Market Mocks OPEC Crude Jawboning; Morgan Stanley Warns Of Risks To 2018 Oil Price

In the clearest indication yet that OPEC jawboning no longer has an effect on markets, and especially headline scanning algos, following numerous headlines from Saudi energy minister Khlaid Al-Falih overnight warning that the oil rebalancing is imminent, and in case it isn't, it will come in 2018 when OPEC and Non-OPEC producers may extend their production cuts, this morning oil is firmly hugging the flatline after a failed attempt to push higher earlier in the session.

As Bloomberg reports, Saudi Arabia and Russia signaled they may extend production cuts into 2018, doubling down on an effort to eliminate a supply surplus as oil prices continue to drop. 

In separate statements just hours apart on Monday, the world’s largest crude producers said publicly for the first time they would consider prolonging their output reductions for longer than the six-month extension widely expected to be agreed at the OPEC meeting on May 25. "We are discussing a number of scenarios and believe extension for a longer period will help speed up market rebalancing” the Russian Energy Minister Alexander Novak said in a statement.

Speaking in Kuala Lumpur earlier Monday, Saudi energy minister Khalid Al-Falih said he was “rather confident the agreement will be extended into the second half of the year and possibly beyond” after talks with other nations participating in the accord.

“The producer coalition is determined to do whatever it takes to achieve our target of bringing stock levels back to the five-year average,” Al-Falih said. While U.S. shale output growth and the shutdown of refineries for maintenance have slowed the impact of cuts by OPEC and its partners, the Saudi minister said he’s confident the global oil market will soon rebalance and return to a “healthy state.”

The response was less than enthusiastic however, with Brent and WTI giving up earlier, while a drop in Chinese crude imports suggested that the demand side of the equation is becoming a growing concern. 

“It hasn’t moved that much on those statements, I’m not sure we’ll get a meaningful upturn unless we see stocks drawing down,” says Torbjorn Kjus, chief oil analyst at DNB Bank. “Maybe it’s not possible to talk the market up anymore.”

A major hurdle for the oil bulls, as discussed here often, is that s OPEC and its allies curbed supply, U.S. production has risen to the highest level since August 2015 as drillers pump more from shale fields. “Given the extent of the over-hang I think they always knew the market was not going to rebalance in six months which is why our base case was always for a deal lasting at least one year, and if not longer,” said Virendra Chauhan, an analyst at industry consultant Energy Aspects Ltd. “Market expectations were lofty, and so OPEC will need to surprise the market with either a deeper cut, or possibly a longer than six-month extension to get prices to move higher.”

Adding to the downbeat sentiment, was a note overnight from Morgan Stanley's Martjin Rats, in which he warned that Market while the "balance looks favorable" for the rest of 2017, the oil price outlook for 2018 is now at risk, adding that "if stocks build rather than draw next year, 2018 futures do not need to be in backwardation. Recently, the market has priced this in, moving 2018 into contango, and putting pressure on front-month prices too."

More details from his full note:

The Mechanics of the Oil Price Sell-Off

Oil prices have come under pressure despite a robust 2017 outlook:

Notwithstanding the recent oil price decline, our analysis continues to suggest a tightening market over the next few months. Lower OPEC production is still to have its full impact on OPEC shipments, imports into consuming countries, and subsequently on visible inventories. Although demand has gone through a soft patch early in the year (see Exhibit 2), it is still set to strengthen seasonally into 2H. As these two effects combine, a period of inventory draws this year is still in the cards.

However, risks are emerging to 2018 balances: It appears however that oil markets are already looking beyond this, and into 2018. Our base case expectation for 2018 is for a balanced market with stable prices around end-2017 levels. Yet, the risks to that outlook are becoming skewed to the downside.

  • First, the US rig count continues to surprise, and this has production implications.  As shown in Exhibit 3, the US rig count recovery has recently overtaken even the stellar rebound after the 2008/09 downturn, which was supported by oil prices rallying from ~$45 to ~$85/bbl within a year. Yet, the US rig count has increased by 7.3 rigs/week over the last 52 weeks, making this the strongest recovery of the last 30 years. As a rule of thumb, an increase in the rig count of 10 units boosts production by ~40 kb/d a year later. With ~390 rigs added since the trough in
    May 2016, the US is set up for strong supply growth next year, that could exceed 1 mb/d.
  • On top, we expect the current OPEC agreement to be extended in May but it is unlikely to be extended again by December. Exhibit 4 highlights the shift in market share away from OPEC towards US producers. We doubt OPEC will allow this to go on for long. If the OPEC/Non-OPEC production agreement comes to an end by late-2017, the cartel's cut of ~1.2 mb/d, as well as Russia's cut of 0.3 mb/d, could be reversed next year.
  • In total, these three sources could bring 2.5 mb/d of extra supply back onto the market, which would need to be absorbed by demand growth of 1.3 - 1.4 mb/d and declines elsewhere. The latter may not be sufficient, as declines in countries like Mexico, China and Colombia are likely to be canceled out by growth in Brazil, Canada, Kazakhstan and elsewhere. If OPEC's production cuts fail to create an under- supplied market in 2017, the oil market may be oversupplied in 2018. It appears this is creeping into investors' expectations and time horizons.

As 2018 futures moved back into contango, front-month prices have come under pressure: Until a few weeks ago, 2018 futures were in backwardation, indicating that investors foresaw per period of market tightness during that period. However, if inventories build rather than draw next year, this part of the forward curve does not need to be backwardated.

This is precisely what has happened: over the last few weeks, oil markets have started to discount a weaker 2018, driving 2018 futures into contango. Although the market balance for 2017 is still robust, this has put substantial pressure on the front part of the curve too.

Looking ahead: Our thesis for 2017 remains unchanged. As mentioned, our analysis still suggests inventory draws in the balance of 2Q and into 3Q. With oil prices sold off, and still a potential positive catalyst from an OPEC deal extension, this should provide support for prices in the short term. However, prospects for 2018 are looking more uncertain