The bearish narrative that pushed oil prices below $30 a barrel on Friday is compelling, but three anomalies in the data suggest the outlook may be much less bleak than meets the eye.
Oil prices have fallen by about 20% this year for a myriad of reasons: Concerns over Chinese growth, a deceleration of manufacturing in the U.S., extremely mild winter temperatures in key Northern Hemisphere oil-consuming regions and the impending return of Iranian oil production. Combine these with a strengthening U.S. dollar and it’s no surprise that oil analysts have been rapidly revising down their forecasts.
Nonetheless, three factors point to underlying strength at odds with price direction:
- Refinery margins globally remain very robust, which usually is not the case in poor demand environments. Consumption of gasoline and jet fuel has been incredibly strong, adding strength to global demand.
- The spread between prompt-month contracts (e.g., March 2016) and longer-dated ones (e.g., December 2018) has been narrowing. Typically, when oil prices decline, especially because of demand weakness or oversupplied markets, nearby prices decline more than longer-dated contracts. Oddly, though, near-term contracts recently have fallen less than longer-dated ones. Drivers include long-dated selling pressure by bank credit desks hedging their exposure to oil producers and credit and equity funds selling to reduce tail risk. Importantly, however, this is not related to a forward view on what price would balance supply and demand or where prices will be in six months.
- Lastly – and probably the most glaring error in the narrative – is that as oil has grinded lower in the past few months, the price of WTI (West Texas Intermediate) has flipped and now commands a premium to Brent. This was common before 2010 and the shale oil revolution. WTI needed a premium to motivate imports to the U.S. and to pay for shipping these imports from the U.S. Gulf Coast to Cushing, Oklahoma, where the New York Mercantile Exchange contract is priced.
One possible explanation: U.S. production declines have been so large that the country will now need to import additional crude oil supplies. Indeed, there are signs that onshore production is falling sharply. The monthly data, although quite lagged, show that onshore U.S. production has declined for seven months, reducing output by some 600,000 barrels per day annualized. Through October, the data suggest supplies have responded meaningfully to lower prices – but still at an insufficient pace to quickly repair the global balance. However, recent weekly data storage and refinery run data imply output declines have been accelerating sharply.
While weekly data is notoriously noisy, and subsequent monthly data could very well paint a different picture, we take note as this decline in implied production is consistent with front oil prices outperforming the longer-dated prices and with WTI heavily outperforming Brent.
In short, the moves in the curve and the premium in WTI versus Brent are both inconsistent with the narrative of an ever-oversupplied market that needs lower prices to clear. With recent output reflective of past prices – due to lags between investment decisions, actual investment and subsequent production – and the inability of producers to hedge forward supplies, production declines will only accelerate. In our view, this lays the groundwork for prices to improve and to do so materially.