Sentiment in the oil market can at best be described as depressed. Implied demand at the end of 2018 through mid-2019 suffered as the effects of trade tensions and the manufacturing slowdown sapped demand for refined petroleum products. Most macro forecasts are calling for oil surpluses in 2020 due to growing U.S. production, and prospects for a global energy transition are raising concerns about long-term demand. But we believe a market transition into surplus balances may not be inevitable.
Backwardation continues and supply is tight
Despite the negative sentiment, the oil market remains solidly backwardated, meaning spot and nearer-term futures prices exceed those for contracts further out – a situation that typically occurs only when supply is in deficit and inventories are being drawn to meet demand. Backwardation may also support returns by creating “roll yield” as investors long higher-priced, short-term contracts roll out their exposure to lower-priced, longer-term contracts.
We think the primary drivers are two-fold:
- Despite all the focus on expected growth in U.S. production as new pipelines come on-line in the second half of 2019, U.S. production has been flat to date this year and has lagged expectations.
- OPEC production has declined sharply, both voluntarily and involuntarily.
Just how tight is the crude market? Current Organisation for Economic Co-operation and Development (OECD) crude inventories are nearly 60 million barrels below the five-year trailing average, adjusting for infrastructure fill associated with new pipelines and terminals that is effectively not commercially available – one of the tightest levels in the past decade (see Figure 1).
It is also worth noting disparities in the oil supply data between crude oil, refined petroleum products, and liquefied petroleum gas (LPG), the latter of which is suffering from slowing petrochemical activity globally and growing natural gas production. Simply put, when excluding LPG, which is only partially sourced from refining crude oil, the oil market is actually quite tight. This is something the bearish narrative is missing.
Forecasts for 2020: Overly pessimistic?
While there are many moving parts and the slowing global economy poses downside risks, we believe current prices underappreciate the potential for positive catalysts. We agree that output will likely increase in the second half of 2019, but see reasons why some forecasters’ baseline supply estimates may be excessive. For one, most bearish forecasts for 2020 assume a big ramp-up in U.S. output in the second half of 2019 and into 2020, yet the number of active rigs and completion crews is hitting two-year lows, and exploration and production (E&P) companies have tightened the reins on investment. In addition, the global transition to lower-sulfur shipping fuels later this year and into 2020 following the implementation of new regulations will drive demand for lower-sulfur crude oils and will benefit key refined products, helping to offset some of the broader weakening in demand. And while we aren’t optimistic that LPG balances will improve significantly, we believe the crude oil market is in much better shape than the major forecasting agencies’ projected balances, which include all hydrocarbons, would imply.
In sum, we do not view a market transition into surplus balances as inevitable – indeed, we believe continued tight crude balances could be the bigger surprise to the market. Such a scenario would likely be good for commodity investors, as continued backwardation in the markets has contributed positive carry, supporting returns even if prices fail to appreciate meaningfully.
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