When looking at the price of oil in 2015, Canada's Bank of Montreal admits it was wrong. Very, very wrong.
In our "2015 Year Ahead" report we laid out three plausible scenarios: (1) our base case, which forecast Brent crude oil prices of $50-60/bbl over the first half of 2015 and $60-80/bbl over the second half of the year; (2) a bull case, which forecast a Brent trading range of $85-95; and a bear case, which suggested a Brent trading range of $50-60/bbl. The actual trading range in 2015 proved to be even more ‘bearish’ than our bear case, with Brent generally trading between $36 and $60/bbl. So what did we get wrong?
The answer: pretty much everything but mostly the fact that in the race to the production bottom ("we'll make up for plunging prices with soaring volumes") only dramatic outcomes, which shock the status quo, have any impact, to wit:
"we assumed that Iraq production would average 2.9 million bpd; actual production was roughly 1 million bpd higher. We also assumed that Saudi Arabia would be content to hold production at 9.2 million bpd whereas actual production was roughly 800,000 bpd higher. In our view, this incremental 1.8 million bpd of production was the principal reason that global oil inventories swelled by more than 340 million barrels to a record high of approximately 3.1 billion barrels and why crude oil prices have collapsed."
Well, that, and the fact that the financial BTFD community finally threw in the towel on the most financialized commodity, and following two failed attempts at dead cat bounces, may have thrown in the towel. That said, just looking at speculative positions, oil may have a long way to drop still.
[10]
Which may also explain why, as noted last week [11], someone has made material directional (and/or hedge) bets via puts that oil will slide to $25, $20, even as low as $15.
[12]
However, now that the financial overhang from the price of oil has been stripped away, the supply/demand fundamentals once again matter. Which brings us back to BMO, and its latest oil price forecast for the coming year. According to the far more downbeat (compared to last year) Canadian bank, "the current supply-demand balance is not sustainable; something has to give." More:
If OPEC production increases with the return of Iran and non-OPEC production declines only modestly, global inventories could test capacity in 2016. Since this can’t happen either OPEC and/or non-OPEC has to voluntarily (or involuntarily in the case of a disruption) reduce supply. We believe that crude oil prices will need to remain low enough for long enough to force non-OPEC producers to reduce production. We believe that Brent oil prices in the range of $35-45/bbl are required to force a further reduction in the U.S. rig count and/or shut-in oil production from higher cost sources such as stripper wells, conventional heavy oil and mature offshore platforms. Our base case assumes that Brent crude trades in the $35-40/bbl range over the first half of 2016. We believe that this could lead to a reduction in non-OPEC supply in the second half of 2016 that balances supply and demand and supports modestly higher prices in $45-55/bbl range over the second half of the year. The reduced activity should also allow inventories to begin being drawn down in 2017, which should support prices in the $50-60/bbl range in 2017.
More on the near record supply/demand imbalance:
We believe that the weakness in crude oil prices reflects a combination of fundamental factors and financial flows. Fundamentally there is simply too much oil. The main culprit is Iraq, which increased production by roughly 1 million bpd over the last 12 months, along with Saudi Arabia which added an additional 800,000 bpd over the same period. In our view, this incremental 1.8 million bpd of production was the principal reason that global oil inventories swelled by more than 340 million barrels to a record high of approximately 3.1 billion barrels and why crude oil prices have collapsed.
[13]
* * *
In other words, in order to avoid embarrassment for the second year in a row, BMO is merely parroting the Goldman base-case of a reduction in the net supply imbalance in the second half of 2016, which should push prices of oil higher. On paper, sure. In reality, who knows.
Which is also why BMO, prudently, hedges by laying out the biggest downside risk to any forecast: a full-on price implosion.
Could oil prices collapse to $20?
The short answer is ‘yes.’ We believe that crude oil prices could fall further unless global oil production is reduced. As shown in Table 2, we estimate that the global oil market could be oversupplied by roughly 920,000 bpd in 2016. The key assumptions are year-over-year growth in global demand of 1.2 million bpd, Saudi Arabia, Iraq and Libya hold production at current levels, Iran ramps up production at moderate pace over the course of the year and the U.S. rig count remains at current levels.
[14]
This would translate to a build in global crude oil inventories of roughly 231 million barrels over the course of the year and potentially result in OECD crude oil inventories reaching capacity by the end of the year, as shown in Chart 14. Another risk is that Libya increases production. The countries two warring factions recently signed a UN-brokered agreement to form a national government. This could lead to higher levels of production, potentially adding another 1 million bpd to the already over-supplied market. Under this scenario, we believe that crude oil prices could plunge to $20/bbl to ensure that enough crude oil is taken off the market to prevent inventories from breaching capacity.
Good luck with that "voluntary" reduction thesis. If anything, the worse the fiscal outlook of any given oil-exporter gets, the more it will export to offset declining prices, as Chinese steel producers have been kind enough to demonstrate [15].
[16]
Which is why, for anyone focusing on the fundamentals instead of the financials (and the biggest upside price risk has nothing to do with geopolitical events but more with a central bank -coughnorwaycough - announcing it would launch a commodity-focused QE) a $20 case should be the base-case around which to hedge, especially since last week Dennis Gartman turned "Very, Very Quietly Bullish Of Crude. [17]"
In a follow-up article we will show what $20/oil means for the key industry participants in the context of everyone's specific oil price floor, and what happens if and when it is breached.
