Wednesday, July 24, 2019
05:07PM / ARM Research / Header Image Credit: Yahoo Finance
At the start of the year, we had projected that growth in crude oil supply from US and other nonOPEC producers, as well as weaker pace of growth in demand will result in an extension of the net surplus position in the oil market. Accordingly, based on our interpolation between changes in net supply and Brent crude, we forecast crude oil price of $50/bbl.-$60 bbl (base case of $55.95), with upside risk to our forecast stemming from full compliance with the OPEC and allies output cut, and worsened geopolitical tensions in Venezuela and Libya which could settle oil prices at $60-$70/bbl. range. Largely in line with our bull estimate, crude oil prices tip-toed to close H1 19 at $66.6/bbl. (24% higher than FY 18 close) stemming from overcompliance by OPEC (especially Saudi Arabia) as well as unprecedented involuntary cuts by Iran and Venezuela, all of which more than outweighed shortfall in demand to moderate the market surplus to 190kbpd. compared to H2 18 average of 1.3mbpd.
Over the rest of the year, we expect increased net surplus of 630kbpd, underlined by our projection of supply growth over H2 19 by 1.14mbpd largely reflecting increased outflows from US and Canadian producers which will offset expected declines OPEC producers. On the other hand, we envisage increased demand going into the second half by 690kbpd, anchored on expectation of increased crude consumption by China teapots as well as in the US and India. Thus, based on the interpolation of the foregoing, we increase our H2 19 estimate for average oil price to $58/bbl. from $52/bbl, which brings the 2019 full year average price forecast to $62.3/bbl.
Oil prices trended in line with our Bull case thesis
At the start of the year, we had projected that growth in crude oil supply from US and other nonOPEC producers, as well as weaker pace of growth in demand will result in an extension of the net surplus position in the oil market. Accordingly, based on our interpolation between changes in net supply and Brent crude, we forecast crude oil price of $50/bbl.-$60 bbl (with a base case of $55.95), with upside risk to our forecast stemming from full compliance with the OPEC and allies output cut, and worsened geopolitical tensions in Venezuela and Libya which could settle oil prices at $60$70/bbl. range. Largely in line with our bull estimate, crude oil prices tip-toed to close H1 19 at $66.6/bbl. (24% higher than FY 18 close) stemming from overcompliance by OPEC (especially Saudi Arabia) as well as unprecedented involuntary cuts by Iran and Venezuela, which more than outweighed shortfall in demand to moderate the market surplus to 190kbpd. compared to H2 18 average of 1.3mbpd. On a quarterly basis, average Brent crude oil prices printed at $63.83/bbl. over Q1 19 (7.2% lower QoQ) and $68.47/bbl. over Q2 19 (+7.3% QoQ).
Geo-politics changed the narrative
Geopolitical tensions had more impact in dictating the direction of oil prices over most of the first half of the year. In fact, this put fundamentals on the back seat and paved the path for a new narrative. Heated tensions in Iran increased risks to smooth oil supply, after the initial waiver granted to eight countries (including India, China, Japan etc.) – who accounted for 70% of Iran’s oil exports – by the Trump-administration ended on May 1st. This led to drop in Iran oil production from 2018 high of 3.84mbpd to the record low of 2.1mbpd in June. Series of events, including attack on two Saudi Arabian tankers, seizure of Iran tankers by British Government and an attempted retaliation, shooting down of a US jet, and the breach of the nuclear agreement by increasing Uranium enrichment worsened the outlook for a peaceful resolution in the interim. Further espousing the impact of the geo-political tension were lingering tensions in Libya and Venezuela. While outputs in Libya have surprisingly improved compared to start of the year (June: 1.13mbpd vs. 830kbpd), despite increased attacks in Tripoli, threats to production linger. On the other hand, Venezuela’s production has consistently gone south from 1.36mbpd average in 2018 to 700kbpd in June. For Venezuela, it appears sanctions will intensify as the Trump administration continues to increase pressure for an end to the Maduro’s government.
OPEC+ leads in Global oil supply cuts
A conglomerate of the voluntary and involuntary cuts from OPEC producers triggered decline in global oil supply by 1.59mbpd to 100.20mbpd in H1 19 relative to 101.79mbpd in H2 18. Notably, while shale production over the period grew 470kbpd, reaching a record high of 12.2mbpd for the first time in May, the stronger cut by OPEC+ (of 1.71mbpd) drove market supply lower in H1 19. Among the Cartel, Saudi Arabia spearheaded the cuts, as the de-facto leader took on cuts of 618kbpd over H1 19, which offset increases from noncomplying members.
