When oil price bottomed around $27 per barrel last year in February, many predicted a major reversal and the dark days for producers to be over. Yet, more than a year after the bottom, the oil market is struggling to cope up with the supply glut and lack of clarity. A deal by OPEC and 11 participating non-OPEC countries to reduce production by 1.8 million barrels per day has failed to soothe the market concerns. Every day, contrasting forecasts continue to appear in the media suggesting a spike in oil price or a tumbling to the bottom once again. So, how can you know which side to take? We at FxWirePro believe (despite our guidance and forecasts) that readers should make up their own views (a must, even if they are trading on our calls) based on facts. Here are the key factors that one needs to watch to understand the market dynamics that might lay ahead,

US production has been recovering since it bottom in July last year. Though the country is producing lesser amount crude compared to the pre-oil-crush levels, production has increased by 719,000 barrels since July. The number of active oil rigs operating in the US has more than doubled since it bottomed around in May last year. It is currently at 662 and the production is at 9.147 million barrels per day.
OPEC deal is likely to serve as the most crucial factor to watch out for. On May 23rd, OPEC ministers are scheduled to meet at the Vienna headquarters to decide on the deal extension. Mark your calendars for that date. We expect the OPEC and participating non-OPEC countries to extend the current production cuts deal.
The level of inventories would also play a crucial role in price discovery. Declining inventories would invariantly result in a higher crude oil price. As of now, inventories in the US rests at 533 million barrels, the highest ever. Recently, the gasoline inventory has come down but still higher at 239 million barrels when compared to historical data. The OPEC deal has pushed the oil market to backwardation but the inventory is yet to come down significantly.
Demand has been growing at a rapid pace since 2016 thank to lower oil price and contribution from countries like India and China. But experts expect higher demand this year from the United States as record numbers of cars and trucks were sold during the winter and holiday season.
New projects would play a very significant role for future prices. Recently Goldman Sachs have warned that many projects adopted during the $100 per barrels crude oil are set to come online this year and in the next few and would lead to higher than expected production. On the other hand, International Energy Agency has warned that lower level of investments due to 2014 oil price crash and continued lower price would eventually lead to supply constrain and eventually higher oil price.
These five fundamentals would be crucial in determining oil price in the months and quarters to come. WTI is currently trading at $50.6 per barrel and Brent at $2.8 per barrel premium.

Russian Oil Revenues, Budget Outlook and USDRUB levels

Inflation in the week to 16 January slowed to 0.1% wow, from 0.3% wow in the first nine days of January. On our estimates, headline inflation was 5.3% yoy as of 16 January, down from 5.4% yoy in the previous week. We expect headline inflation to drop to 5.1%-5.2% yoy in January. In its meeting last Monday (16 January), the government decided not to spend windfall oil and gas revenues. According to Finance Minister Siluanov (who revealed this news yesterday), the government made a decision to save extra oil and gas revenues from higher oil prices, instead of spending it. According to the government estimates, the government will receive additional RUB 1tn (1.1% of GDP) with the average Urals oil price at $50/bbl, or RUB 1.4tn (1.6% of GDP) with the average Urals oil price at $55/bbl. (In the federal budget law, the government assumes average Urals oil price at $40/bbl in 2017- 2019.)

The decision to save windfall oil and gas prices is favorable for the prospects of the policy rate cut by the central bank (CBR) and for sovereign credit (as Russia would not use its declining fiscal reserves for financing the deficit). Although the government is unlikely to reduce net OFZ issuance in the local market (according to the law the government will increase net issuance to 1.2% of GDP in 2017 from 0.5% of GDP in 2016), the CBR’s more accommodative policy will support demand for OFZ from local investors. In our view, the decision should be taken positively by fixed income investors. Another near-term implication of this news is that the market should price in a policy rate cut as early as in the next rate-setting meeting (on 3 February).

We are not saying that the CBR will cut the policy rate at that meeting but the likelihood of such an outcome has increased to around 25%, in our view. We are still expecting the first policy rate cut in the second meeting of 2017 (on 24 March). The CBR may consider regular FX purchases for the replenishment of Russia’s FX reserves, if the scenario with higher oil prices materializes. Such FX policy will be coordinated with the Finance Ministry, in the absence of a fiscal rule. Although this news (revealed yesterday) is in line with our expectations, it does not provide us with any new information about the conditions under which the CBR will resume regular FX purchases. However, we reiterate our view on that issue.

