Commodity Review-Crude

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1 -Crude Treasury Research Group For private circulation only Oil Maintain a cautiously bullish view Chart: US production continues to surge and is expected to overtake Saudi Arabia in the coming month. Oil prices have rallied in the past two weeks in expectation of extension of the OPEC deal. Compliance with the deal has been above market expectations aided by Saudi Arabia cutting more than promised and supply disruptions in two exempt nations (Libya and Nigeria). While the extension of the deal was net positive, absence of deeper cuts and lack of any changes in quotas disappointed the markets. Going by the fundamentals, we expect the oil prices to get a boost in the near term owing to a rebound in global demand, and the usual summer driving season in the US market. Chart: While OPEC production reduced, it was offset by rise on Non-OPEC production OPEC production cut deal struck last November has so far failed to achieve one of its key objectives-moving the global oil inventories closer to its long term average. While the production cut deal has caused reduction in the cartels oil supply, it was offset by surge in production by US. OPEC has seriously underestimated the resilience of US shale producers. US shale drillers have now become more efficient, reducing their breakeven costs by more than half over the last three years. US oil producers can no more be dubbed as marginal players. The explosive growth in the Permian basin, if continued, is expected to reach over ~5 mbpd by 2020, a level more than countries such as Iran and Iraq. The current US oil production stands at ~9.3 mbpd. Estimates suggests that US is set to displace Saudi Arabia as the largest second largest oil producer in the near future. Now where does all this leave the oil market balance? Sri Virinchi Kadiyala sri.kadiyala@icicibank.com Fundamentals, i.e., the basic forces of global demand and supply paint a somewhat rosy picture. Estimates by International Energy Administration (IEA) suggest that oil market might have already turned into deficit (demand outpacing supply) by the end of the first quarter, Factoring an extension of the deal would make sure that the deficit expands through the 3 rd and 4 th quarters. Any further deepening of the cuts (increase in quotas) would ensure that the inventory levels move faster towards long period average. However, compliance with the deal will be comparatively difficult as many seasonal factors turn negative. Member countries must do real sacrifice by reducing their exports and production, which will be costly. The upward revisions to global growth forecast by the IMF bodes well for maintaining a robust oil demand. We expect the Brent to rise to the level of ~USD by year-end and then decline in 2018, as oil market turns back into surplus once again. In this report, we discuss oil supply-demand dynamics further in detail below. June 1 st, 2017 Please see important disclaimer at the end of this report

2 Prices Since the OPEC production cut deal was reached in November, last year, oil prices witnessed a slight upsurge and hovered in the mid 50 s for the most part. The first few weeks of May saw oil enduring significant declines, wiping out the entire gains made post the deal in last November. Following pronouncements by OPEC officials, oil prices quickly reversed, and are currently in the middle of two week rally. Spread between Brent and WTI moved in a narrow range during the last six months. The spread on average expanded during the first quarter of the year peaking at USD 2.86/bbl in the month of March. However, after receding mildly to USD 2.70/bbl in the month of April, the spread once again increased to rise above the USD 3.00 levels on cues of OPEC production cut getting extended in May. Oil prices have been volatile in the run up to the OPEC meet. The spread between WTI and Brent remained steady. Progress on production cut deal so far The compliance with the production cut deal was better than market expectations. It was largely driven by Saudi Arabia cutting more than its share of the promised quantity. The supply cuts were also aided by two exempt nations-libya and Nigeria whose supplies were marred by disruptions. While Libya saw the production decline thanks to militia conflict, Nigeria had a planned maintenance. Russian compliance with the deal was ensured by bringing forward refinery maintenance, aided with seasonal decline in demand. Further, many countries increased their production to unsustainable levels, in the last months of 2016, only to bring to normal levels in 2017, showing an artificial decline in the deal window. A confluence of these factors helped OPEC maintaining a better than expected compliance rate. The compliance rate already stands at around 110% by April according to OPEC s secondary estimates. However, OPEC deal has failed to make any significant progress in drawing down record inventory levels. While OPEC member countries reduced their supply, they had severely underestimated the resilience in the US oil production. The continuously increasing US production made sure that the gains from the cuts proved elusive. OPEC compliance was better than market expectations Overall compliance was aided by disruptions in exempt nations. Note: OPEC-11 excludes Libya and Nigeria which are exempted from the deal. 2

