What’s the story?
Despite a small bout of profit-taking overnight, crude oil prices have experienced a strong rally over the past 6 months, with both WTI and Brent up more than 50% from their June 2017 levels. These are the highest levels since 2014.
What’s Driving the Rally?
- Demand/Supply –A combination of strong global oil demand growth coupled with falling inventories, thanks in part to OPEC’s output cuts, have been the primary driver of the rally. The reduction in excess inventories has resulted in oil moving from contango to backwardation (which occurred late last year), slowing producer hedging flows, leaving the forward curve unanchored and deferred prices steadily rising above marginal costs.
- Geopolitical Risks– In addition, rising geopolitical risks (Iran, Venezuela) have exacerbated the move.
- Cold weather– Oil demand has been boosted significantly in recent weeks by the extremely cold weather in North America. This seasonal fillip adds to robust economic activity that has lifted growth expectations for 2018
- Upgrades –In the past two days we‘ve seen several Sell-side upgrades coming through to oil price forecasts (Morgan Stanley upgraded Brent forecast to USD75/bbl on Tuesday to reflect oil market likely remaining undersupplied in ’18, keeping backwardation intact); (BAML have upgraded their WTI forecast from USD52/bbl to USD60/bbl).
- Speculative money– Goldman Sachs oil trading desk notes that money has been flowing into oil, with “total oil positioning now close to record levels, with oil managed money positioning adding 64 million barrels in the first 2 weeks of January alone, with increased longs driving the move”.
Will Backwardation Persist?
- Oil moved from contango to backwardation late last year. Backwardation has historically made oil futures trading much more profitable. This has resulted in increasing demand from the paper market (which is 50x larger than the size of the physical market) which may continue to support oil prices.
- Inventories, which have been falling, are the key drivers of the term structure of the forward curve. Oil markets were 0.5 mb/d under-supplied in 2017, which the market believes will likely moderate, but consensus estimates are still forecasting a slight deficit this year in 2018. “This will likely keep inventories on a downward trajectory, which is likely to keep the current steep backwardation in the Brent and WTI curves intact” according to Goldman Sachs.
Saudi Aramco IPO
- Fuelling the interest in oil is the much-hyped potential IPO of Saudi Arabia’s national petroleum and gas company, Aramco, which will be the largest IPO ever. A final decision has yet to be made by Saudi Crown Prince Mohammad bin Salman on the IPO date, however a late 2018 target has been suggested
- Saudi Arabia has shortlisted New York, London and Hong Kong – singly or in a combination – for the international portion of the listing
- Riyadh could raise as much as $100 billion in the sale of up to 5 percent of Aramco if it achieves a projected $2 trillion valuation
- Unconfirmed sources have stated in Bloomberg that China has offered to buy up to 5 percent of Saudi Aramco directly, and that Goldman Sachs, Citigroup and Deutsche Bank are poised to take lead roles in the IPO
What are the Risks to Oil prices?
- Excess Supply and US Shale Production –Bank of Singapore continues to view that “Lingering concerns over excess supply means that we still see downside risks for oil prices, though we raised our 12-month target for WTI to $50” (MIG December/January 2017/18).
- US Shale production is going to be a big influence of oil prices this year and a key question on investors’ minds at the moment is“How much can shale grow at current WTI prices of ~USD64/bbl?”. The short answer is that the market has mixed views on how quickly Shale production can fill the inventory gap. In the US, drillers added 10 rigs to fields last week, the most in more than six months, according to data from Baker Hughes on Friday – the largest week on week change since June, bringing the total count to the highest since September. Despite this however, the market again showed indifference to the results, and the news did little to change the upward momentum behind the oil price this week.
- OPEC Cuts Cut Short– If oil prices continue to rally, it is possible that the OPEC-NOPEC production cuts might be cut short if the market were to remain balanced. However it is worth noting that last week, Iraq said that OPEC-led output cuts should continue, despite recent price gains. The comments from Iraq echoed a call by the United Arab Emirates and other producers that the cuts should stay in place despite high prices, at least until the group’s initial goal of global inventories returning to the pre-oil collapse five year average is reached
What Can Clients Do?
Despite this recent rally, the Global Energy sector was an underperformer over the past 12 months, with the MSCI World Energy Index returning only 8.99% versus MSCI World of 22.69%. Bank of Singapore upgraded the Energy sector to ‘Neutral’ last year, recognizing that from a valuation perspective, Energy was beginning to look more attractive. As we head into 4Q earnings season, and with elevated oil prices, 4Q earnings will likely get a boost from significantly higher oil prices. However for some companies, the market has already priced this in. Therefore we encourage clients to be selective with their choices – the below table highlights those US, European and HK/China Oil and Gas Companies in our Research coverage that still have upside to our Fair Value. Alternatively, clients may also consider broader ETF exposure via the two ETFs below.
ETF’s to Consider for Broad Exposure:
XLE UP – SPDR ENERGY SELECT ETF
XOP UP -SPDR OIL AND GAS EXPLORERS ETF