By James Williams – Looking at the smaller picture, Brent Crude had a lot of macro risk priced in coming into 2012. Expectations of Middle East unrest – in particular Iran – and a liquidity event coming out of the US saw prices reach USD123/bbl in March. By May, however, some USD30 of gains had been pared back to USD89.61/bbl on 21 June.
The bigger picture, barring the odd geopolitical shock which would support short-term positive price momentum, is markedly different: the long-term structural bull market is over. Period.
Over the last decade it was pretty easy to stay bullish on oil because no matter what happened, if price went from USD20 to USD150, supply never really went up much. Take 2008 and 2009 out of the equation and you had global supply growth of about 600,000 barrels/day non-OPEC versus global demand growth of about 1.3million barrels/day: hence the structural bull market.
“What has fundamentally changed with oil is not a demand story but absolutely a supply story. Because of the shale oil revolution US production is now rising by 20,000 barrels/day on average each week since the start of the year. The supply response is coming and that completely changes the supply/demand equation.
“The super-cycle is done. This is nothing short of epic,” says Seth Kleinman (pictured), Head of Global Energy Strategy, Citi.
That said, given that the market has low spare capacity, the potential for oil to bounce back in H2’12 is strong. Kleinman observes that even though the market has started repaying attention to Iran the macro risk it represents is still underpriced in the market. Israel is likely to refocus the international community’s attention and keep Iran under pressure, which should be enough to push prices higher.
Dominic Schnider, Head of Non-Traditional Asset Class Research at UBS Wealth Management, takes the view that over the short-term renewed price weakness for crude is on the cards because the market is oversupplied. Schnider notes that sequential growth in demand – that is an increase from 1.7million to 1.8million barrels/day from Q2 to Q3 – is unlikely to materialise as weak global economic growth dampens demand.
“We’re probably only going to get 1.5million barrels/day. On a seasonally-adjusted basis, inventories are likely to build in Q3 this year and that’s going to push prices back below USD90/bbl. That for me is the overarching story. With respect to Iran, I don’t think the US are at all interested in exacerbating the situation because if Obama is faced with high oil prices it’s going to cost him the election, potentially,” says Schnider.
Heading into 2013, however, Schnider is confident that crude could go up to USD105/bbl to USD110/bbl.
Sabine Schels, commodities analyst at BofA Merrill Lynch Global Research, agrees that despite the hard run-up in prices in July – which has seen Brent climb from – the market is seeing excess supplies as demand weakens: “The issue clearly is that Saudi Arabia oil output is remaining stubbornly above 10million barrels/day, Libyan production has come back on line, so in the short-term I’d say the market has maybe run up a little too quickly.”
Right now the Brent forward curve is in quite a steep backwardation, despite briefly dipping into contango about six weeks ago, but this is more a function of supply constraints in the North Sea following the Norwegian oil strike. Whether the backwardation continues entirely depends on how bad the global macro situation gets says Schels. “If we see a much sharper deceleration in demand then the backwardation will unlikely hold up. I think in that case Saudi production will have to ease off.”
Kleinman’s reasons for being short-term bullish on crude for Q4 2012 are numerous. Firstly, the market has already experienced a massive liquidation earlier in the year when speculators sold off positions. Seasonally, the market is out of the worst period, when March and April are typically the lowest points for product demand, and often strengthens towards year-end. Crucially though, what could support further upside is a supply story. Says Kleinman: “The right way to look at oil is that oil prices, in the bigger picture, are trending lower but there will be one or two geopolitical-driven spikes on the way down. The likelihood of one of those spikes happening, i.e. Iran, is high.
“Supply is the question mark and two key factors have been pressuring prices on the supply side: the US and Saudi Arabia.”
The oil rig count has showed signs of wavering in the US, albeit only slightly, when WTI hit USD80/bbl in June. Kleinman says that there would be a big difference in drilling activity between USD70 and USD80; sub-USD70 some of these players would come under pressure and would auger a supply-driven floor.
For Saudi Arabia, even though they are going to continue pushing oil out at high volumes a few weeks ago they caught the Asia market off-guard by raising their Official Sales Price for Arab Medium and Arab Light well in excess of what was expected: climbing 20 cents from USD1.15 a barrel to the Oman/Dubai average plus USD1.35 a barrel. Whether that actually translates into less supply is not clear but it’s the first sign they’re taking their foot off the floor in terms of pumping oil to market.
