Oil market amid shifting demand and supply situation

Summary:

• Oil had a stunning beginning of the year surging over 20% since the latest local low

• Activity in the US extraction sector is declining what may lead to a drop in the US production

• OPEC+ cuts are going live, Saudi Arabia slashes production and exports to support price recovery

After several weeks of declines oil prices finally began to rebound. Nevertheless, price declines caused numerous countries to take action aimed at limiting further downside. Moreover, the US shale sector is yet to experience difficulties relating to lower price levels. The situation may be reflected in the oil market balance outlook for 2019, especially in the first half of the year. In turn, there is a scope for oil prices to be more volatility in the months to come.

End of carnage on the oil market

Oil reached four-year highs in October 2018 on the same day the S&P 500 pointed another all-time high. However, both crude and equity prices plummeted since then and there were few reasons behind this:

• Economic slowdown and less upbeat outlook for 2019

• Ongoing trade war between China and the United States

• Relatively small increase in consumption in developed countries, especially the United States, compared to initial estimates

• Too steep output increase in OPEC countries and Russia aimed at offsetting declining production in Venezuela, Libya or Nigeria

• Further production increases in the United States combined with winning market share from other producers

In meantime, the OPEC cartel tried to boost moods on the market signalling that there is a need to rebalance it through production cuts. The production cut was agreed on but on smaller scale than markets expected it. Limiting output by 1.2 million barrels per day could easily be offset by rising production in non-OPEC countries (United States, Canada, Brazil) therefore it was not enough to prevent further price declines. However, the turn of 2018 and 2019 was marked by improving moods on the equity markets, scope for striking a trade deal between China and the United States as well as decisive action from some of the OPEC+ countries that in some cases limited oil production by more than was previously announced.

After a significant sell-off in the final quarter of 2018 oil prices began to recover. Bulls managed to defend the 61.8% Fibo level of the latest major upward impulse. The closest resistance level can be found at 38.2% retracement level near $63 handle. Source: xStation5

End of another shale boom

Situation in the US shale sector greatly improved during the past four years. Cost cuts were followed by new investments and technological expansion. In turn, profitability of the US shale companies improved and the sector began drilling more and more rigs. Shale extraction became the major source of oil for the United States. Nevertheless, problems araised. Firstly, lower oil prices led to budgeting in less investment projects in 2019. Secondly, lack of proper transferring infrastructure, especially in the Permian Basin region, limits further output increases. According to Dallas Fed the extraction activity shrank significantly during the fourth quarter of 2018. Almost every activity index for this sector is declining suggesting that “shale peak” may be looming just around the corner. Number of completed rigs stopped to rise due to the latest sell-off, what may even lead to declines in the US production over the longer term.

Number of uncompleted rigs is increasing quickly while the number of completed rigs is dropping. Prices declines may suggest the end of the shale expansion in the United States, especially as the product end-price would need to be reasonably higher to support further investments. Source: Bloomberg

OPEC+ plans bigger output cuts

OPEC+ countries began to implement recently agreed production cuts. However, countries like Saudi Arabia already hint that they may limit output be more than it was agreed on. Saudi Arabia alone plans to slash exports by as much as 800k barrels per day in comparison to November’s exports. Moreover, Iranian exports keep decline despite sanction waivers granted to countries like India, China, Japan or South Korea. Venezuela and Libya also keep experiencing problems with oil exports.

How the oil market balance looks right now?

Just a few months ago most of the forecasts pointed to a significant increase in implied oil inventories throughout 2019. IEA suggested that the first quarters of the year may result in 1-1.5 mb increase in oil inventories what in turn forced OPEC+ group to slash production. However, situation has changed since then. Demand increase in 2018 is estimated to be around 1.5 million barrels per day. Various estimates hinted at 1.3 mbd increase in demand in 2019. However, if we take into account more severe global economic slowdown this number may go to as low as 1 million barrels per day.

When it comes to the supply side the situation is way more complex as it does not depend solely on the economic growth and oil prices. Supply increased by 2.5 million barrels per day in 2018 while forecast for 2019 suggest that supply will increase by 2.19 mbd with 2 mbd increase accounting solely to the North American countries. Current estimates point for the US production to increase by 1.5 million barrels per day but if we take into account potential slowdown in the shale sector this increase may be much smaller. We assume that oil supply will increase by 1.5-2 million barrels in 2019. OPEC forecasts hint that demand for cartel’s oil may be smaller than 32 million barrels per day during the first half of the year. However, this smaller demand may be offset by declining supply. What does it mean for oil prices? We may experience a situation similar to the one from 2017 when, despite mixed expectations, production cuts indeed led to the balancing of the oil market.

OPEC and EIA assume that demand and supply will rise moderately throughout 2019. In our opinion supply may decline more than demand. Such a situation should occur especially in the first two quarters of the year. Source: OPEC