Edward Bell - Commodity Analyst
Published Date: 08 February 2018
Oil markets have performed better than we expected to start 2018 and as a consequence we have marked our forecasts to market. We now expect Brent futures to average USD 59.50/b for 2018 and WTI to record an average of around USD 57/b, an increase of more than USD 3/b for both contracts. While we are acknowledging prices have begun the year too high for our existing forecasts to be tenable, our view on the medium term trajectory for prices has not changed. Indeed, our conviction that market fundamentals still point to lower prices by the end of the year has been reinforced by developments in recent weeks.
In our last Monthly Insights we outlined some downside risks that could threaten the oil market rally and several have begun to play out accordingly. US oil production has now exceeded 10m b/d according to EIA weekly data, pushing the US ahead of Saudi Arabia as the world’s second largest producer. Likewise, the drilling rig count in the US has levelled off and is now showing a modest upward bias, adding 12 rigs in January. Considering the lag between oil futures and explorers sanctioning drilling programmes, current levels of oil production at around 10m b/d would have been approved when prices were closer to USD 50/b at the end of Q3 2017. What the supply response may be to prices recently as high as USD 66/b for WTI could be staggering over the next few quarters.
The IEA’s projections for US production are for more than 1m b/d of y/y growth each quarter this year. The US last produced at such a blistering pace in 2013-15 when quarterly global demand was averaging more than 1.5m b/d y/y and OPEC production was still disrupted by the fighting in Libya and sanctions on Iran. Without those supportive dynamics, the surge in US production alone will overwhelm all the incremental increase in demand.
Source: IEA, Emirates NBD Research
The outlook for OPEC production is more mixed but we expect that production from the block will be higher in 2018 than it was last year. We have revised our oil market balances to account for the calamitous decline in Venezuela’s output. Production there fell more than 270k b/d in 2017 and at least a similar sized decline appears likely this year as the oil industry hemorrhages money and the risk of US sanctions on exports from the Latin American producer weighs on the production outlook. Balanced against this, however, is the potential for Libya and Nigeria to add barrels in 2018. We are tentatively forecasting Libya holding production around 900k b/d and Nigeria at 1.6m b/d (a nearly 10% and 7% increase respectively). The production profile for both countries, still officially exempt from OPEC’s production cut arrangement, will have an outsized bearing on overall market balances as both could increase output of light sweet crudes and dump them into an already glutted Atlantic basin.
Among those producers that have committed to the cuts we have revised higher our expectation for compliance among some members who had under-delivered but still forecast growth from nearly all OPEC members this year. Saudi Arabia has room to increase production while still adhering to the terms of the deal; we expect that it will still over-cut but at a less extreme levels than the average of around 120% compliance in 2017. Small additions from other producers, particularly in MENA, may be masked in Q1 by the deterioration in Venezuela’s output but will begin to make themselves more noticeable by the second half of the year.
On a net basis, these revisions along with the IEA’s forecast of slowing demand growth point to a small market surplus in 2018 but essentially near enough to be considered balanced. A balanced market will prevent inventories from growing but they will fail to converge on their five-year average. We still hold this is a misguided measure of market tightness as convergence on this benchmark is aided by an ever increasing average level. We believe that days of demand that can be met by OECD inventories is a more robust measure of ‘tightness’ and expect the ratio to stay above 62 days in 2018, higher than its long run level of less than 60 days.
Source: IEA, Emirates NBD Research
As we pointed out last month external factors to market fundamentals are the more significant near-term risk. Oil sold off sharply in early February in tandem with equity markets as financial markets reassessed inflation and rate trajectories. Unlike the broadly supportive macroeconomic outlook in most countries that should allow for a recovery in equities, oil prices are falling in a fundamental market that is much more precariously balanced. Hence, any rout that started in financial positions in oil markets could accelerate downward. Speculators had already begun to build short positions in recent weeks, albeit at a small scale, while long positions at the end of January were cut by the largest amount since August for WTI and since June for Brent.
A robust January non-farm payrolls report, including elevated wage growth, has pushed rates markets to anticipate as many as four rate hikes this year. All else being equal, higher rates should draw flows toward the USD and help the greenback strengthen, particularly against peers like the EUR and JPY where central banks are still at the initial stages of monetary policy normalization. We estimate that as much as 40% of the improvement in oil prices since June 2017 is down to a weaker dollar and that a sudden reversal in the currency would sap considerable strength away from oil. While a sharp appreciation of the dollar is not our near-term forecast, we don’t forecast much further downside for the dollar either, removing a crutch from oil in the near term.
Source: EIKON, Emirates NBD Research. Note: quarterly average in USD/b.
For both Brent and WTI we expect that Q1 will represent the high for 2018 and that prices will gradually edge downward for the remainder of the year. Brent will be 9% higher than its average level in 2017 while WTI will be up as much as 12%. Our revision to prices fall heavier in Q1 than across the rest of the year as oil markets were caught up in an over-exuberant rally that failed to tally with fundamentals.
Global markets under strain
Revisiting our oil price outlook