Oil Market Fundamentals Remain Tight

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 – Oil market fundamentals remain tight
 – Analysts assess price levels for demand destruction
 – Price forecasts revised
 – Deutsche suggests preferred oil market exposures
 

By Chris Shaw

Since the loss of exports from Libya last year, Barclays suggests the oil market has consistently underestimated the strength of fundamentals. Each time the market has come close to fully pricing in fundamentals a key variable has changed, the result being market perceptions have then swung the other way.

Looking forward, Barclays expects the market's focus will shift back to OPEC volumes, especially if the strength in the market's supply and demand dynamics becomes more widely accepted. While Saudi production may rise this is only likely to meet seasonal increases in domestic demand, so preventing any build in global inventories. At the same time Saudi spare capacity would be run down to below one million barrels per day, setting an upward trajectory for prices. 

While oil prices have been fairly volatile in recent months, Barclays expects a calmer June quarter. What should dampen volatility in the group's view is the potential release of strategic reserves and the unlikelihood of any escalation in terms of military activity against Iran.

On the flip side there are still some upside risks from tight market fundamentals, including a positive demand shock from Japan and ongoing non-OPEC supply issues. Japanese oil use is seen as probably the single largest demand side uncertainty in the view of JP Morgan, as any decision to restart closed nuclear power plants could see that nation's oil use fall sharply.

JP Morgan expects Japan could re-start six of 54 nuclear reactors by the peak summer demand period of July-August, but this additional power supply is likely to meet shortages rather than displace oil demand. 

As noted by JP Morgan, the difficultly in accurately assessing Japanese demand is oil is the swing fuel in that market. This means its use will vary widely based on summer temperatures, power conservation measures and any shift in nuclear policy. 

In terms of the tightness of oil market fundamentals in general, the major driver has been solid demand from Asia in particular. Barclays suggests this demand goes beyond simply restocking and is actually representative of underlying demand, as inventory build this year has not risen to unusual levels.

Barclays suggests one way to analyse the oil market is to split the market into the BICS and non-BICS – BICS being Brazil, India, China and Saudi Arabia. If expectations for BICS are correct the shape of the demand picture is right, which is not always the case when assessing markets such as the US, EU or OECD.

In the view of Barclays, a major reason oil prices have doubled over the past five years is the strength of demand growth from the BICS, which has continued even as Brent prices averaged US$111 per barrel last year.

In more recent times a further factor in tightening the oil market has been refiners reducing imports of Iranian crude. This process is expected to continue to the extent that by the time embargoes are officially implemented later this year, oil exports from Iran may fall by a net amount of one million barrels per day from the levels seen in January.

When the issues in Iran are added to supply disruptions in the Sudan, Syria and Yemen, Deutsche Bank suggests the total impact on market supply could be as much as two million barrels per day. As this is coming at the same time as positive economic data is supporting oil demand, and given these disruptions will be slow to be resolved, the broker has lifted oil price estimates for the full year.

Deutsche is currently forecasting global economic growth for 2012 of 3.5%, which is well above the 2.5% level that would signal significant downward pressure on global oil demand and therefore the oil price.

Prices are not yet at a level that would signal a tipping point for global oil demand according to Deutsche. Looking at oil relative to world GDP the broker estimates this year oil's share will be around 5.0%, which implies around US$130 per barrel would be a tipping point for oil demand rationing on a more graduated basis. 

At US$150 per barrel Deutsche suggests there would be a more sudden and vigorous rationing of oil, something expected to signal a more precipitous drop in global demand. 

For 2012 Deutsche is now forecasting Brent prices of US$117 per barrel, up from US$115 per barrel previously, with risk to this forecast to the upside in the broker's view. These risks include a potential escalation of conflict and unrest in both the Middle East and Africa, while downside risks include possible releases of strategic reserves.

Long-term Deutsche has not adjusted its price forecast of US$125 per barrel for Brent from 2015. The long-term forecast reflects the challenge of growing supply to keep pace with demand growth given ongoing issues with non-OPEC supply and the potential for political factors to impact on OPEC production growth.

