‘We are seeing many supply adjustments that are simultaneously transitioning through the market, making us a lot more positive, with regards the evolving market balance over 2019.’ What’s in store for the energy sector – and specifically oil – in 2019? One thing is for certain: Saudi Arabia, having set a budgetary breakeven above $80bbl, will be determined to manage the price higher.

The year 2018 brought with it some exceptional challenges and one of the most extreme swings from positive to negative sentiment we have seen in decades. We can only construct a view as to how the energy landscape will unfold over the course of 2019 once we attempt to understand why the market corrected to such an extent. Essentially, we need to assess whether the fundamentals eroded enough to warrant such a move.
If they haven’t, then we should deduce that there is an opportunity ahead of us. Although the oil market eventually moves with the overall fundamentals, it is susceptible to a significant level of subterfuge and massaging of sentiment, over the short term.

As many investors know, Saudi Arabia holds a vast majority of the world’s spare capacity (oil that can be brought to the market within 30 days and produced for at least 90 days). Another of the many requirements to be classified as spare capacity is the fact that the oil available must be of varying qualities United States shale oil falls down on both of these requirements so it is not classified as spare capacity). If you are a producer with perceived spare capacity, you have political muscle and you hold the ability to influence oil prices. Over the short term, Saudi Arabia has two price influencing tools at their disposal; the first is geographical focus, in other words where they direct their exports, and the second relates to the volume of those exports, specifically how much of their spare capacity are they willing to ‘dip into’ in order to increase volume.

If Saudi Arabia feels that it needs to manage prices lower then it will discount prices to the most visible and most frequently reported market and inventories in the world, the US, which would in turn encourage inventory building. Subsequently, market prices are more influenced by the movement of the closely followed US inventories than by builds in inventories that are less frequently reported on, like the non-OECD regions.

Conversely, if Saudi Arabia wishes to send prices higher, the country will price its oil into the US at a premium, but discount oil to the East (thereby encouraging more prolific buying from the less frequently measured and less observed, non-OECD countries). Consequently, the International Energy Agency (IEA) will likely report a draw from US inventories and the market will, in the short term, perceive that the market is under supplied; under these conditions oil prices will have a tendency to move higher. However, all of this happens with a time lag - field management (controlling flows), shipping (it takes over a month to transit from Saudi to the US and China), and reporting delays (all OECD country reports are collated by the IEA and reported monthly, however, there is a two month lag in these reports) means that the visibility of price influence takes time to transition through to actual price action. The time lag between the event and the export/supply reaction can leave the market vulnerable to building or collapsing inventories and the vagaries of bullish or bearish sentiment.

What transpired during 2018 is an interesting insight into the relationship between Saudi Arabia and Washington. Following US President Donald Trump’s re-imposition of sanctions on Iran on May 2018, thereby helping facilitate the growth of Saudi’s hegemony in the region, Saudi returned the favour by increasing the discount of oil being sold into the US whilst simultaneously reducing the discount of oil being sold into non-OECD areas. Subsequently crude exports to the US increased significantly (as a way to offset the loss of future Iranian oil supply and control prices going into the US mid-term elections). The intention was to calm the market and to prevent a runaway oil price, as President Donald Trump entered into highly contested and extremely important mid-term elections. However, the market shrugged off the build-up in US inventories, worried that Saudi’s move was unsustainable as the country was dipping into (anaemic) spare capacity and (seven-year low) inventories in order to facilitate the export hike. Consequently, the price per barrel rose into the mid-80s, accelerating as the US mid-terms approached.

A high oil price was the last thing that Trump needed going into a highly-contested battle with the Democrats – so he acted. In a move which we can only surmise was much to the Saudi’s consternation, Trump issued eight waivers to countries that were heavy users of Iranian oil. This move saw the potential for 1-1.3 million barrels of supply injected into the market, something that changed the market's focus from fearing the lack of spare capacity to a fear of oversupply and building inventories. At the same time US production numbers spiked, spurred on by the recent completion of a pipeline that unlocked logistical bottlenecks.

The culmination of these three fears (rising US inventories, increasing Iranian crude exports and accelerating US supply) led to a rapid deterioration of oil fundamentals. What we now have to decide is whether these events have dented the medium- and long-term oil cycle. In short, while there has been cause for concern, we don’t believe that this is more than a temporary correction. Indeed, we hold that this correction has been overdone. 

