Oil price will fall further but 2016-17 futures look undervalued

The past two weeks have been pretty significant in terms of the general direction of oil futures benchmarks. As the market grappled with the Iranian nuclear settlement, Greece’s debt woes, seemingly lower Chinese demand and oversupply permutations, the International Energy Agency opined that oil prices were likely to go lower.

In near tandem with the IEA’s comments on 10 July, Brent and WTI oil futures curves for 2016 and 2017 started falling to their lowest level since the contracts commenced trading (see graph below). The agency’s monthly comment on the ‘crude’ state of affairs predicted the current phase of low oil prices is likely to last well into 2016.

“The oil market was massively oversupplied in the second quarter of 2015, and remains so today.  It is equally clear that the market’s ability to absorb that oversupply is unlikely to last. Onshore storage space is limited. Something has to give; the bottom of the market may still be ahead.”

 

Brent calendar swaps 2016 – 2017 for last 12 months. Source: Barclays / Bloomberg. Graph ©

Barclays Commodities Research

The IEA also revised its forecast for global oil demand growth this year marginally downwards to 1.39 million barrels per day (bpd), adding that it expected global demand growth to slow to 1.2 million bpd in 2016. The agency also held out little prospect of an OPEC production cut, with members Saudi Arabia, Iraq and United Arab Emirates posting record production figures for June, and Iran tipped to add to its output, even if the jury is still out on the actual size of the increment.

All of this is well and good, and the IEA is right – “something has to give”, especially as China’s oil demand growth rate is not quite what it used to be and is unlikely to return to 2012-13 levels anytime soon.

Yet, factoring all what has transpired, it still does not merit the sharp swing downwards of 2016 and 2017 futures, with 2016 Brent around $62 a barrel and the WTI trading well below $55 at the start of the current trading week, and heading lower. The said levels are below my median forecast of $57.5 and $62.5 for WTI and Brent respectively for next year. This is reactive undervaluation, pure and simple.

Since the IEA’s take was our starting point, it is also worth noting the agency’s Director of Energy Markets and Security Keisuke Sadamori’s take, who noted last month that non-OPEC production is likely to fall from the fourth quarter of this year onwards, despite the Russians and marginal US shale producers having shown great resilience so far into the current oil price slump.

Most see this drop in production coming from the US (excepting the remarkable Eagle Ford), Russia and Latin America (mainly Mexico, Colombia and Brazil). Additionally, Canadian production could flat line, if not plummet in real terms come the end of the year.

I have said all along that declining output from the aforementioned would not make the supply / demand mismatch disappear overnight. Rather a gradual production decline would support the oil price, as would a gradual rise in emerging market demand in general, and an improved take-up by India and South Korea in particular. Hence, all things remaining even, factoring in the above makes the current 2016-17 levels of both benchmarks appear lower than they should be. Of course, there is a risk things could get uneven; afterall this is the oil market we are talking about!

WTI calendar swaps 2016 – 2017 for last 12 months. Source: Barclays / Bloomberg. Graph © 

Barclays Commodities Research

For instance, Iran could, contrary to all pragmatic expectations, decide to shoot itself in the foot and take down a few others by actually flooding the market or dumping already extracted barrels held in storage thought to be in excess of 40 million. The effect would be net bearish for WTI and Brent 2016 futures, but would also tip Iran, which relies on oil for 42% of its national revenue, into a recession. I maintain that Iran neither has the capacity nor the inclination to attempt such a stunt.

Elsewhere, Libya’s production could spike and dive erratically, and Iraq has the capacity to surprise. Some players sitting on a mountain of debt in the US Bakken Shale could also hold out a lot longer than the market anticipates on the strength of their existing hedges to keep on pumping, with little choice on the horizon.

However, the way I see it and many others in the City do too, is that most of these potentially bearish influences have already been priced in and if they were to come into the equation, 2016 prices are likely to lurk around current levels rather plummet to sub-$40 levels. Deutsche Bank, Barclays and Societe Generale analysts are the among many who do not see a nosedive in the case of either benchmark. As Barclays analysts noted: “Demand is expected to grow by around 1 million bpd in 2016, but current strip prices could stimulate further consumption, presenting upside risk to the oil price.”

“The prospect of higher demand and lower supply stemming from a sustained low-price environment [relatively speaking], particularly from non-OPEC producers, suggests that strip prices should rise.” In fact, Barclays’ 2016 forecasts of $64 for WTI and $68 for Brent are way more optimistic than mine. “Although there are risks to both the upside and the downside for crude, we believe that bullish factors will likely win out and the 2016 and 2017 calendar strips will move higher from here,” the bank’s commodities research team added.

A counter-seasonal rebound in US oil inventories has not helped market sentiment but is unlikely to persist, in the view of Deutsche Bank analysts. “However, this does not change the weak outlook for global oil balances as US producers are yet to be meaningfully disincentivized from increasing drilling activity, which we expect to occur over the coming year.”

I believe so too; as the current global oversupply level is broadly in the 1.1 to 1.3 million bpd range, according to aggregated data. If this were to come down to 800,000 bpd or thereabout as non-OPEC supply drops, gradually geopolitical risk that has been largely neutralized by the current glut, would start coming back into play squaring up to an incremental trickle of additional Iranian oil.

Let me attach a caveat – I am not suggesting we would see Brent futures dash towards $100 over the next couple of years. Market conjecture, most recently by Moody’s, that low oil prices are here to stay is a valid one, but for me the median level would be $60, barring a financial tsunami. In summation, there are enough reasons out there to suggest 2016 and 2017 Brent and WTI contract levels shouldn’t be where they are, but rather a tad higher.

http://www.forbes.com/sites/gauravsharma/2015/07/24/oil-price-will-fall-further-but-2016-17-futures-look-undervalued/3/?ss=energy