The Rally in Oil Prices isn’t Over – The Outlook just got Better

The Rally in Oil Prices isn’t Over - The Outlook just got Better

The Rally in Oil Prices isn’t Over

Oil prices declined by more than 6 percent in the last few trading days, following reports that OPEC and Russia could boost production in the second half of 2018. However, the outlook is still bullish, at least according to Goldman Sachs.

As of now, it appears that Saudi Arabia and Russia are in discussions about how much oil to add back onto the market, with the upper bound rumored to be between 800,000 bpd and 1 million barrels per day (mb/d), or a more modest 300,000 bpd at the lower end. Late last week, WTI and Brent plunged on the news that the group could alter production levels in a few weeks.

“While today’s announcement lifts some of the uncertainty on whether and when OPEC and Russia would increase production, we do not view this as a material change to our bullish oil outlook,” Goldman Sachs wrote in a research note last Friday. The investment bank argued that an increase in supply could be forthcoming because the oil market is already tight, and the extra supply is needed.

There are several reasons why oil prices might not be heading for another downturn, the investment bank argues. Inventories are already back to the five-year average. Demand is strong and is likely underestimated. Venezuela is quickly losing output and there are other potential outages looming. Meanwhile, infrastructure bottlenecks in the Permian could mean that U.S. shale disappoints. In fact, without OPEC and Russia increasing supply from current levels, inventories would fall “to historically low levels by 1Q19,” Goldman said. “In short, the supply response was needed.”

“The current level of the market deficit, the robustness of the demand backdrop, and the rising levels of disruptions all set the stage for inventories to fall further all the while OPEC spare capacity is drawn down.” Even if OPEC and Russia opt for the more aggressive supply response, approving an increase of 1 mb/d, “such an increase would simply offset the involuntary production declines with the group still committed to restraining output,” Goldman wrote.

Moreover, the “gradual implementation” of any increase would still leave the oil market in a supply deficit through the third quarter. In the past, production increases are phased in, so “a 250 kb/d monthly production increase from July onwards would only reduce the 3Q18 deficit to 0.5 mb/d. Any later implementation would further exacerbate the 3Q18 deficit,” Goldman wrote.

And as we move into 2019, more supply will be needed to meet growing demand. On top of that, while a decision by OPEC and Russia to increase production does at additional barrels to the market, it also cuts into the group’s spare capacity, taking away a buffer that could offset a potential outage.

With less dry powder to call upon, the potential for a price increase rises. In fact, even without an outage, history suggests the oil market adds a bit of a risk premium to the price of oil when spare capacity is whittled down to low levels.

The Rally in Oil Prices isn’t Over - In fact, it just got Better

Overall, Goldman Sachs was unfazed after news broke that the OPEC/non-OPEC agreement could be abruptly altered, even after weeks of top OPEC officials insisting that the cuts would remain unchanged through the end of the year. The bank reiterated its call for Brent oil prices to average $82.50 in the third quarter, and still sees risks to oil prices for the rest of the year and for 2019 “skewed to further upside.” If OPEC and Russia do not alter production levels, the supply deficit could rise to 1 mb/d. That suggests that the addition of that amount in the second half of the year wouldn’t create another supply glut, but would simply keep the oil market balanced.

For now, the oil market has become quite skittish, and hedge funds and other money managers have sold off long bets on futures, helping to magnify the price correction. Investors are clearly fearing that another downturn is possible. According to Bjarne Schieldrop, Chief Commodities Analyst at SEB, there is still some excess net-length that could be undone, which means oil prices could dip a bit further.

But SEB largely agrees with Goldman. “Russia and Saudi Arabia are discussing putting production cuts back into the market now not just because they have reached the OECD inventory target but because increased production is needed,” Schieldrop said in a statement on Tuesday. “The discussion between Russia and Saudi Arabia now is not so much about pushing oil prices down as it is about avoiding that the market tightens too much and oil prices go too high.” SEB predicts that OPEC+ will add more supply back onto the market, but even still, inventories could continue to decline this year and next. – Nick Cunningham

 

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