Meanwhile, for Russia (the key OPEC+ ally), compliance with the revised quotas, which kicked off in January 2019 was quite debatable. The cuts required Russia additional cuts of 230kbpd to 11.2 mbpd. However, Russia was not as bullish for higher oil prices as its ally but was comfortable with prices hovering around $60/bbl, according to statements made by the energy minister Alexander Novak. However, the Ural taps were forced shut after reports of contamination of oil that flowed through the Druzhba pipeline to Europe in late April. This resulted in the 700kbpd capacity pipeline halting production for a few weeks. Transneft (operator of the Druzhba pipeline) estimates that 22million bbls of contaminated oil were exported across countries. Thus, average daily production dropped 180kbpd over April to May to 11.3mbpd.
Meanwhile, the other involuntary supply cuts stemmed from shortfalls in outflows from Iran and Venezuela, with average daily production over H1 19 down 730kbpd and 290kbpd to 2.54mbpd and 0.94mbpd, respectively, compared to H2 19. Ironically, Trump’s propagated sanctions lent a helping hand in driving the bullish factors. Venezuela’s sanctions on January 28th also took the market by surprise and drove brent prices higher. Meanwhile, skepticism regarding extension of the Iran sanction waivers (which were enforced in November 2018) were cleared after Trump announced withdrawing the waivers in April to take effect in May.
Weak global economic growth takes a toll on Demand
Global oil demand declined 450kbpd over H1 19 to 100.01mbpd, reflecting decline in consumption among OECD countries (-900kbpd) which offset increase in non-OECD countries (+450kbpd). Demand was weaker in the first quarter (99.7mbpd) but showed improvement in the second quarter (100.3mbpd), following pickup in consumption among the non-OECD countries. Faltering demand in the US, Canada and Europe, were major drivers of the weak OECD demand recorded so far this year, while demand in China supported demand growth among the non-OECDs.
Over in Europe, demand dropped by 370kbpd to 14.04mbpd. The erosion in refinery margins, which dropped from a high of $11.53/barrel in November 2018 to as low as $1.81/bbl in June depicted the extent of weakness in demand witnessed over the period. Specifically, slow growth in Germany following declines in industrial production (1.74% YoY) and units of car production over the first five months of 2019 have constituted to the drag in growth across the Euro Zone.
For the non-OECDs, oil consumption remained solid in China despite lingering trade tensions with the US. China’s daily average consumption increased 310kbpd reflecting resilient growth over the first half of the year (6.4% YoY in Q1 19 and 6.2% YoY in Q2 19). That said, the increasing demand for crude stemmed from new large-scale private refineries (also known as the teapots) which commenced operation in the first half of the year. The onboarding of the new 400kbpd capacity refinery by Hengli Petrochemical Co. as well as new refinery by Zhejiang Petrochemical with same capacity propelled the increased demand. Data by the Chinese General Administration of Customs showed crude oil imports over the first half of the year averaged ~9.87mbpd which is 8.8% higher YoY.
Permian Gulf Spurs Shale Torrent
As mentioned above, for the first time on record, US daily production crossed 12mbpd in April and hovered above it to touch 12.2mbpd in June. Most of the increase stemmed from the Permian basin (~64% of the DPR regions), wherein average daily production YtD increased by 867,825 bbls YoY to 4.04mbpd. In addition, the Bakken, Eagle Ford and Niobrara regions also recorded increases in average daily production by 194,283bbls, 108,777bbls and 108,667bbls YoY respectively. The increases reflect payoff from the additional 43 rigs added over the year – and improvement in production per rig by 3% YoY across regions – which pushed total rigs count to 672 at the end of H1.
Rising US oil production efficiencies stemming from more improved fracking of shale rocks have boost the outlook for a potential US oil surge in the near term. However, the outflows, although touching new record-highs, have been held back by constraints on pipeline capacities. Going by available oil programs by the top upstream players, ~2mbpd production capacities are estimated to be added over the second half of 2019. With the new capacities coming on board, we see scope for further increases over H2 19 to average 12.74mbpd compared to 12.0bpd average daily production in H1 19
Geo-political tensions, not voluntary cuts, to keep OPEC at bay
On OPEC, going further into the year, while the cartel members voted to extend the oil cuts agreement going into March 2020, we still expect non-compliance, or at best, less extent of compliance in the second half of the year. To buttress the foregoing, latest data by OPEC shows Saudi Arabia, for the first time this year, recorded an upturn in production by 126kbpd to 9.8 mbpd in June. However, this remains well below the stipulated 10.31mbpd quota. The Saudi government also affixed a time frame to keep production below 10mbpd through August. While Saudi is well able to keep production within its boundaries, we see room for increase over H2 19 compared to the record lows in H1 19. Further compounding concerns of non-compliance by member countries is the extent of increase which emanated from Nigeria (+129kbpd MoM to 1.86 mbpd in June), months after launching the 200kbpd capacity Egina field. For the OPEC+ key player, Russia, we project a recovery from the oil contamination which occurred in Q2 19, and factor in non-compliance to the cuts, albeit by slight margins.
