With oil production plunging in Venezuela and Iran, tension in the Middle East at its highest point in years, and the threat of further outages in Libya, why are oil prices not trading higher?
Even price volatility has been rather low, a surprising feature of a tight market rife with geopolitical risk. Brent crude has been stuck between a relatively narrow range of $70 to $75 per barrel for more than a month, despite all the turmoil.
Furthermore, even the back end of the futures curve has barely budged, trading between $60 and $65 per barrel. At the same time, the front end of the curve has moved into steep backwardation – when near-term contracts trade at a premium to longer-dated futures. Backwardation is typically associated with a tight oil market – essentially, traders are willing to pay a premium for oil today relative to deliveries six or twelve months out.
What does all of this mean? “The recent movements in the oil price complex indicate some deep dislocations between the physical and futures markets and in market expectations about current and future oil market fundamentals,” the Oxford Institute for Energy Studies (OIES) wrote in a new report.
Last year, the oil market saw the opposite situation occur. The back end of the curve rose in anticipation of a tighter market while the near-term futures suggested the market was well-supplied, OIES noted. That discrepancy was sorted out when a wave of supply came online from OPEC+, the U.S., and the Trump administration gave surprise waivers to Iran. The end result was a crash in prices.
How will the gap in expectations be resolved this time around? “If 2018 is a good guide, the price level will eventually increase to reflect the current tightness in the physical market,” OIES said. The significant outages in Venezuela and Iran, the oil contamination problems in Russia, the potential for disruptions in Libya and the slowdown in the U.S. shale industry all point to increasing tightness. The big question is how and when Saudi Arabia will respond. Riyadh is very reluctant to see a repeat of 2018 when prices crashed following production increases. This time around Saudi Arabia will err on the side of letting the overly tighten, although the OPEC+ group has adopted a “wait-and-see” approach, putting off a decision until the June meeting (which may even get pushed into July). That way, OPEC+ officials will have more data on how U.S. sanctions are affecting production in Iran and Venezuela, and events surrounding the U.S.-China trade war will also become clearer.
However, the wait-and-see strategy carries risks. “The challenge though is that rather than being resolved, most of the uncertainties (both on the supply and demand side) will only intensify in coming months,” OIES warned.
Supply outages are already at multi-year highs of about 3 mb/d and could rise further. While OPEC+ can compensate for such a large volume of disrupted output, outages cloud the supply/demand picture and make it difficult to plan. In any event, if OPEC+ burns through spare capacity, that in of itself can drive up prices and volatility, even if every barrel knocked offline is accounted for.
However, the biggest source of uncertainty is on the demand side. The U.S.-China trade war threatens global growth at a time when economic indicators are not looking great. Ultimately, a downturn would drag down prices.
OIES lays out a few scenarios. If OPEC+ sticks with the cuts, Brent prices could rise by $5 per barrel in the second half of 2019 relative to the first half, topping $77 per barrel later this year. If they add supply back onto the market by eliminating “over-compliance,” Brent may stay at around $70. If they exit the agreement entirely prices could fall as low as $60.
Adding to the confusion, OIES included some pricing forecasts that incorporated an economic downturn. A gloomier economic outlook combined with an ill-timed exit from the OPEC+ agreement could send prices down to $50.
Ultimately, OIES argues, there is a rather large gap in expectations between the bulls and bears. The bullish case rests on supply outages and OPEC+ sticking with its cuts, while a more bearish scenario sees turmoil within the OPEC+ coalition, forcing a premature exit from the deal. Adding to the downside risk is the possibility of an economic slowdown. The difference between these two outlooks is significant.
As such, the current state of low volatility, which hinges on assumptions about the steady hand of Riyadh, may not last.
“The extent of dislocations in expectations and the challenge of navigating in the current foggy conditions indicate that the oil market is set for a very bumpy ride,” OIES concluded.