What is offsetting the drop in crude prices following Obama’s latest embarrassing backtracking from his “blow things up first, ask Congress later” peace track? According to some, it is this note from Goldman which suggests oil price pressure from an improving geopolitical picture will be offset by rising backwardation.
Rising backwardation offsets a negative price view
Although geopolitical risks dominated the market flows in late August, oil and gold prices have since returned to mid-August levels as the likelihood of international military intervention diminished in early September. More generally, commodities returns since we last published in mid-July have been mostly flat as weather-driven declines in agriculture and natural gas offset gains elsewhere. This flat headline number, however, masks the real shift in commodity markets which has seen significant increases in the backwardation of the forward curves in oil, which still remains strong despite the September 9 sharp headline-driven sell-off.
This rise in backwardation in oil, in our view, is not driven by the events in Syria, but rather by increasingly tighter fundamentals that are a result of the production shortfalls in Libya and Iraq against improving Chinese demand. Despite our view for modest price declines over the next 3 and 12 months, this strong positive carry is expected to offset these declines, leaving returns mostly flat over the next year. Accordingly, we are maintaining our neutral recommendation on commodities.
Oil risks still dominated by Libya, not Syria
Although we view recent political events as having decreased the probability of an international military intervention in the conflict in Syria (see Exhibit 1), we still see risks to oil prices skewed to the upside over the next several months as the pressure on OPEC spare capacity will likely peak during this month. In particular, recent reports suggest that no progress has been made over the Libyan protests, while current exports are still running at extremely low levels and it would take weeks to resume shipments, which leaves mostly downside risks to our 500 thousand b/d forecast for Libyan oil production for September This, combined with our forecast for reduced Iraqi production in September, will likely put significant pressure on OPEC production over the next six weeks (see Exhibit 2). We estimate the call on production from Saudi Arabia to exceed 10.5 million b/d this month while at the same time total OECD petroleum inventories are likely at their lowest levels since 2004, which drives our near-term Brent forecast of $115/bbl.
However, in our view barring more serious spillover from Syria into the broader region, the seasonal decline in oil demand in Saudi Arabia toward the end of the year and a gradual recovery in ex-Saudi OPEC crude oil production levels will likely reduce the pressure on OPEC spare capacity markedly and allow prices to return to levels consistent with a more balanced market by end 2013 and early 2014. As a result, we are maintaining our 12-month Brent forecast of $105/bbl.
We prefer the frontend of the curve over the backend
With tight oil inventories supporting record levels of backwardation in the oil market forward curves, buying deferred oil contracts is an attractive investment proposition even if oil prices stay where they are or even fall slightly. The question then becomes where on the forward curve one should position themselves to maximize returns. The answer to this question comes from looking at relative size of the spreads across the forward curve, or “butterflies.” When the magnitude of the timespreads in the front are larger than the magnitude of the timespreads in the back, it argues to roll the frontend of the forward curve as opposed to buy the backend.
For example, even after the September 9 sell-off, the front timespread on Brent is $1.35/bbl versus the next month out at $1.28/bbl while at a year out it declines to $0.70/bbl. This suggests that by rolling the very frontend of the forward curve the returns would be greater than simply buying one year out. Specifically, rolling the frontend over the course of one year would generate nearly 15%, all else constant, while buying one year out and holding for a year would only generate a 8% return, nearly half the return from rolling the frontend of the forward curve.
The margin of adjustment is shifting from the US to emerging markets
The events of the past month also suggest that the margin of adjustment in the oil market is no longer the US, but is now shifting to the emerging markets. In the past, we have argued that the US was the margin of adjustment for the oil market due to relatively low end-use taxes on products such that price rises were more directly passed through. And given the more discretionary nature of the demand, particularly US gasoline, it would be the first in the world to respond to higher prices. However, given the recent strength in the US dollar and a surge in US domestic oil production, we believe that US gasoline is losing its role as the margin of adjustment.
Not only has the shale revolution left the US well supplied in light products, but thinner marketing margins suggest the US can tolerate much higher oil prices before prices rise sharply at the pump, leaving the US far better insulated from higher oil prices than in the past. In contrast, global distillate markets are far less well supplied as the shale revolution hasn’t increased supplies from the middle part of the barrel (see Exhibits 3 and 4). Middle distillates, diesel in particular, are also the dominant fuels used in emerging markets where currency devaluations have pushed local oil prices to all-time highs.
More recently in India, where the rupee has devalued by around 21% since the beginning of May, the sharp rise in rupee-denominated oil has led the government to consider austerity measures to reduce India’s oil import bill. It is important to emphasize that the recent rise in rupee-denominated oil is 18% higher than the July 2008 peak while for the US the current price is 22% lower. In other words, the margin of adjustment is moving away from gasoline and the US and towards distillate and the emerging markets.