“The rebalancing of the oil market has likely been achieved, six months sooner than we had expected.”
Goldman Sachs (NYSE:GS) dramatically revised its outlook for oil in 2018, saying that it underestimated how rapidly the market was tightening. As a result, Brent prices could hit $82.50 per barrel by the summer.
There are a few reasons why the investment bank is suddenly much more bullish on crude. First and foremost, oil inventories have declined much faster than everyone expected, pushed along by strong demand, high OPEC compliance, maintenance and steep declines in production from Venezuela. Goldman says that these factors are not going away anytime soon, and will continue to tighten the market.
In the fourth quarter of 2017, Goldman estimates that the oil market was in a sizable supply deficit, on the order of about 1.1 million barrels per day. That translated into inventory declines in the OECD by about 105 million barrels. Those declines put global inventories at about the five-year average.
That deserves some repeating: Goldman Sachs believes that the closely-watched metric — the five-year average inventory level — which OPEC is targeting, and which has received a lot of speculation around when it would be reached, has probably already been achieved.
One overlooked factor that lends additional weight to that assessment is that the oil market is bigger than it used to be. Demand is larger than it used to be, and so is storage capacity. So what constitutes “average” should also be at a higher level. Moreover, new production from U.S. shale requires a buildout of more pipelines, which permanently absorbs a certain quantity of oil that doesn’t really show up in the data. Goldman says this new infrastructure could account for as much as 40 million barrels of oil in the U.S alone.
Demand also deserves some focus. Goldman says that broad economic growth in much of the world, occurring simultaneously, particularly in emerging markets, will help keep oil demand elevated. The fourth quarter likely saw demand increase by 2 mb/d year-on-year, while 2017 saw growth of 1.73 mb/d. In 2018, demand growth shoots up to a staggering 1.86 mb/d, the investment bank predicts, before easing just a bit to 1.6 mb/d in 2019.
Meanwhile, the tightness in the oil market has steepened the futures curve into a stronger state of backwardation — in which near-term futures trade at a premium to contracts dated further out. The stronger backwardation provides investors with even stronger returns when they go long on oil, allowing them to roll over contracts on a monthly basis. Goldman says investors could see 24 percent returns on petroleum over the next six months.
Finally, OPEC compliance is well over 100 percent as its members continue to stick closely to their commitments. That, combined with collapsing Venezuela production, has accelerated the rebalancing effort.
Because market data is published on a several month lag, particularly the OECD inventory data around which OPEC is basing its strategy, OPEC will likely keep compliance high through the spring at least. For its part, OPEC has said it intends on sticking with the cuts through the end of 2018, but Goldman argues that the group will probably overshoot the market, draining inventories well below the five-year average by the third quarter. That ultimately could lead to a gradual increase in OPEC and Russian oil production in the second half of the year.
The group will likely try to come to some arrangement to avoid an aggressive ramp up in production. Plus, ongoing declines from Venezuela will mitigate production increases elsewhere. Overall, Goldman predicts that OPEC and Russia will add 315,000 bpd in the second half of 2018 versus the first half.
Goldman cautioned that this extremely bullish forecast is “cyclical.” Over the medium-term, U.S. shale will ramp up and OPEC will abandon the production cuts, stamping out any chance of higher prices on a sustained basis. The investment bank still predicts Brent prices of about $60 per barrel by 2020.
But this so-called “New Oil Order,” as Goldman has deemed it, will be on “hiatus” for a few years. In the short run, oil prices could rise quite a bit.
By Nick Cunningham of Oilprice.com