3 Going forward, compliance with the deal would be difficult. The favorable effects observed from the exempted nations are expected to vanish as Libyan production is back on track, and is forecasted to increase production to 800kb/d by the end of this month, its highest level since December, Nigeria, the other exempted nation, plans to restore exports from its Forcados terminal next month. Russia, which has recently announced that it has completed its full share of production cuts, was a major benefactor of the deal. The seasonal demand patterns witnessed in Russia, which helped the country sail through the cuts, are turning negative, making the Russian compliance all the more difficult. Member countries must now make painful sacrifices like cutting exports and foregoing revenues to ensure future compliance. OPEC deal extended through the first quarter, The deal announced the addition of a new small country Equatorial Guinea, a country which accounts for a mere 0.3% of global oil production. However, its impact on overall supply dynamics is negligible. In terms of number of participating countries, the deal took the tally of to 14, an all-time high. The extension through March, 2018 marks the prolonging of the rare collaboration between OPEC and non-opec members such as Russia, which was last seen some 15 years back. Most of the terms of the deal such as extending the deal through first quarter, 2018 and retaining similar quotas and exemptions were already rumored by mid-may. Though, absence of any positive surprises capped gains, they would inadvertently hurt the US shale producers who would otherwise have got another major hedging opportunity. Thus, OPEC deal has essentially ensured to place a floor for the prices. Oil markets are slowly narrowing down the excess surplus. Crude is set to enter deficit from the second quarter. OPEC members have promised discipline, by forming a monitoring committee which would meet in regular intervals, and take regular stock of compliance and other related developments. Further, during the press conference, they have signaled flexibility, implying a deepening of cuts if the need arises. Curiously absent from the deal was a clear cut exit strategy. Khalid al-falih, Saudi Arabian oil minister, has said that theirs is not a structural intervention, but a mere effort at bringing the market to a balance. This would imply that, once the markets do come into balance, OPEC would withdraw from cuts and let the market forces determine prices. Investors would now be focusing on compliance and US inventory levels. Any surge in production by exempted nations (Libya and Nigeria) would also be keenly tracked. 3

4 US oil balance Barring the last week s reduction, US crude oil production continues to rise, expanding for eleventh straight week. With production now at ~9.32 mbpd, US is now in striking distance of market leaders Saudi Arabia and Russia. The production is also at its highest level since August, Over the last six months, US oil producers registered an impressive cumulative growth of ~7%. US oil producers continue to overshoot the market expectations. And what s different this time around is that the increase in production comes amidst oil prices hovering around the mid-fifties, a price way below the highs seen in 2014, when US now famous production story started. US crude inventories which continue to remain way above five year averages, are slowing starting to decline. With the official beginning of summer driving season this week, oil demand is expected to increase in the coming months. American Motor vehicle association has reported that the average miles driven is already up by 1%, YOY in March, taking the upcoming summer driving demand to an all-time. We expect the demand to take its toll on inventories, and we expect the draws to continue their momentum. US crude stockpiles continue to be above five year average. However, decline in inventories have finally started. The decline in gasoline and other distillate inventories is adding to the bullish sentiment. Source: EIA, Bloomberg, ICICI Bank Research US oil production continues to expand Source: EIA, Bloomberg, ICICI Bank Research Global inventories are forecasted to moderate in the upcoming quarters. Source: EIA, Bloomberg, ICICI Bank Research Source: EIA,OPEC, Bloomberg, ICICI Bank Research US SPR sale Reports of US administration mulling over sale of half of US s strategic petroleum reserves over the next decade is expected to have minimal impact on the overall balance. While US s SPR are the world s largest, capable of covering a week of global oil demand, its staggered release, is expected to add a mere 0.1% to the global oil supply, basing on some back of the envelope calculations. Rather than the quantitative effect, it s the symbolism of a major country hypothesizing selling its strategic reserves, is what signals a fundamental shift in oil market. 4

