As pessimism sweeps over the oil market, a few prominent voices are unbowed, arguing that the market is well on its way towards balance.
Goldman Sachs’ head of commodities Jeff Currie said at an S&P Global Platts Conference in London this week that investors should probably be going long on crude oil because the market is already in a supply deficit. He pointed to the futures market, where the curve could be headed into backwardation – a situation in which near-term oil futures trade at a premium to contracts further out. That structure points to concerns about a deficit in the short run, which is why front month contracts would trade at a higher price than deliveries six or twelve months away.
But the backwardation is also a symptom of fears over long-term oil prices. Goldman Sachs has consistently argued that crude prices could remain relatively low for years to come as the cost of production has shifted lower. So, lower long-term prices have pushed the back end of the futures curve lower, with near-term prices trading higher.
There is a feedback effect from the market shifting into backwardation. If spot prices are above long-term prices, then fewer companies will be willing to lock in next year’s production at those lower prices. Without industry-wide hedging, the ability to grow production is diminished. Or, as Goldman Sachs put it in its latest research note, “fear of long-term surpluses reinforces near-term shortages.”
Putting some of the jargon aside, Goldman is simply arguing that the oil market will be much tighter this year than most people seem to think. The investment bank forecasts returns on commodity prices on the order of 13.3 percent over the next three months and 12.2 percent over the next 12 months.
That prediction is based not just on the idiosyncrasies of paper trading, but ongoing improvements in the physical market. For example, Goldman predicts a rather modest inventory build of just 6 million barrels (crude oil and refined products) across the U.S., Europe, Japan and Singapore between March and April, which is much lower than the typical 16-million-barrel increase for this time of year.
Goldman also cautions everyone not to read too much into the exceptionally high inventory level in the U.S. because the U.S. has the lowest cost storage capacity, and as such, it will be “the last to draw.” Also, the U.S. has the most “visible” data, so there are a lot of drawdowns happening elsewhere in the world out of full view of market analysts. In short, U.S. inventories are a “lagging indicator of the rebalancing.”
And even that lagging indicator is starting to improve. The EIA reported on Wednesday a surprise drawdown in oil inventories, with stocks dropping by 5.2 million barrels, much more than the markets had anticipated. That led to strong gains for WTI and Brent, both of which were up nearly 4 percent during midday trading on Wednesday. Even better, gasoline stocks did not rise, bolstering the view that the drawdown was for real and not just a shifting of product from crude storage to gasoline storage.
If U.S. inventories are the last to draw down, as Goldman Sachs says, then the fact that they are indeed drawing down lends some credence to the investment bank’s assessment.
The IEA agrees with Goldman’s view, arguing that supply is already exceeding demand in the second quarter, and the deficit will grow in the second half of the year as long as OPEC extends its production cuts. “It is starting to become clear that if the objective of the OPEC cuts was to flip the market from surplus into deficit that is now slowly beginning to happen,” the IEA’s head of oil analysis, Neil Atkinson, said at the Platts London Conference.
So why did prices sell off so sharply last week? As they have mentioned before, Goldman chalks it up to technical trading and sentiment, not because of poor fundamentals. They admit that the market is balancing slower than everyone expected, but the investment bank stood by its prediction that the oil market is tightening.