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Oil Producer Report

Crude Oil Trading Report: Better entry point ahead for producers

By March 12, 2018No Comments

The market is looking for direction, pinned between seasonal weakness and verbal intervention from Saudi/Russia defending the $60 bbl line in Brent.

We see better entry points ahead for commercial producers with a strong asymmetry in their favour. Essentially, the heavy lifting has been done with a multitude of supportive events ahead. Any pullback should be used to optimise hedging books.

While the “Central Bank of Oil” intervenes, three key variables matter for the oil market: 1) macro, 2) shale exports and 3) geo-political risk ahead.

THREE DOMINANT VARIABLES

The presence of CTAs ($14bln), risk parity ($7bln) and passive index funds ($36bln) has increased the importance of global macro indicators including volatility, inflation, Fed policy, equity market performance and yield curve. These indicators are set to have an outsized impact on flat price direction as non-oil specialist flow is now the single most dominant concentration of length in the front of the curve.

From a fundamental perspective, global macro matters more than ever as above trend-line oil demand growth is the key ingredient to inventories reaching the 5-year moving OECD average.

Consensus oil demand forecasts for 2018 are between 1.6-1.7mb/d – above the 10-year trend-line growth of 1.1 mb/d (2008-17). Strong oil demand growth is critical to offset the wall of US shale growth. For context, the oil market has not seen four consecutive years of >1.5mb/d oil demand growth since the 1970s.

Trump’s announced tariffs on steel and aluminium pose a risk for an outright trade war, however, retaliatory measures have been limited and more importantly, the impact and response from China has been inconsequential.

2) US shale growth.

The EIA recently increased its US shale forecast to 1.3mb/d in 2018. US shale growth estimates are in line with peak 2014 levels (1.3mb/d). Aggressive growth forecasts on shale are well discounted by the market, at this point, as analysts race to outdo the other with ever growing supply forecasts.

We are watching closely and while we see shale growth as a primary risk to stronger prices in 2H 2018 there remains growing uncertainty on the magnitude and sustainability of this growth.

Infrastructure constraints, not only pipeline bottlenecks but oilfield supplies such as sand, as frac equipment may limit supply growth.Cost inflation is another limitation and Trump tariffs on US steel imports will do nothing to relieve these concerns.

Further, shale’s focus on profitable growth, while offering a return on-and-of capital to shareholders, puts a cap on growth as challenges remain for companies to spend and pay dividends within cashflow with WTI trading in the $60/bbl range.

PRICE & VOLATILITY | ICE BRENT

PRICE & VOLATILITY | ICE BRENT

What did raise some concern was the recent IEA 5-year outlook. The concerns are twofold:

a) Non-OPEC supply is expected to meet all incremental demand growth through 2020. Oil markets typically weaken when non-OPEC supply growth exceeds/meets incremental demand growth as it threatens OPEC (and this time Russian) market share.

b) US shale is estimated to meet 60% of future oil demand growth. This alone seems manageable, but, the growth in US export capacity suggests that every incremental growth barrel from the US will be exported. We have repeatedly highlighted that US export capacity growth remains the key concern for Atlantic Basin crude (Brent) and Saudi and Russian market share in 2019 and 2020.

3) Political. The list includes further US sanctions on Venezuela in the lead up to election at the end of April, potential roll-back of US sanctions on Iran, increase in Middle East tensions with a recent article from the Financial Times that highlighted the growing risks of a second Arab spring.

At the moment, US shale growth forecasts have been offset by stronger than expected oil demand, while concerns on global macro and policy have been counterbalanced by growing political risks in OPEC producing countries. Brent has been relatively unchanged over the past month, but these factor as set to play a deciding part for 2H 2018.

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Long-term Oil Demand Trends | Source: BP 2017 Statistical, IEA, EIA and OPEC

Long-term Oil Demand Trends | Source: BP 2017 Statistical, IEA, EIA and OPEC

CTC TRADING VIEW

We are bullish 2H 2018 with stock draws ranging between 250-350 kb/d. We are currently in the “eye of the storm” with current market weakness due to seasonal factors. Should bears prevail over the next month, pushing prices lower, we view it as an opportunity for producers to restructure 2018 hedges (a period with already good hedge coverage ratios), with a plan to roll up calls and/or sell puts to convert collars into 3-ways.

For new hedges, we see better entry points as we approach 2H 2018, where supply/demand balances look more constructive.

VOLATILITY

Lastly, a couple of trends that are likely to remain consistent throughout 2018. First is higher volatility driven by higher interest rates but also growing concerns on government/Fed policy risks and growing geopolitical risks in OPEC producing nations. As we explain to our clients, volatility comes in clusters. Note that the S&P 500 had 7 days of +/- 1% move in 2017 – it has had 17 such days since the beginning of the year.

CONSUMERS BACK WITH POTENTIAL SURGE

Second, is the re-awakening of consumer hedging driven by new International Maritime Organization (IMO) spec changes to high sulphur fuel oil. Compliant fuels look to be the most likely solution with incremental distillate demand estimated at 2.5-3.0mb/d. Jet fuel demand remains a key driver of oil demand growth through 2025, therefore the pull on overall middle distillate demand as well as a backwardated curve will lead to more consumer hedging activity.

The recent weakness in Brent and gasoil spreads suggests activity levels have already picked up. Our conversations with major transportation companies point that many are on the side-lines eyeing large volume hedges.

For producers, the more balanced flow in the backend of the curve between producers and consumers will improve hedging levels with lower put skew and potential shallower backwardation.

PLEASE CONTACT THE DESK FOR FURTHER DETAILS.

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