All ado about nothing

The rationale behind this view is that, firstly, Saudi Arabia began cutting its export focus from the OECD (and most notably the US) as soon as the mid-terms were completed and ahead of the subsequent OPEC meeting in December 2018, dropping them by around 65% (by c. 20Mbbls a month) by December. Secondly, those countries receiving temporary Iranian crude waivers may not import as much as the market is anticipating. Italy and Greece have already sourced crude from elsewhere and stated that they will not jeopardise those relationships in favour of temporary access to Iranian oil. South Korea and Japan are having trouble accessing vessels that international insurance companies are willing to insure; therefore Italy, Greece, Japan and South Korea are not currently availing themselves of the permitted 325 000 barrels of crude oil. It will be interesting to see how China and India behave with regards to the waivers. The quotas terminate in early May 2019 and China, while in trade discussions with the White House, will be keen to remove as many of the political cards left on President Donald Trump’s negotiating table. Therefore, it would be prudent to reduce their dependence on Iranian crude. It appears that, by December, China had cut their imports from Iran by almost 50%.

Thirdly, with regards to the US crude production, there are several indicators that lead us to believe that in the short to medium term, we are going to see a decline in US production growth beginning in the fourth quarter of 2018 and running through to the third quarter of 2019. A confluence of reasons are behind this, including pipeline constraints, budget exhaustion and the impact of the oil price on budgetary spend.

The fourth quarter is the time during which US production companies set budgets and an oil price in the 30s is almost certainly going to curtail growth (Midland oil prices were, at US$39 per barrel in January 2019). Diamondback, the third-largest Permian producer, recently stated that “due to the dramatic decline in oil prices and our commitment to capital discipline, we are reducing our planned 2019 activity to levels where we can operate within cash flow”. This contraction of activity will not be an isolated event.


Looking to the next 12 months

For two years in succession oil production growth has not had to meet demand growth in its entirety. From the first quarter of 2017 to the first quarter of 2018 the market was able to pull roughly 590 000 barrels from drawing down on OECD inventories in order to meet a large portion of the 1.7 million barrels a day (Mbblsd) demand increase over the period. In 2018, the mantle was then handed to Saudi Arabia to pull in supply from spare capacity – oil that should really only be tapped during times of extreme tightness. It is not a source of supply that is sustainable. This reduction in spare capacity was a large contributor to oil moving above $80bbl but was ultimately a significant portion of the volume that drove the oversupply in the market.

However, the extent of the inventory overbuild this time is not a patch on what the market experienced in 2016 – the 2019 first quarter peak in inventories is likely to be below 1% (c.20 million barrels), versus an almost 8% (220 million barrels) breach in 2016. We believe that we will be back below the five-year average in the second quarter of 2019. That is not to say, however, that the market cannot continue to pull from inventories and spare capacity in the second half of 2019, but the drawdown is unlikely to continue coming from the Saudis, since their inventory cover is already  -30% below their 2011-2016 average (almost 15% below their previous low in 2011) and they have just clawed back much-needed spare capacity via the OPEC cuts.  Calling the bottom (or top) is always difficult, but in 2016 prices started turning nine months before the top in inventories.

As we progressively move through 2019 it will be increasingly harder to ignore crude quality when trying to determine where the overall oil price is headed – particularly as we head closer to the implementation of IMO2020, the law requiring ships to use less sulphur in their fuel, thereby forcing c.97% of the vessels to switch from sulphur heavy residual fuel to diesel. Over 80% of supply growth over the last two years has emanated from light oil (United States shale oil) and a barrel of light oil will produce twice as much gasoline but almost half as much distillate (including diesel) as an equivalent barrel of Brent oil. Consequently, refiners are finding it increasingly difficult to produce the required diesel to satiate the market. We have, even before the effects of IMO 2020 are felt, seen a progressively tight distillate market and a looser gasoline market – diesel storage in the US hit 10-year lows in November 2018 while gasoline storage (as at December 2018) was approaching 10-year highs. This has sent the prices of diesel v gasoline to their widest spread in four years. This divergence in prices is likely to continue widening as vessels begin to switch to diesel (by the third and fourth quarters) and refineries begin to prepare by building distillate inventories (the first half of 2019). The fuel that they previously used (residual fuel oil) will likely price down to a point where it has to find another market (likely to be the power market, backing out coal/gas). Consequently, we could see a big demand surprise towards the end of 2019, going into 2020, of crude oil. One Texas refiner we recently visited envisages a two million barrel demand spike. If we see just half of this amount of additional demand growth, then the market could be significantly tighter than forecast.

We see the potential for a much more constructive oil price dynamic in 2019, helping stocks higher and revenue higher for production companies. However, we continue to envisage a market that is reluctant to spend on significant supply growth (something that, in itself, is a positive macro driver for the oil price) so service stocks may continue to be challenged.
Differentials are likely to extend higher, particularly in the second half of the year when IMO 2020 increases the demand for distillates and further exacerbated as we see the completion of Permian pipelines in the fourth quarter of 2019 unlocking supply of lighter oil.  The risk of Iranian sponsored disruptions could also be a wild card, particularly if waivers are dropped in the second half of the year.

Other articles in this issue of Global Perspectives

1. Dust yourself off…
2. A world still in transition
3. Emerging market trends to watch