The fragility of oil prices has been tested by a confluence of factors over the last few weeks. We identify three further downside risks to the oil price that could drive volatility near term. By remaining aware of these risks, investors should be able to successfully navigate this environment.
After three months of relative stability, WTI oil prices have dropped below $50 a barrel, falling 10% in two weeks. This sharp correction, prompted by persistently high US inventories and confusion related to Saudi Arabia’s February production levels, reminded investors of global oil market fragility and how quickly sentiment can turn.
Our long-term view remains the same: range-bound oil prices at $45-55 a barrel. Despite this, investors may have to endure further shorter-term oil price volatility. We believe three factors could fuel near-term risks to the downside:
Sluggish crude inventory normalisation
Despite OPEC production cuts, crude inventories in OECD countries remain high, particularly in the US where high imports have contributed to an increase. In the next few months, declining shipments from the Arabian Gulf and the end of the refinery maintenance season are expected to drive US inventory levels lower. However, any data suggesting otherwise could cause further downside volatility.
US Crude inventories remain elevated
Rapid US shale production rebound
Rebounding US shale production could weigh on prices in the second quarter of 2017. Positive global oil sentiment since the end 2016, driven by larger-than-expected OPEC production cuts, has encouraged US producers to get back to work. Capital expenditures are expected to increase approximately 30% year-on-year.
While capex remains at half of the industry high in 2014, improved shale productivity that enables producers to break even at $45 a barrel, as well as a rapidly rising rig count and uncompleted well inventory, points to US production growth in 2017 – estimated at between 0.2m and 0.9m barrels per day. Was production to hit the higher end of this range, we could see oil price pressure in the second half of 2017.
Uncertainty over OPEC production
The next OPEC meeting takes place on 25 May, when the organisation will decide whether to extend production cuts. OPEC’s decision to cut production last November has been the main driver of the oil price rally and the price’s subsequent stability over the last few months.
While theories abound, it is difficult to predict the OPEC decision. At times, OPEC, and especially Saudi Arabia ahead of the pending Aramco IPO, appear to support the extension of the cuts. At others, Saudi Arabia has made it clear it ‘will not bear the burden of the free riders’ – non-OPEC producers, including US shale. Ahead of the upcoming meeting, in line with others in the past, it is likely that global oil prices will remain volatile, trading on this speculation.
Not all doom and gloom
Despite these three risks, it is not all doom and gloom in the oil markets. As the world economy is expected to grow at 3.2% in 2017, global oil demand is forecasted to rise by about 1.6m barrels per day to 99m barrels by the end of 2017. This compares to expected supply growth of about 1m barrels per day to 99.3m barrels– assuming 0.32m barrels per day growth in US production. However, it is unclear whether expected demand growth can completely absorb potential supply increases from OPEC and US shale.
In credit investing, staying cognisant of the downside risks is of vital importance. Given the risk factors discussed above and the potential associated volatility, at Hermes Credit we currently prefer higher quality energy holdings – such as lowest-cost exploration and production operators Canadian Natural Resources and Range Resources. We also like companies not directly exposed to oil price volatilities, like pipeline operators Kinder Morgan and Enbridge. There are also some specific emerging markets turnaround credit stories demonstrating significant ESG improvements – such as Petrobras.
Source: EIA, Bloomberg
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