The strong and consistent rally in crude prices that took place between the end of June and early December, does not seem to be over yet.
Oil market has shifted considerably over the last few weeks. Brent is trading above $66 per barrel.
Investors are sitting on record bullish positions in Brent futures and options and a near-record position in crude and products derivatives more generally.
The build-up of a massive bullish long position in oil and the limited number of short positions that remain to be covered, are become a major risk to prices.
Money manager’s total long and short positions in Brent and WTI | Source: Reuters
So far, the outage on the Forties system and the tensions burst in the Middle East seems to have discouraged more short-selling and kept oil prices stable at their recent highs.
The Middle East is once again the focus of the biggest alerts. At the end of 2017 the instability was fuelled by the controversy generated by the recognition of Jerusalem as the capital of Israel by the US government.
The beginning of 2018 is marked by the surprising and growing mobilizations in Iran. The demonstrations against the Tehran regime could open new gaps in the alliances sealed by the OPEC countries to extend their production cuts during 2018.
The “sweet” oil price range.
In recent months, the oil market has been very quiet. Oil prices have adjusted very smoothly to events since the middle of 2017. Volatility has been significantly below the long-term average and has trended lower.
While OPEC has reasserted some control of the market in the last few months, the room for manoeuvring is getting tighter and tighter. The context in which OPEC operates has changed dramatically. One key question that OPEC had to face continuously during the past two years was whether there is a ‘sweet’ oil price range that could keep the market in balance.
If the 60-70 $ per barrel level has long been considered the perfect range, there is one factor that could change dramatically this idyllic scenario: US oil production.
US crude oil exports surged to a record high of 1.8 mb/d in October 2017, topping the 2mb/d at the end of the month, exceeding even the most bullish of expectations. But what are the factors behind USA ability to export? Are there effective capacity constraints that can cap departures?
The attributes of US shale are very well known:
- the investment cycle for US shale is relatively short;
- projects have low capital intensity – the capital investment required to bring a new shale well into production is minimum compared to the cost of conventional wells;
- fields decline sharply from initial production – the only way to increase production and offset the impact of decline rates is to bring more and more new wells into production;
- US shale producers are highly reliant on financial capital markets – they are highly leveraged and are therefore heavily exposed to changes in credit market conditions.
These special features allow US shale producers to be more flexible and more responsive to price movements. Some describe US shale output growth as a ‘switch on–switch off’ type of supply. Even if this definition could be considered quite correct however, it is important to underline that there are still some important lags between price changes and output responses. These gaps depend on different factors such as the extent of hedging by US shale producers, their ability to register high levels of productions in core areas, their success in reducing breakeven costs, and their ability to increase productivity gains.
A not so elastic supply..
The change in price observed in the last couple of years revealed some important information about the reaction of US shale to price movements. At around $50 per barrel, growth in the USA was moderate unless starting from a low base (such as the increase in output between 2016 and 2017). However, there is wide uncertainty regarding US shale response in the $60–$70 price range. Estimates vary between 700,000 b/d to above one million b/d for 2018.
U.S. crude oil exports, excluding Canada | Source: EIA
Achieving these volumes is dependent on several factors. First, US production growth must be sufficient to allow an increase for both refinery and incremental export demand in 2018.
Second, there will need to be a sufficient supply deficit in global balances for shale production growth to fill.
Third, sufficient infrastructure must exist to allow shale production growth to move from the wellhead to domestic trading hubs and then from these trading hubs to export terminals. At the moment the outlook for 2018 remains positive: export volumes should remain robust also thank to the strong gap between the prices of WTI and Brent, currently touching the 6-7 $, enough to open the export arbitrage window from the OPEC members.
Brent vs WTI Spread | Source: YCHARTS
Shale producers are being given the green light to produce: their equity is rallying from the August lows, appetite for their debt is healthy, the market is backwardated and prices are higher. It seems clear to both US producers and exporters that the world needs their oil.
Maria Mura | Energy Consultant