26 November 2018
After a strong rebound earlier in the year, oil markets face a challenging final quarter of 2018. The previous rally in Brent crude prices was driven by markets pricing in the loss of all Iranian oil supply to following US sanctions, while both Russia and Saudi pre-emptively added supply to help counter the expected drop. However, Trump granted waivers to eight countries, including China and India, the biggest buyers of Iranian oil and challenged the bullish consensus. Furthermore, unexpectedly strong production out of the US, as well as Libya, Nigeria and Brazil, compounded the situation. The market has ended up awash with oil, oversupplied by about one million barrels per day (consensus estimates).
The macro and equities backdrop threw another spanner in the works. As a ‘risk’ asset, when global equity indices touch bear territory, oil typically follows. At the same time, while not flagged in oil import statistics, the potential for an economic hard landing in China remains a concern.
The shape of the oil futures curve is now in contango (upward sloping), implying that traders expect futures prices to converge down to the spot price. The shift to contango has exacerbated the move in front-month contracts, while futures beyond 12-months saw smaller moves in comparison.
Source: Bloomberg, Fidelity International, November 2018
Many financial players have been caught out by the swift, sharp downturn in sentiment, with the hedge fund community likely to have suffered significant losses. Relative Strength Indexes have dropped well into oversold territory.
Source: Bloomberg, Fidelity International, November 2018
Price forecasts could be on the high side
We initially expected 2019 oil prices to be $5 lower than in 2018, based on $70 for Brent and $65 for West Texas Intermediate (WTI). This still remains out base case. However, while our forecasts seemed conservative based on market prices earlier in the year, they now look rather more aggressive following the more recent moves. We will review our forecasts following OPEC’s December meeting and as Saudi Arabia’s intentions become clearer. If OPEC cuts production then, $70 for Brent next year remains a fair estimate, with WTI $5-10 below this. However, if the cartel does nothing, we might need to reconsider.
There is unlikely to be much price support between now and the OPEC meeting, but it’s also hard to imagine oil selling off every day until then. In fact, we’re already starting to see a small bounce from oversold conditions. Demand is usually lowest in the first quarter of the calendar year so it will be necessary to remove some supply from the market to reflect this, which OPEC seems willing to do. Saudi Arabia has already mentioned production cuts of between 1 million to 1.4 million barrels per day.
We probably won’t see $30 oil again any time soon
Anything is possible, but we believe $30 oil is highly unlikely given the lessons learned by OPEC in the last downturn. US shale production did not diminish with lower prices; instead companies lowered their cost structure and innovated. Almost all the companies I cover use $50 WTI for planning purposes because their cost structures support decent revenues at this level.
US company discipline should also help
We do not believe that US companies will grow for growth’s sake as they have in the past. Their investor base has been burned too many times and would rather see free cash flow used for dividends, share buy backs and debt reduction. Meanwhile, pipeline constraints and export bottlenecks could limit US production growth next year. A repeat of 2016, where the world was oversupplied by more than 2 million barrels per day, seems improbable.
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