That said, we think rising tensions in Iran, Libya and Venezuela are likely to keep the expected increases in check. Iran touched record low levels of production and does not appear to be reverting anytime soon, while crises in Libya and Venezuela do not appear to be losing steam. We project further cut-backs in Iran and Venezuela production by 467kbpd and 220kbpd which will offset increases from Saudi Arabia and Nigeria by 280kbpd and 120kbpd, respectively. For Russia, we estimate average daily production of 11.58bbls which is 90,000bbls more than H1 19. Overall, we forecast decline in OPEC production over the second half by 305kbpd to 29.9mbpd, compared to H1.
Closed WTI-WCS spreads to ease Canadian crude cuts
Over in Canada, earlier in January curtailments were placed which required oil cuts by 236kbpd by oil majors in a bid to clear inventory build-up and close the spreads between Canadian’s Western select prices and the WTI. Successfully, the WTI-WCS spread narrowed from $29/bbl in November 2018 to $13.74/bbl at the close of H1. As a result, the Alberta government began to ease the curbs on oil sands outputs. From the initial stipulated cut of 325kbpd in January, this is scheduled to reduce to 95kbpd by August. The Alberta reduction are well-spaced, with 25kbpd increases allowed in July and August apiece. Considering the successful neutering of the gaps, we think the Alberta government will continue to manage the production outputs going into the rest of the year. To mention, oil producers have placed demand on government to ensure railway infrastructures are in place in exchange of ensuring compliance with the stipulated cuts. In addition, the approval for expansion of the highly controversial Trans Mountain pipeline in June from the Alberta to British Columbia will increase outflow by 3 times to 890kbpd and points to increased crude from the region. That said, going into the rest of 2019, we increase our forecast output growth to 160kbpd from 120kbpd earlier in the year.
Weak global growth continues to strangle demand
On the demand side, we remain pessimistic with our projections going into the second half of the year due to concerns of global economic growth. However, our expectations for demand in China have been tuned up a notch on the positive, underlined by the new refiners which came on board in H1 19. While refinery margins (Singapore-Dubai Hydrocracking refinery margin: from $5.5 in H2 18 to $3.3/bl in H1 19) have thinned out due to the supply glut, we think the increased export quotas by the Chinese government would help improve flows. Thus, we increase our demand forecast for China over H2 to 14.57mbpd (previously 14.26mbpd). Overall, we expect stronger demand in H2 18 compared to the H1, upheld by the summer driving season in Q3 as well as winter season in Q4. Overall, we project global demand of 100.71mbpd over the second half of the year.
Oil prices revised higher
Overall, we expect market balance to remain in a net surplus, with average of 630kbpd over the second half of the year. This is underlined by our projection of a supply growth in H2 of 1.14mbpd (previous estimate of 1.7mbpd) reflecting reduced expectation of non-compliance by the OPEC+ producers and disruptions from the Middle East producers. On the flip side, US production is expected to be higher, following ease in pipeline capacities. On the other hand, we are more optimistic on demand growth going into the second half, with demand growth expectation of 690kbpd (previous estimate of 300kbpd), largely due to increased consumption by Chinese teapots.
Thus, based on the interpolation of the foregoing, we increase our H2 19 estimate for average oil price to $58/bbl. from $52/bbl, which brings the 2019 full year average price forecast to $62.3/bbl. That said, we believe on slower increase in supply by 450kbpd owing to unimproved ease in US pipeline constraints, hits from natural disasters as we approach hurricane season and better than expected compliance to stipulated cuts by OPEC+ producers (especially Saudi Arabia and Russia) could send oil prices to $76 - $80/bbl. over H2 19 (FY 19: 71.06/bbl). On the flip side, downsides to our projections could stem from a much worse impact of the lagging growth across global economies which could pressure demand growth, as well as possible glut from US ramp up in supply and loosed compliance from OPEC+ producers. This, we estimate could push oil prices to as low as $56/bbl. over H2 19 (FY 19: $61.1).
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