We expect the CBR to resume FX interventions (to buy FX) in 1Q 2017, as it did in 2015, when the rouble strengthened beyond 50 against the dollar. Our view is based on the idea that, in real effective exchange rate terms, the rouble is trading as strong as in 2015. In 2015, the CBR held volume-based intervention in the amount of $200mn a day (for more than two months) and purchased roughly $10bn in the local FX market. In our view, both, the CBR and the government are quite sensitive to potential further strengthening of the rouble (especially in real effective exchange rate terms). In our view, the CBR will be reluctant to allow the rouble to strengthen beyond 57-58 against the dollar.

Russia Outlook and Central Bank

The main event this week is the central bank’s rate-setting meeting on Friday (16 December). We expect the central bank (CBR) to leave the policy rate unchanged, in line with the CBR’s previous commitment to refrain from policy easing until 1Q-2Q 2017. In our view, the meeting will be crucial in terms of the signal it might provide for the prospects of policy easing in 2017, in the aftermath of the OPEC’s 30 November agreement to cut oil output. Furthermore, the outlook on oil prices will shape the CBR’s forecast revisions that are due to be published the same day in the Quarterly Monetary Policy Report. We believe the CBR will be more optimistic on the pace of recovery in economic activity, as well as more comfortable on the attainability of its 4% inflation target in 2017. We think the CBR will also make a hint this Friday with regards to a possible policy rate cut in the first meeting of 2017 (3 February).

Also this week, the focus will be on the following economic data releases:

 ? Tomorrow, Rosstat will publish the second estimate of 3Q real GDP data and its supply-side breakdown. According to the preliminary estimate, the pace of contraction in real GDP fell to 0.4% yoy in 3Q from 0.6% yoy in 2Q. We expect Rosstat to confirm the preliminary estimate.

? At some point this week, the Finance Ministry will publish the federal budget execution data for November. On a 12-month rolling basis, we expect the federal budget deficit to widen in November from 3.6% of GDP in October.

? On Thursday (15 December), Rosstat will publish the November industrial output data. We expect industrial production to have picked up in seasonally adjusted terms in November, in line with the strong manufacturing PMI data since July 2016.

Rosneft Sale, Oil Price and Ruble

The government managed to sell its 19.5% stake in oil company Rosneft for EUR10.5bn ($11.3bn). The stake was sold to the consortium of Glencore Plc and Qatar Investment. Both will have 50% share in the stake. In a meeting with Rosneft’s CEO, President Putin urged Rosneft to develop a joint plan with the central bank (CBR) and the government for a smooth conversion of FDI inflows into rouble. We are not aware of the details of this scheme, but given the context of Putin’s comments the implications of this deal on the market should be neutral for the rouble. Having said that, we think this deal should be positive for the sentiment in the local market, as the market did not expect foreign investors to be involved in this privatization. Following this news (late in the evening local time), the rouble strengthened by almost 1.0% against the dollar. Inflation expectations improved only marginally in November. According to the central bank survey, year-ahead inflation expectations (based on normal and uniform distribution) fell to 5.6% and 5.5% in November, from 5.8% and 5.7%, respectively, in October. According to the CBR’s statement, inflation expectations remain elevated relative to the CBR’s 4% inflation target. In the CBR’s view, elevated inflation expectations justify a relatively tight monetary policy stance. Inflation in the week to 5 December was 0.1% wow, on par with the previous week. On our estimates, headline inflation was down to 5.7% yoy as of 5 December. We expect headline inflation to reach 5.6% yoy by the end of this year, which is consistent with the CBR’s forecast. According to Finance Minister Siluanov, the government may spend the windfall oil revenues in 2017. In our view, this is a very likely scenario if the average Urals oil price stabilizes above $40/bbl in 2017 (the base assumption for the federal budget law in 2017- 2019). The increase in spending will be supported by the proximity of presidential elections in early 2018 and an almost two-year-long recession. The news is negative for the prospects of a decline in nominal interest rates, in our view.

