Tuesday, May 15, 2018

Crude Oil: The Next Five Years

OPECs 2016 shift back to its former strategy has led to a sharp decline in global inventories and a rally in spot prices. It has also reintroduced the problem that OPEC spare capacity deters global oil companies from investing in future production. This problem is now exacerbated by increased hedging activity from shale oil producers. As a result, non-OPEC output ex-shale will start to decline in about 2-3 years, just when shale oil production begins to struggle offsetting ever increasing decline rates. We believe the next big move in oil will be in longer-dated prices, which will need to go higher in order to secure future supply.

OPEC once again changed strategy...

In 2016 we published a note with the title “OPEC at the crossroads” (June 06, 2016). In that note we described the difficult choice OPEC had to make: Should it continue to let the market play out as it did for the past couple of years, hoping that low prices will push out or at least curtail the shale oil producers over the long run; or, should it return to its former strategy and try to balance the market. While OPEC seemed initially reluctant to do the latter, in late 2016, the OPEC members changed their mind and agreed to curtail output. The new stated strategy sounded much like the old: OPEC would curtail production until global inventories normalized.

...which lead to a dramatic decline in inventories...

As we have explained before, OPEC cannot influence the price of oil directly. It can only manage inventories. What do we mean by that? Longer-dated oil prices are set by the marginal cost of future supply, or in other words, what long-term price is needed in order secure future supply? Spot prices can fluctuate widely around this longer dated price, depending on how much inventory there is1. Hence, by letting inventories decline, OPEC can push the curve into backwardation, which is exactly what happened since the production cuts. Importantly, by the time OPEC decided to curtail output, the market was already balanced and inventories were drawing in line with seasonal patterns. The production cut pushed the market immediately into a deficit. As a result, global inventories have been drawing over 300 million barrels more than normal since mid-2016 and days of supply cover is back to normal levels.

...pushing the crude oil price curve into backwardation and spot prices sharply higher

This led to a USD30/bbl rally in crude oil spot prices. In order to fully understand this price move, it is important to highlight the strong inverse relationship between inventories and time-spreads. A commodity price curve tends to trade in contango when inventories are high and in backwardation2when inventories are low (see Exhibit 2). The reason is that in an environment of low inventories, consumers of a commodity are willing to pay a premium for immediate delivery. For example, an airline is willing to pay a premium for jet fuel delivered today rather than in six months if jet fuel inventories are low. If the airline runs out of jet fuel, the planes will be grounded, which will be much costlier than paying a premium for prompt delivery of fuel. In contrast, when inventories are very high, consumers of a commodity are not worried that they could run out of this input good. Because it costs money to store commodities (storage cost, insurance costs) and there is a time-value attached to money, consumers of a commodity prefer to get delivery only when they really need it. As a result, spot prices will trade below forward prices in such an environment.

The sharp decline in oil inventories over the past two years lead to a massive shift in time-spreads. In early 2016, the Brent curve was in steep contango. Prompt month prices traded USD15 below the 5-year forward. As of today, it is trading USD15/bbl above the 5-year forward (see Exhibit 3). 

Longer dated price remained practically unchanged for the past two years. Hence, the entire move in the spot price was due to the shift in the curve, which was driven by the inventory decline. Importantly, the change in the spot prices does not imply that the market somehow changed its view on how much it costs to produce oil. Longer-dated prices, which are set by the marginal cost of future supply, are still below USD60/bbl. 

This means that the market still believes that USD55-60/bbl gives enough incentive to producers to make the necessary investments to meet future demand. The spot price rally thus was simply due to the decline in inventories.

- Source, James Turk's Gold Money