5 Shale wellhead breakeven prices have reduced by ~50% in the last four years. Source: Rystad Energy, ICICI Bank Research. The strategy behind OPEC s self-inflected injury of allowing the oil prices to slump was to drive away high cost producers. The eventual result is for everyone to see. The Shale producers have shown remarkable elasticity confirming the peculiarity of oil markets where costs follow price. Shale companies have sharply enhanced their efficiency. The two broad themes underlying shale s surge are technological efficiency along with clever leveraging of capital markets. The US shale production continues to increase, with the Permian basin showing highest increments in the last two years. The production is expected to get a further boost as investment gets locked in after the recent price surge. According to a Bloomberg survey, 45% of the companies surveyed have already hedged their entire 2017 oil production. Nominal evidence of this can also be witnessed in the growth of rig count, which continues to expand in US. The lagged impact of growing rigs will be seen aiding production next year. Demand outlook While markets seem to be completely fixated on the supply side dynamics of oil, we feel that it is the demand that is a more crucial driver of oil prices. Historically, it has been the higher demand that drove prices rather than the supply cuts. Global growth prospects continue to be one of the unambiguously positive drivers of the oil prices. Notwithstanding the first quarter GDP figures, US economy is expected to post a strong rebound in the upcoming quarters. Euro area too shows considerable strength. Going forward, the incremental growth in demand would be largely driven by emerging economies like India, China. Chinese economy continues to surprise on the upside, with the growth figures overshooting the official targets. Indian economy is expected to rebound with domestic consumption and investment being key drivers. In sum, the rebounding global growth is reflected in the IMF s upward revision of its global growth forecast, which is expected to grow at 3.4% vs. a growth of 3.1% in the previous year. This is expected to have positive effect on oil demand. On the Dollar front, our house view continues to see a stable outlook for the Dollar index in the upcoming quarters. Subsequently we don t foresee any major risk to prices from Dollar volatility. Financial Markets Moving onto the financial markets, the net managed position as well as the structure of the futures market are expected to provide clues on markets perception of oil prices. Investors continue to pile up net long contracts following signals of OPEC extending Brent Market continues to be in contango the cut into first quarter of The Brent future prices continue to be in contango. The continued presence of contango is aiding the US shale producers who are locking in future production. A transformation into backwardation, a state where future prices are less than the present, is suggested as a probable solution in helping OPEC drain the bloated inventories. While backwardation would help in reducing the inventory levels, its impact on oil production is ambiguous. Historical evidence suggested that US oil production rose most during periods of backwardation ( ).. 5

6 The euphoria surrounding the extension of the deal through the first quarter of 2018, has rallied prices in the last two weeks. However, absence of deeper cuts and doubts over continued compliance by member countries will cap gains. Our view continues to be cautiously bullish on the oil market in the near term and is driven by two factors. First, the upcoming summer driving season is expected to boost demand significantly and we expect the draws in crude inventories to continue at an even higher pace. With oil market set to enter the deficit mode, and the demand having an upside bias, we expect the deficit to expand going further in the upcoming quarters. However, the rise in prices will stall in Q4 as supply outpaces demand. Add to that a diluted compliance by OPEC member countries, and we may well be staring at an oil market which once again turns back into surplus in first quarter,2018. Oil prices are forecasted to go up in the near term. However, the gains will be capped as oil market is expected to go into surplus in Source: EIA, ICICI Bank Research. Source: EIA, ICICI Bank Research. 6

7 Treasury Research Group Economics Research Sunandan Chaudhuri Senior (+91-22) Economist Kamalika Das Economist (+91-22) (ext. 6280) Samir Tripathi Economist (+91-22) Pradeep Goyal Economist (+91-22) (ext. 6229) Sumedha Dasgupta Economist (+91-22) (ext. 7243) Renuka Khadke Economist (+91-22) (ext. 8976) Sri Virinchi Kadiyala Economist (+91-22) (ext. 7206) Treasury Desks Treasury Sales (+91-22) Currency Desk (+91-22) Gsec Desk (+91-22) FX Derivatives (+91-22) /43 Interest Rate Derivatives (+91-22) Commodities Desk (+91-22) Corporate Bonds (+91-22)

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