Energy and crude oil prices in particular have been underperforming sharply since mid-April and so far this year.
This underperformance reflects an increasingly likely swift recovery of US oil production and US oil inventories that remained stubbornly high after an already mild US winter. In addition, concerns over potential peaking growth in key consumer China and somewhat softer macro data in the country recently added hereto. The sell-off in crude oil prices occurred despite compliance to the coordinated oil production cut deal (OPEC and non-OPEC) being high. Most notable in this environment has been the unwinding in speculative net long positioning seen since March when the euphoria related to this oil production cut deal of end November last year faded somewhat. Not extending the oil production cut agreement would be a severe blow to oil markets. All eyes are therefore on the joint meeting on May 25.
We are constructive oil prices from here, as an extension of the production cut deal is likely with both Saudi Arabia and Russia hinting hereto. A H2 2017 extension is the base case but a 9-month extension is rumored to cover seasonally weaker Q1 2018. A deal extension would keep OPEC oil production levels close to 32.5 mbd, representing an 1.2 mbd contraction from the October 2016 reference levels. Importantly in this respect is timing of the cuts as compliance to the deal is said to have been already high at the start of the first 6 month period in January (above 90%), a compliance level which has only increased since. This production discipline then has to be weighed against a likely return of US oil production growth. As for the latter, by the end of this year, US oil production is expected to grow above +700 kbd on an annual basis. A remarkable return of US oil production growth indeed but still falling short of the intended -1.2 mbd OPEC cut and the -0.6 mbd non-OPEC cuts. US production growth would also come later than the deal related cuts as well.
At end April, US oil production growth on an annual basis is estimated to be up little over +300 kbd. Annual US oil production growth turned back positive for the first time early March this year and continues to steadily increase. A turning point in annual growth started in July last year, some two months after the US oil rigs count troughed at 316 in May last year. The latter at end April this year is back at 697 or more than double the levels back then.
Of course, the return of US oil production growth is well documented. They reflect an important increase in efficiency and productivity, upgrading to more productive fields (“high grading”) and a completion of drilled but uncompleted wells. With oil prices at their low early 2016, US oil companies slashed E&P spending by some 40% last year. By now, this trend has reversed and plans cater for spending growth close to +30% again. Drilling costs as well, that tumbled by about one third from Q1 2014 till November last year, are on the rise again since November last year (estimated +7% since, till end Q1). The latter therefore would become a positive cost driver for oil prices going forward. Estimated US shale oil breakeven price levels nevertheless have been declining from levels over 60 USD in the second half of 2014 to some 40 – 45 USD currently. In light hereof a further swift return of US oil production given current oil prices is likely. However, as mentioned, US oil production growth is estimated to fall short of the coordinated oil production cut by OPEC and non-OPEC if the deal is extended in the second half of the year.
In this environment US and global oil inventories should start to draw from here. Better seasonality (like an upcoming US driving season) leading to an estimated over +1.5 mbd oil demand increase in the second half compared to the first should also be supportive. US refineries are already running above seasonal norms currently, with runs at 91.5% of capacity early May (compared to below 90% last year).
Speculative net length in WTI and Brent (a contrarian indicator) also has been unwound to levels below half of the rise seen during the deal announcement. Meanwhile, speculative gross shorts in Brent are almost ¾ back up from the rise seen prior to the deal announcement. The speculative overhang for that matter is smaller today.
An uplift in front prices on the back of these dynamics, in combination with producer hedging further out, finally could lead to some partial curve backwardation, in itself potentially inducing further investor inflows in Oil.
Koen Straetmans is a senior strategist multi-asset at NN IP.
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