No Emotions, Only Facts And Numbers

Global oil market trends indicate the low probability of a new wave of price cuts in this market until the end of the current year.

Source: Stock photo

First of all, I would like to note that in the second quarter the balance in the global oil market has shifted toward demand – i.e., it at least became less “bearish.” I came to this conclusion based on the analysis of two models, which reflected the dependence of quarterly Brent prices on the level of commercial oil stocks accumulated in OECD countries and the number of days of forward consumption in OECD countries.

According to the first model, the commercial oil stocks in OECD countries at the end of Q2 2017 corresponds to Brent oil prices at the level of $48. That is very close to the current price – i.e., the price is almost balanced:

According to the second model, the number of days of forward consumption in OECD countries in Q2 corresponds to Brent oil prices at the level of $55, which exceeds the current price level by almost the size of a standard deviation. In other words, according to this model, the current market price of Brent oil is even below the sustainable level. I would like to note that this model is more acceptable because it reflects the dynamics of the demand.

So, after the wave of decline observed from May to June and the growth in July, the price of oil stabilized near the fundamentally justified level. What’s next?

In order to try to answer this question, I should first draw your attention to OPEC’s predictions concerning the global oil market. I am not talking about the last forecast, but about how OPEC changed its forecasts recently.

In July 2016, OPEC gave its first forecast regarding oil demand in OECD countries in 2017. In that forecast, OPEC predicted consumption at a level of 46.5 mb/d. Then, from month to month, OPEC gradually increased its forecast until it reached 47.2 mb/d, announced this month. As for 2018, OPEC gave only two predictions, where the demand for oil in OECD countries was also revised upward.

A similar thing is observed with OPEC’s forecasts for global oil demand. Thus, the first OPEC forecast assumed the world demand for oil in 2017 at the level of 95.3 mb/d, while the second was already at the level of 96.5 mb/d. The forecast for 2018 was also revised upward in August.

As for OPEC’s forecasts regarding oil supply, they demonstrate inverse dynamics. In May, OPEC predicted oil production in non-OPEC countries in 2017 at the level of 58.2 mb/d. However, in the last forecast, this figure decreased to 57.8 mb/d. The oil production in 2018 outside of OPEC has also been reduced in August.

It is interesting to note that the main reason for the lowered expectations regarding oil production outside of OPEC is the decreased projections of the U.S. production level. In its latest forecast, OPEC predicts the average U.S. oil production level in 2017 at the level of 21.3 mb/d, although in May the predicted level was 21.5 mb/d.

So, judging by how OPEC changes its forecasts, it can be concluded that at least in 2017 world oil demand has been underestimated, whereas the supply capacity outside of OPEC has been overrated. Both are positives for the price of oil.

Moving on, using the latest OPEC forecast and assuming that OPEC oil production remains at the level of Q2 of the current year up to and including Q1 2018, we get the following picture of the global oil market balance for the next three quarters:

As you can see, in Q3 and Q4 there is a daily shortage of oil in the market of 1.2 mb and 0.7 mb, respectively. However, in Q1 2018 there will be a surplus at the level of 0.6 mb/d.

If we consider a conditional scenario where a global deficit or surplus of oil exclusively affects the commercial stocks of OECD countries, by the end of Q1 2018 these stocks will decline by 117 mb to 2916 mb. That is 89 mb above the five-year average – i.e., the stocks will be 89 mb above the goal pursued by OPEC, judging by official statements of its representatives.

And now the main question arises: Will the agreement on limiting oil production be extended in such circumstances? Two months ago, I was sure that it would not happen. But now I’m not sure.

Let’s go back to the end of 2016. After the agreement on limiting oil production was reached in the 171st OPEC meeting, Brent quickly grew to the level of $56 and passed into the lateral trend. At the time, I saw many predictions that the next stop would be $60. After these projections did not materialize and Brent was corrected to $50, it seemed as if the prolonging of the agreement in the 172nd OPEC meeting would make things better. Unfortunately, that did not happen.

At the same time, I noted that the statements of the parties involved in the agreement (the “OPEC+11”) became less optimistic. In particular, back in May the head of Rosneft (OTCPK:RNFTF), Russia’s largest oil company, considered it important for the Ministry of Energy to coordinate with the participating countries a smooth exit from the global agreement on limiting oil production after its expiry date, in order to avoid price volatility in the global market. After Brent tested the level of $44 in June, at least Russian oil oligarchs stopped making similar statements.

In my opinion, Brent under $50, even with the prolonging of the agreement on the limitation of oil production factored in, sobered up the parties to the agreement. If, at the end of Q1 2018, the agreement is canceled Brent will easily drop to $40 again. Apparently, this price level satisfies neither OPEC nor Russia.

In addition, it’s worth noting that judging from how U.S. oil stocks are changing, this year – for the first time in a long time – U.S. oil production lags behind the growth of its consumption. At least this can be considered the first OPEC success in its confrontation with U.S. shale producers.

Finally, I would like to address the latest money managers’ actions that complement the overall picture. Since the beginning of July, hedge funds have increased their long positions in WTI (NYMEX and ICE) by 137,101 lots.

As a result, the total amount of their net long position significantly exceeds the three-year average level for this time of the year.

The liquidity of this market is growing, and the current money managers’ positions amount to 7.6% of the open interest, which is an average indicator.

And, finally, predicting the WTI oil price based on the size of the money managers’ net position, we come to the conclusion that the current price almost corresponds to its balanced level:

As we can see, the number of long positions held by the money managers is adequate to the current oil price, and, in my opinion, they are not getting ready for the next wave of decline.

Putting It All Together

So, I believe that before the end of the year, the new wave of oil price decreases is unlikely. At this point, the current balance of the global oil market, the expected deficit in the second half of the year, the observed growth in global consumption (which is higher than expected), the possibility of extending the agreement on the limitation of oil production at the end of Q1 2018 and money managers’ actions are not consistent with the “bearish” market.

In the immediate future, I think Brent and WTI prices will be moving in the ranges of $50-54 and $46-50, respectively. As such, now is probably a good time to sell put options.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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