“Put the recent liquidity event together with this US/Saudi supply picture and you have a moderately constructive outlook: on the supply side it looks like a floor is within sight. Throw Iran into the mix and I think the odds of a spike are high.
“Our average price forecast for Q4 for Brent is USD105,” says Kleinman.
Schels believes the case for further upside in crude this year depends on monetary easing. “The house forecast for H2’12 is an average of USD106/bbl for Brent and USD97/bbl for WTI.
“Our assumption is that we’ll get more fiscal and monetary easing in emerging economies; real interest rates in emerging markets as a whole are sitting at a relatively high spread because inflation has fallen relative to the developed markets so they have room to adjust down. Also, we see the US economy deteriorating quite a lot after the elections because of the fiscal cliff and we think that is already giving a shock to confidence. We think data will worsen over coming weeks and that the Fed will respond to that with QE3 in September.
“The uncertainty we face now is clearly unprecedented. The house view is that policymakers are not going to stare into the abyss and not react.”
Based on pure demand dynamics, Schnider thinks that Brent crude should be trading in the USD80/bbl to USD90/bbl range. “Demand will be 1.5million barrels not 1.7-1.8million barrels as expected so it’s the weak demand dynamics that we think will lead to further downside in oil price: USD90/bbl is not a hard floor, but a level where Saudi Arabia is likely to cut meaningful supply. In the short-term the market could fall into contango if it falls to USD90/bbl or below, but it won’t last and you should see it moving back into modest backwardation in Q4.”
As for trade ideas, Kleinman suggests in the short-term buying Brent structure which should strengthen from its seasonal trough. “The next trade to think about is to sell prompt European refining margins. The biggest trade out there is that Brent/WTI will stay wide – this is not an infrastructure story, it’s a supply story. The US is choking on crude. Sell WTI against Brent down the curve.”
Seasonally hot weather has supported significant upside in US natural gas climbing from USD2.18/MMBtu on 13 June to USD3.18/MMBtu on 25 July. Like oil, shale bed gas production has sent US natural gas inventories this year to record seasonal levels, making them far more depressed relative to other countries: around USD8/MMBtu for UK Natural Balancing Point (NBP).
Despite prices in the US bouncing up in recent weeks, the potential for further upside, whilst certainly possible, is limited in Schels’ view: “We do think prices will continue to recover into 2013 – we see them averaging USD3.50/MMBtu although I think there’s some upside risk to that number. The reason being that this market is very flexible, it has taken a while to rebalance because producers were reluctant to cut back on outflow (thanks to strong demand).”
Low prices are a function of an oversupplied market as opposed to weak domestic demand. Production cutbacks in the current low price environment should make for a tighter market next year, says Schels, but it’s unlikely prices will go from USD3/MMBtu to USD4/MMBtu: “This would then give producers a strong incentive to increase drilling so whilst the price has some upside, it’s limited.”
Although problems in the eurozone represent a macro risk to gas consumption as demand remains weak, Schels believes that European gas prices will remain supported this year as indigenous production continues to decline. Barring further declines in coal prices, gas could be getting close to a floor as producers cut production and dry gas rigs continue to fall.
“For Henry Hub natural gas our average price forecast for Q4 is USD3.20/MMBtu,” confirms Schels.
UBS’s Schnider thinks that the floor has probably been reached and is forecasting an average Q4 price of USD3/MMBtu. In his view it’s clear the low prices seen in 2012, at one point reaching USD1.8/MMBtu, cannot be sustained, but he does think there is room for higher prices in 2H12. “This is based on the thought that we need to work through ample coal inventories at US power plants. That will cap things for a while. Once those inventories are worked off, and with the help of warmer temperatures, the whole complex will start to move higher in tandem.
Kleinman comments: “Down the road global natural gas prices will fall, but it’s going to take a while. The US won’t be exporting LNG until 2016 at the earliest.”
With limited upside potential in US gas prices because of the sheer volume of shale reserves, and coal prices unlikely to appreciate significantly, Schnider suggests selling volatility to reflect that view: “I would sell a call option in gas because it benefits from the forward curve; coal inventories will limit the upside for gas.
“By taking the position that there’s not much room for lower coal prices, with inventories being worked off and prices trading attractively versus marginal production costs, you could sell a put option and collect the premium.”
Citi foresees a continued narrowing of the spread between European and Asian gas prices with winter gas in Europe likely to remain supported. Its forecast figures for NBP are 52-p/th for Q3 2012, and 62-p/th for Q4 2012.