A look at the market in recent weeks suggests a pause in prices is likely, Barclays noting since prices rose above U$120 per barrel for the OPEC basket the market has traded in a narrow range. At the same time overall volatility levels have been relatively low, which implies there is little momentum in prices at current levels.

Beyond the shorter-term, Barclays has considered the impact of higher oil prices, attempting to assess what could happen to global oil demand given different oil price scenarios. This is assessed around a base case forecast for this year of US$115 per barrel for Brent crude, which reflects expectations of tightening fundamentals, limited spare capacity and few geopolitical tensions.

Under such a base case scenario US oil demand is forecast to fall by 1.3% this year and European demand by 2.1%, while an increase in Chinese demand of 7.4% should be enough for global oil demand to increase by 1.2%.

At US$100 per barrel growth in non-OECD oil demand would likely be extremely strong, while any fall in OECD demand would be mild. If prices were to stabilise at current levels of US$125 per barrel non-OECD demand would continue to grow in the view of Barclays, by enough to offset the decline in OECD demand. This would mean global demand growth would remain positive if the oil price remained around current levels. 

If prices rose to US$150 per barrel Barclays suggests global oil demand would fall sharply, to the extent there would be demand destruction in OECD nations. At such a price non-OECD nations could still generate positive growth, but Barclays takes the view the burden of subsidies on government would become so large there could be significant alternations in domestic price policy. 

Barclays concludes current market conditions of low inventories and stretched spare capacity mean the global oil market is heading towards a dangerous zone for demand, and potentially for global economic growth as a result. 

Looking more closely at the US market, JP Morgan notes crude production in January rose strongly to a rate of nearly 6.1 million barrels per day. This is the first time the monthly average has moved above the six million barrels per day mark since 1998. When combined with falling demand and growing product exports means net oil imports into the US are the lowest for 16 years.

This trend appears set to continue, JP Morgan forecasting net imports through 2012 are likely to average below eight million barrels per day. This is about one-third less than the peak annual average import level achieved in 2005.

Helping US production increase is growing output from "tight oil", or shale oil projects. UBS estimates such output is likely to increase from 0.7 million barrels per day in 2011 to 2.8 million barrels per day in 2016 and 3.7 million barrels per day by 2020. 

In part his reflects the relatively cheap cost of developing such reserves. On UBS's numbers, the break-even for developing US onshore tight oil is between US$60-$65 per barrel, of US$65-$80 per barrel when taking into account the cost of acquiring acreage.

In terms of risks to this view, UBS suggests the major upside risk is the growth potential of the tight oil sector continues to be underestimated. Infrastructure constraints represent the major downside risk, while environmental issues are a further concern.

Higher output from shale oil projects means the US is now set to be the largest source of production growth outside of OPEC. UBS expects total US oil production will grow from 9.1 million barrels per day in 2011 to 11.2 million barrels per day in 2016 and 12.1 million barrels per day in 2020.

While this should translate into slightly higher implied OPEC spare production capacity in coming years the impact is not enough to cause UBS to adjust its long-term oil price forecast of US$95 per barrel. 

Having said that, UBS cautions prices within the US may be pressured by the growing volumes of tight oil, especially if infrastructure bottlenecks are not resolved. 

In terms of how investors can best play the oil price outlook, Deutsche continues to favour Oil Search ((OSH)), Santos ((STO)) and Woodside ((WPL)). The attraction of Oil Search is pure-play exposure to the economically strong PNG LNG project already under construction, while Santos also has PNG LNG exposure and a high level of fixed price contracting at its GLNG project. 

Woodside is seen as attractive given the start of production at Pluto-1 both reduces exposure to development risk and lifts exposure to oil prices given increased production. Karoon Gas ((KAR)) is Deutsche's preferred mid-cap exposure given potential to create value through an extensive drilling program in coming months. 

The FNArena database shows Sentiment Indicator readings for these stocks of 0.9 for Oil Search and Santos, 0.3 for Woodside and 1.0 for Karoon.
 

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