At the beginning of 2017, we predicted strengthening fundamentals would drive the oil price to near $60 bbl by the end of the year. While our expectations were met, the market proved reluctant to react. It took the oil price until the end of June to react to the rapidly improving fundamentals and it took the stock market until the end of August to start its ascent. However, looming risks to the global oil supply indicate oil equity prices are on a positive trajectory for some time to come.
Oil markets are currently undersupplied, with inventories far lower than where they began 2017 and OPEC extending its cuts into this year.
We are now entering 2018 in a far more balanced state than we exited 2016. Oil markets are undersupplied, albeit with OPEC cuts still in place, with demand being bolstered by synchronised global economic growth and inventories far lower than the beginning of 2017. In fact, anecdotal evidence points to a global inventory market that has arguably already balanced – with days of forward cover in the low single digits or possibly even lower - which should support the spot price going forward.
There was a significant move higher in the spot oil price in 2017, as oil priced for immediate delivery moved up $10 bbl. However, oil priced for delivery for the end of 2020 was unchanged on the year, and $9bbl lower than the spot price. This ‘backwardated’ cost curve is unusual, because normally storage costs for holding the oil for one year would be compensated for in a higher price. A significant part of the bullish story we believe could evolve in 2018 is the fact 2019 and 2020 priced oil could move appreciably higher. This is a result of the dearth in mid and large scale projects delivering first oil in 2019 and 2020 – the hangover from the slashing in capex that started in 2014. A backwardated oil price is normally a very bullish signal for energy stocks. Hence, a flattening of the futures curve could lead to an energy market outperforming the oil price.
Risk one: a compromised supply chain
The combination of more balanced inventories, the low number of projects delivering first oil between 2019-2021, years of slashed maintenance spend and empty government coffers in producing countries is contributing to a significant rise in the oil risk premium. If an external incident were to happen, companies would struggle to meet demand. As the year progresses, the oil price will become increasingly sensitive to any supply disruptions.
These disruptions are becoming increasingly likely. Equipment maintenance may have been compromised for some years as the lean pricing environment encouraged producers to cut costs. On the other hand, the chances of civil unrest in petro-economies are high, even as budgets recover.
In December, we saw one of the pressing risks to oil markets become reality. In the middle of the month the energy market lost 400k bbl/d oil production in the North Sea, due to a cracked pipeline. The 235-mile Forties pipeline, which links the UK and the North Sea, carries about 40 per cent of the physical oil in the Dated Brent benchmark. The shutdown prompted an immediate price move of US$2-3 a barrel and lasted three weeks. This drove up the prices of other oil grades as buyers searched for alternatives to feed refineries.
Risk two: rising instability in the Middle East
The other primary risk to oil markets in 2018 is the growing political tension in several of the major oil-producing economies. Towards the end of 2017, protests in Iran put further upward pressure on the oil price, sending it to three-year highs. Many Iranians believed the more moderate Rouhani, combined with the lifting of nuclear sanctions and a rebounding oil price, would bring a period of improving and freer lifestyle. Those hopes have not been met.
Growing resentment to the routine corruption, continued religious ideological oppression and economic mismanagement in the country is threatening the current regime. The geographic and demographic scope of the protests make this uprising particularly threatening for the Iranian regime – while the Sunni/Shia balance of power within the Middle East has rarely been so precarious. Not only is an ideological battle between the Saudi-led Sunni and Iranian-led Shia being fought physically across the Middle East, but opposition religious hegemonies are now being threatened from within.
The US spotlight is firmly fixed on Iran and it seems to be firmly behind the ‘speculated’ Saudi-Israeli alliance, stoking the flames under the Sunni/Shia cauldron. Under these conditions, the US will look for a reason to re-impose sanctions regarding Iranian oil exports. Although it could do this relatively swiftly, US-only sanctions would appear impotent. To carry any weight, the US needs to move under a pretext that will garner support from Europe, et al. This will be a tough task, as many European countries do not want to be too closely associated with an overtly aggressive foreign policy that is prone to change with a tweet. However, if sanctions do return, particularly with the support of the Europeans, then we can expect a much tighter, higher oil market and price in 2018.
Richard Robinson is manager of the Ashburton Global Energy fund.
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