The fragility of oil prices has been tested by a confluence of factors over the past month. In this investment note, Audra Stundziaite, Senior Credit Analyst at Hermes Investment Management, identifies the four fundamental factors likely to keep global oil markets finely balanced over the medium term. By remaining cognisant of associated risks, she argues investors should be able to successfully navigate through this environment.
After three months of relative stability, WTI oil prices dropped more than 10% in March, prompted by persistently high US inventories and confusion related to Saudi Arabia’s February production levels. Prices rebounded in late March and early April on signs of inventory draws, as well as more constructive headlines regarding the upcoming OPEC meeting and rising geopolitical tensions in the Middle East.
This price volatility has reminded investors of global oil market fragility and the importance of appropriate positioning. We maintain our view of range bound oil prices at $45-55 a barrel, as the four factors below are likely to continue influencing the delicate rebalancing act within global oil markets.
Inventory levels remain elevated
Despite OPEC production cuts, crude inventories in OECD countries remain high, particularly in the US, where high imports and refinery maintenance have contributed to an increase. In the next few months, declining shipments from the Arabian Gulf, the end of refinery maintenance period and the beginning of the summer driving season are expected to drive US inventory levels lower. While data over the last few weeks points to inventory draws, the US Energy Information Administration revealed inventories remain near the upper limit of the average for this time of the year.
Potential OPEC production cut extension
The next OPEC meeting takes place on 25 May and a decision will be made on whether to extend production cuts. OPEC’s decision to cut production by 1.2m barrels a day last November, in order to reduce crude inventories, has been the main driver of the oil price rally and the subsequent stability over the last few months.
While headlines seemingly vary on a daily basis, recent commentary indicates OPEC is inclined to extend the cuts. Saudi Arabia – OPEC’s biggest producer and the world’s top exporter of oil – reportedly told the cartel it wants to extend the agreement. However, Saudi Arabia has previously made it clear it will not ‘bear burden of the free riders’ – a likely message to US shale. A rolling over of the OPEC agreement will provide support to oil prices, but any doubts could potentially result in a correction.
Source: EIA, Bloomberg
US shale rebound could pressure prices
Positive global oil sentiment since the end of last year, 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 is enabling producers to break even at $45 a barrel. This, along with a rapidly rising rig count and an uncompleted well inventory, points to US production growth in 2017 – estimated at between 0.2m and 0.9m barrels per day.
Should production exceed the higher end of this range, it is likely to offset more than half of the combined circa 1.8m barrel cutback by OPEC and others, including Russia. This could put pressure on oil prices in the second half of 2017.
Demand is robust, but investors must remain alert
In addition to the supply-related factors above, demand appears resilient. With the world economy expected to grow at 3.2% in 2017, the International Energy Agency forecasts global demand to rise by 1.3m to about 97.9m barrels a day. However, this is 0.1m lower than the prior forecast, due to lower than previously expected growth in countries including Russia, Korea and the US, as well as the Middle East. In a meantime, supply is expected to grow by 0.5m barrels a day, averaging 97.5m, assuming US supply growth of 0.7m barrels a day.
The factors above seem to suggest the delicate balancing process remains intact, keeping oil prices range bound. Given our ‘lower for longer’ expectation for global oil prices and the rather unappealing credit valuations on offer (WTI stood at $91 a barrel the last time global energy spreads traded at similar levels), at Hermes we currently prefer companies best positioned for such an environment. These include the lowest-cost exploration and production operators – such as 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 specific emerging markets turnaround credit stories that are demonstrating significant ESG improvements – such as Petrobras.