Crude Oil Trading Report: OPEC defending the $60 put

OIL DRIFTS INTO NO-MAN’s LAND WITH SAUDI/ RUSSIA PUT FIRMLY IN PLACE

Saudi Arabia and Russia gave a 10/10 market performance by agreeing to roll over production cuts until the end of 2018. We would argue with a positive surprise with the inclusion of Nigeria and Libya into the production agreement.

The lack of movement in oil prices throughout the curve and the magnitude of the selloff in near term volatility and put skew suggests that market participants were provided with none of the potential fireworks promised by many of the investment banks.

The funds long in size the $80 and $85 calls and the “asymmetry to downside” short dated put buying were both wrong.
The solidarity of the joint announcement from the world’s two largest oil producers, Saudi Arabia and Russia, was exactly what the market needed to extinguish doubts.

Russia appears economically more comfortable at $50/bbl than Saudi Arabia, however it is safe to say both prefer $60/bbl. We are expecting Saudi to defend price if the $60 bbl Brent line is crossed (on compliance and production cuts).

A DEEPER UNDERSTANDING OF POSITIONING

We believe that analysing the composition of the length increase at the front of the curve since September, is key to price direction. We see the 1,250mbbl of spec money in the complex now is comprised of 350mbbls of net length held by hedge funds and CTAs.

For this category, pivot points are clear, the $60/bbl floor provides the “line in the sand” not to be crossed below. One of the key variables we are monitoring here is our momentum model replication signals for a flip from “buy” to “sell” signal. The magnitude of such a shift would be colossal for the paper market. A trigger from max long to short makes the U-turn a ~700mbbls position. For perspective this is equivalent to the entire US shale annual hedging program (but placed over a few weeks).

These long positions need a geopolitical event in the Middle East or Venezuela that would be enough to provide a catalyst to safely unwind. While fundamental supply/demand balances are constructive, the thin line between over/under supplied global markets does not permit this position to unwind without moving the market meaningfully.

A very similar scenario played out in March 2011 with the Arab Spring taking down Libyan production. Arguably, Middle East geopolitical risk is at, or above Arab Spring levels currently, particularly when growing tensions between Iran and Saudi Arabia are considered.

This is enough to dis-incentivise short sellers (until year-end) but the verdict remains out if it is enough to keep the CTA length at bay.

Our analysis has index funds representing more than 500mbbls of the net speculative length. This is important to understand as it is ‘sticky money’; driven by backwardation and positive yield roll. We are just entering the contract roll window for BCOM (Bloomberg Commodity Index) and the SPGSCI Commodity index roll positioning.

For this category, we believe monitoring structure is key to flat price direction into year-end (and inflows into the wider commodities sector for 2018).

UNCERTAINTY LOOMS INTO 2018 ON BOTH DEMAND AND SUPPLY

The market faces significant uncertainty on demand /supply as we enter 2018. Most important, the market will lose an important tailwind, steady stock draws. For the 1H 2018, the market will be slightly oversupplied in the order of 200-300kb/d. This is well below seasonal norms but builds could dent the positive narrative that has been building in oil.

Overall, the supply/demand outlook for 2018, as a result of the OPEC/NOPEC production cut agreement flips from a modestly oversupplied market of 200 kb/d to a deficit of 200 kb/d. This narrow shift to a more constructive outlook looks less appealing for the incremental buyer given the uncertainties involved.

Below is our guide through the primary concerns in 2018 balances. Reconciliation of these factors will determine price trajectory:

1. Oil demand: Oil demand growth since 2010 has been the highest since 1970s (let’s think about that for a moment!). Consensus oil demand (IEA, EIA, OPEC) is estimated to grow at 1.5mb/d in 2018. This represents the 4th-consecutive year of >1.5% YoY growth, something not seen since 1994-97 period. Demand also has its work cut out for it as it is unlikely to get the same contribution for OECD countries. The US and Europe contributed ~400 kb/d to 2017 growth (25% of total 1.6mb/d). A demand recovery in places such as Russia and Brazil must fill the gap. We remind our clients that China demand between the highs of early 2017 to past 3 month average swings by almost 1m/d (it makes OPEC/NOPEC deal look less significant!).

Additionally, global Central Banks will be tightening monetary policy. Granted, this is from a low base but could be a headwind to maintain record demand growth forecasts. Refining margins and timespreads for refined products have weakened from very healthy levels. If margins continue to drift lower it could signal that demand outperformance has potentially run its course. We are monitoring!

2. North American production growth (exports matter most!): Canada and US production growth is expected to average 1.2mb/d. However, the real risk in 2018 is the potential expansion of export infrastructure in the US gulf coast. Simply, holding exports constant at the 2-month average suggests a 580 kb/d YoY increase in oil imports into the Atlantic Basin – this is before production additions of 1.2mb/d. Projections have export capacity rising to 3-3.5mb/d by the end of 2018. This could increase average export levels to over 2mb/d for 2018, representing a YoY increase between 0.9-1.1mb/d imports into the Atlantic Basin.

While an increase in US shale production is needed to balance markets in 2018, the increase in exports suggests that it is less than the 1mb/d Q4/Q4 growth implied by current consensus forecasts. Infrastructure expansion unlocking previously land locked crudes poses a significant risk to oil markets in 2018 as it implies a much lower production response from US shale to possibly unbalance oil markets. A Dubai-WTI contract has been established and highlights that the Pacific Basin plans to participate fully in the expansion of North American crude supplies. The US recently moved into China’s top 10 for crude importers. A move higher at the expense of Russia and Saudi Arabia may realign incentives between the two nations.

3. Geopolitical risk within OPEC: Growing Middle East tensions as well as Venezuela default risks have kept short positions near record lows. Spare capacity within OPEC is roughly 2.0mb/d, therefore little room remains for any long term production outages. There are so many flashpoints at the moment that it becomes hard to pinpoint an order or timeline.  We will note simply that the “noise level” is reaching an untenable level and that we expect risk-premia to become more embedded into energy markets into next year.