short term negative demand shocks. The 1998 Asian crisis, 2000/01 Dot-com/911 economic and even the 2008 financial crisis demonstrate times when OPEC was effective in cutting supply and a subsequent oil market recovery within 12-18 months. However, the emergence of the North Sea as a primary growth engine for non-OPEC production in 1986 was a period, where OPEC built significant spare capacity and low, range bound oil prices lasted through to 1999.
Saudi is going through challenging times and domestically aims to increase spending and handouts, which are mathematically impossible without a massive deficit even at current OPEC basket price of $67/bbl. Saudi will need a Brent equivalent of $75/bbl minimum in our analysis. This is not a given with the macro-economic uncertainty ahead with China slowing and a White House focused on protectionism.
BRENT SPREADS IMPROVING SIGNIFICANTLY | Blue line – av. front 3 spreads, Orange line – Brent physical/paper spread and White line – Brent Price | Source: CTC & Bloomberg
VENEZUELA & IRAN – CRUDE DISLOCATIONS & “SOME” FLAT PRICE SUPPORT
The US has imposed sanctions on Venezuela in an effort to push Maduro into capitulation and hand over power to Juan Guaido. The immediate impact on the oil market has been a narrowing of the light/heavy differentials. Iran and Venezuela sanctions in combination with OPEC, Canadian production cuts and growing US shale production has created a mismatch of heavy/light barrels in the market.
Ultimately, the consequence of US sanctions on Venezuela production and oil prices depends on how long the power struggle takes to play out. A quick transition, which the White House was aiming for, was angled as bearish for oil prices and (again…) is proving so far geopolitical miscalculations.
The US policy goal in Venezuela was for regime change, and in short order. It appears evident that the situation is not heading towards a quick (US) solution and that tensions will persist, impacting oil flows.
Whether the White House calculates a perceived “win” in Venezuela as impacting their decisions on Iran waivers renewing in April/May is unknown.
We recall that some initially were arguing that rising Venezuela production (with Guaido in place) would allow the US to back a “zero oil export policy” on Iran. In broad terms, Iran barrels would be replaced by like-for-like Venezuela barrels. Latest comments coming out of US officials and Secretary of State Pompeo’s CERAWeek speech to punish “bad actors” now indicates a willingness for maximum pressure on Iran either way.
The bull case, therefore, assumes a drawn out regime change in Venezuela that coincides with the non-renewal of waivers on Iran. Sanctions on both Venezuela and Iran would strain OPEC spare capacity and lead to a geo-political premium in the market. The US could use the SPR to dampen any immediate impact on oil markets. Adding light-to-medium barrels to the market would overhang benchmark crudes such as WTI and Brent, which would likely trickle down to lower pump prices, a priority of the Trump administration.
BARRELS AT RISK – Libya, Venezuela, Nigeria and Angola production coming down significantly (blue line) | Source: CTC & Bloomberg
PRODUCERS ARE SELLING
Large producer hedge programs are going through the paper market at the moment. Most talked about recently is the $320 mil premium spent by Petrobras to buy a $60 put for the balance of the year (in our calculation on ~130 mil barrels).
It is not just sovereign-type hedges, but also N. Sea and W. Africa production, often RBL-linked, which are underhedged and coming to the market.
Our proprietary analysis of Brent-related hedging of some 40 upstream companies points to some interesting trends and drivers on hedging – CONTACT US FOR OUR BRENT HEDGING SURVEY.
The result of increased producer activity is significant on the derivatives market (and impacting new hedge structures).
Volatility structure and value has completely flipped in the past two weeks with put protection now at a significant premium. This is equivalent to ~$1/bbl dollar higher now for a zero-cost collar.
This means producers must modify, time and carefully choose their option strategies – CONTACT US FOR OUR RECOMMENDATIONS.
The impact of consumer buying flows drying up with oil above $65/bbl combined with active producer hedging, is also impacting the forward curve. The front end is driven by OPEC+ cuts and a bullish narrative while the back-end of the curve is repressed lower by producer hedging flow.
It is our strong view that a move higher in brent to the mid $70s/bbl will result in only a marginal move higher in CAL20+ oil prices.
BRENT FORWARD CURVE – ORANGE is current and GREEN is 15th March 2019 – Brent price is higher in the front-end but now lower in the back-end | Source: CTC & Bloomberg
DEMAND EXPECTATIONS WILL DISAPPOINT
Consensus 2019 demand growth estimates – when averaging EIA, IEA & OPEC data – forecast 1.4 mil bpd. Revisions lower are inevitable (possibly by 300 kbpd).
- The US had ~450 kbpd demand growth in 2018, this was mostly on the back of “Trump tax cuts” and boost to US GDP in 1H 2018. We see no tax relief in 2019 but US internal political battles just when the FED is “flipflopping” on policy. Our readers need to think about macro implications this year.
- Polarization of politics to affect market in 2019: The EU looks to be undergoing a socio-economic upheaval. “Strong men” are elected, Brexit clouds, “gilets jaunes” movement, Italy’s debt and at least 4-consectutive months of declining German industrial output – the EU region will not be a pocket for demand growth.
- China: We monitor electricity consumption and earnings from companies such as Caterpillar (CAT) as a bellwether for EM growth and specifically machinery sales in China. In-short, China is slowing fast and US-Trade war is having a notable negative impact. Last year, ~80% of oil demand growth came from trucking/diesel consumption in China + India, expectations from that region are at risk this year.
BRENT PUT PREMIUM HIGH AS PRODUCERS BID IT HIGHER AS OIL PRICES RALLIED | Source: CTC
WHAT WE ARE WATCHING
In oil, major outages from “barrels at risk” are critical: Libya, Venezuela, Nigeria, Angola, KRG pipeline and updates on Kuwait neutral zone restart, will need to be monitored. Geopolitics will dominate and events in LATAM and in the Middle East will impact oil directly.
We remind our readers that if equities selloff and the S&P500 retests its December lows, we firmly believe that oil will fall in a vacuum and trade through the $50/bbl lows.
Last year, the bulk of demand growth (60%+) came from two countries only: The US and China. It is quasi-guaranteed that this will not repeat in 2019 and also makes US-China trade wars by far the most important variable to watch.
The outlook points to higher for 2Q 2019 which would provide a window of opportunity before the surge is US light sweet exports hits the seaborn market at the tail end of 4Q 2019.
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