Market rebalancing derailed by price rally...
The oil market rebalancing has started: weak prices in 1Q15 pushed producers to cut capex while supporting demand. This led to a recovery in prices further fueled by relief that US crude stocks would not breach capacity, strong demand and rising Middle East tensions. The rise in prices was further supported by oil screening as cheap relative to E&P equities, drawing cross-asset investors into buying crude.
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But, as Goldman Sachs details below, while the rally in oil prices has closed the valuation gap to equities, these trade on historically high multiples and oil itself is now trading at a premium to its own still weak fundamentals in our view.
Goldman therefore views this rally as derailing this rebalancing and setting the stage for sequentially weaker prices, especially with oil speculative length as long as when oil traded at $100/bbl.
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..given still weak current and forward fundamentals
First, while US crude builds turn to draws, it is total petroleum stocks that matter, as rising product stocks will depress refining margins and weigh on crude prices.
Second, our updated supply and demand balance points to an only gradual decline in elevated inventories in 2016 as production growth from low-cost producers such as Saudi, Iraq and Russia help offset strong demand growth and declining non-OPEC ex. US production. Further, we don’t see the US rig curtailment as large enough yet to put production on a persistent downward trend with risk to our flat Iranian production path skewed to the upside.
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Third, we believe that WTI oil prices settling above $60/bbl will eventually lead US producers to ramp up activity, draw down a large well backlog and hedge, given improved returns with costs down by c.20%.
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Fourth, the broader imbalance of too much capital looking for opportunities in the energy space remains intact
The imbalance of too much capital looking for opportunities in the energy space remains intact. For example, the combined dry powder for M&A from the three US oil majors and of North America natural resources private equity funds currently stands at $150 billion, above our analysts forecast capex for the US E&P sector in 2015.
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While ultimately, the long-run asset value of shale oil reserves bodes well for their ability to attract capital, capital investments are now part of the adjustment process given the collapsed time lag shale has created between when capital is spent and when production rises. With credit and equity access not currently part of the adjustment process, the market has one lever left to balance itself: cash flow through oil prices. This large availability of low-cost external capital therefore exacerbates the need for sustained low prices in our view to keep US producing assets from quickly being redeployed in a lower cost environment.
Sequential price decline still required
As a result, while low prices precipitated the market rebalancing, we view the recent rally as premature with crude oil prices expensive relative to current and forecast fundamentals. Ultimately, with evidence at hand that US producers responded aggressively to low prices, the burden of proof has shifted to how they will respond to the recent recovery and whether low-cost producers can sustainably deliver higher production.
This may as a result delay the sequential decline in prices until this fall, especially as we approach a period of seasonally stronger summer demand.
Calling the timing for prices to sequentially decline is challenging in the short run as we approach a period of seasonally stronger summer demand and China SPR fill. Nonetheless, we expect evidence of this fundamental weakness and expected US producer reaction to gradually materialize in the US weekly rig count, hedging flows, weakening refinery margins and monthly OPEC production and rig count growth.
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Source: Goldman Sachs