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Energy and Oil Developments 

 

Weaker physical market indicators outside the US are disconcerting. While the market has focused on better US inventory trends of late, the global market is quietly showing signs of stress. The US draws are primarily a result of low imports on the back of unsupportive economic arbs in recent months. Yet this lower US import level and returning supply (which is only now showing up for export in Nov) appear to be taking some toll on global markets. The problem appears to be most acute in the Atlantic Basin.

Prompt Brent time spreads eroding. The prompt time spread is now at its lowest level YTD (other than expiry), despite field maintenance. North Sea field maintenance was responsible for the strength / backwardation earlier this year, but maintenance is now fading, adding to North Sea supply. The return of light crude barrels from Libya and Nigeria, along with lower US imports are all also likely contributing to the congestion. Crude differentials are weakening too. Beyond structure, North Sea differentials are all weaker in recent weeks as well. West African crude differentials have also been fading, with some grades now pricing at similar levels to early 2016. Thus, it’s not surprising that Bloomberg reported an abnormally high number of tankers (as many as 10) in the North Sea waiting on transfers. The primary challenge is that Atlantic Basin loadings are finally recovering. Refinery maintenance isn’t the primary issue. The market is currently trading Dec-16 Brent, which should reflect a period of elevated refinery demand. Rather, crude loadings (which are more important than production) are only now recovering in West Africa, the North Sea and Libya after being at low levels from May-Oct. This is why many recent inventory data points citing bullish inventory draws are simply backward looking.

 Rising tanker rates add to the problem as the arb to Asia becomes more expensive. The backlog should clear with appropriate price signals, but it also suggests oversupply risk persists. If Atlantic Basin differentials shift enough, these barrels will find a home. The US import arb appears to be opening back up. Asia also has an appetite for these barrels when the arb is open, and refiners are coming out of maintenance. However, such changes just shift the inventory picture regionally. The Dubai curve offers a mixed picture. Typically, Dubai reflects Asian demand. Front month spreads are volatile with spot purchases and have moved into backwardation after being weak into the roll in early Oct. Yet, the more stable Dubai 2-3 is weakening.

Total rig count and time lags continue to distort the magnitude of US response. The growth rate of more productive horizontal rigs has continued unabated, with volatility coming in vertical and directional rigs. For example, talk of slowing total rig additions in the Permian misses the true trend. Horizontal rigs in the Midland Basin have increased by 14 since early Sep, whereas vertical rigs have declined by 4 and directional rigs are flat. Rigs are also moving to the most productive acreage. Top IP counties in the Midland Basin now have a rig count above pre-downturn levels and only 12 below all-time highs. We should see rig counts continue to increase in the wake of the recent price rally and hedging, but with a lag. Rig counts typically lag prices by 3-4 months, so we would expect to see more rigs added, especially near year-end. Since prices also spur producer hedging, a similar lag exists between rigs and the 12-24 WTI time spread. The correlation between the 4-6-month lagged rig count and the WTI spread is 0.85-0.87 since 2012. The time lag can be longer with horizontal oil rigs due to logistics and pad drilling time, as well as the mix shifts we saw in recent years. Yet, all items point to increased hedging, as well as production growth in 9-12 months time. Commercial shorts reached the highest levels since early April, and the 12-24 spread is approaching YTD highs. The recent rise in horizontal rigs and hedging at increasingly lower thresholds is indicative of lower breakevens and the US potential. In mid-2015, producer hedging was significant at $65. Now we tend to see large amounts of hedging in the low-to-mid 50s. And yet, well productivity has the potential to rise substantially from here. In other words, the US cost curve has moved lower in this downturn and could move even lower over time.

Moreover, a more modest US production decline related to OPEC intervention reduces the need for a sudden and large US response, which suggests fears of a large oil services crunch and cost inflation, or a supply shortfall, are being partly mitigated. We are increasingly in the Exxon camp, as US shale’s disruptive nature remains underappreciated. Many bullish arguments we hear on US tight oil are similar to those we heard in natural gas from 2012-15, and increasingly we see similarities with the development of new basins, shifting capital allocation and productivity gains.