Crude Oil Quarterly Outlook: Q42018 - Aap Gadhe...

Sagar Doshi Chief Manager (Research Analyst)

+91 (22) 4088 5757 Ext.6226 [email protected]

Ankit Narshana Research Analyst

+91 (22) 4040 7596 [email protected]

Abhishek Chinchalkar Research Analyst

+91 (22) 6141 2725 [email protected]

Crude Oil Quarterly Outlook: Q42018 October 2018

For queries/feedback please contact: Phone: 022-4088 6009 Edelweiss Investment Research – Trading Desk

Edelweiss Investment Research

1 Edelweiss Investment Research – Commodity Desk

The recovery off the sub $30 levels has seen WTI oil retracing nearly half of the 2011-2016 bear market decline. The major

factors that have contributed to the rally are production cuts by Saudi and Russia, renewed trade sanctions on Iran by the

U.S., and a tightening physical market. Besides, positive risk appetite coupled with strong economic dataset from across

the globe has also underpinned oil.

Source: Bloomberg, Edelweiss Investment Research

Synopsis:

WTI oil has been trading in backwardation for most of this year, indicating tighter supplies and strong demand. Unless

the structure of the curve swings to contango, we believe that supplies will remain tight and as such oil is likely to

maintain a positive tone going forward.

Pipeline bottlenecks in the Permian basin, the largest producer of U.S. shale oil, is likely to slow down the pace of U.S. oil

output in 2019. This in turn is likely to offer a strong floor to oil price going forward.

An end to OPEC production cuts earlier this year has caused the cartel’s spare capacity to decrease to levels not seen

for the past few years, which means OPEC could find it difficult to replace lost supplies in case of supply disruptions in

any part of the world. This is one of the most bullish factors for oil going forward.

Demand for oil has started to exceed supply over the past four quarters, suggesting that oil market is getting tighter.

With U.S. sanctions on Iran looking set to go ahead on November 4th, the key question is how many barrels of oil supplies

would be disrupted. With OPEC spare capacity already low, failure to fill this void could significantly underpin prices in

the months ahead.

While supply-side factors are quite bullish for oil, demand-side factors are far from certain. Prevailing trade tensions

between U.S. and China and weakness among emerging-markets are key risks that could slow down demand for oil

and thereby limit the extent of price rally.

So far, trade tensions between U.S. and China have not had much negative impact on oil, as demand in either of the

nations has not been impacted. However, continued escalation of tensions could start impacting Chinese growth,

which in turn could weigh in on oil price too.

Other than worries over Chinese demand, there are worries over Indian demand too, especially as fuel price in the

nation continues to surge and as talks surface that the country could lower its oil imports.

EIA and OPEC have lowered their global growth estimates for 2019, suggesting that demand for oil could be impacted,

especially if prices continue their north-bound journey.

Overall, we feel that oil prices will trade with a positive bias in 2019, with WTI possibly averaging in the $80 range and

Brent in the $90 range. That said, from a technical stand-point, in the short-term, we expect oil prices to correct 6-8%,

before beginning their new leg higher.

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Edelweiss Investment Research

Crude Oil Quarterly Outlook: Q42018


A). SUPPLY

I). Crude in backwardation, but tightness narrowing


The chart compares the spread between first month and sixth month continuous contract

with the price of oil and U.S. inventories.

The oil curve has been in backwardation since late 2017, reflecting tighter supplies and

stronger demand.

A strong correlation is also seen in oil prices and stockpiles with the oil curve. It can be seen,

the decline in oil prices and rise in stockpiles coincides with the oil curve moving into

contango, a situation that reflects markets are amply supplied.

Also, crude stockpiles moving below their 5-year average further validate the prevailing

tightness in the physical markets.

While the steepness of oil backwardation curve is receding, we believe that unless the

structure of the curve swings to contango, supplies will remain tight and as such oil is likely to

maintain a positive tone going forward.

II). Rising infrastructure bottlenecks in the U.S. to support oil price

Prevailing

backwardation

suggests that

physical markets will

remain tight

U.S. production has

crossed 11mbpd for

the first time ever,

but bottleneck in

the Permain region is

likely to slowdown

the pace of output

expansion in 2019



The Permian basin, which produces more than 30% of total US crude, has started facing

severe infrastructure bottleneck.

We have shown this by the use of Basis-differentials (see chart on the right above), which

represents the difference in prices between locations.

The price received by a producer for a barrel of oil sold in Cushing is approximately $72. The

price paid to sell that same barrel in Midland is $62. Thus, the differential between these two

pricing points is $10. Note in the graph above that the differential has moved from $0.37 in

1Q18 to >$10 this month.

The primary reason for such a situation is that there are simply not enough infrastructures to

transport the increasing supply of oil being produced by the Permian Basin producers.

With pipelines from the Permian basin to the Gulf Coast having reached full capacity

(current output of 3.66mbpd vs. pipeline space of around 3.60mbpd), production is likely to

be hurt as infrastructure constraints will limit the quantity of oil that moves to the Gulf coast

for refining or exporting.

As such, we believe that unless capacity additions outstrip the growth in Permian oil

production, the Midland differentials are likely to persist, causing the growth in the Permian

basin and subsequently that in the U.S. to potentially slowdown next year. This, in turn, would

underpin prices.

III). Shrinking OPEC spare capacity could tighten market


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OPEC Spare Capacity as a percent of global

demand (mbpd)

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Unless capacity

additions outstrip the

growth in Permian oil

production, Midland

differentials are likely

to persist

With global

inventories already

declining and with

OPEC spare

capacity falling, any

fresh geopolitical

tensions could lead

to a sharp rally in oil

prices


The chart on the left shows OPEC spare capacity as a percent of global oil demand. OPEC’s

decision in June’18 to boost its output has caused spare capacity to shrink to levels not seen

this decade.

On an absolute basis too, spare capacity today is below what it was at the turn of the

century, whereas global oil demand has increased nearly 25 percent during this same time

period. This means the OPEC would have less buffer left in their ammunition in case there are

any supply disruptions among member nations or in any part of the world.

With global inventories already declining and with OPEC spare capacity starting to shrink, oil

prices could rally significantly in case of any unforeseen supply outages or an unexpected

pickup in demand.

Meanwhile, the second of the two charts above shows the market balance of crude oil

(taken as the difference between global demand and supply). Region above zero indicates

demand exceeding supply, while region below zero indicates demand falling short of

supply.

Notice that over the past four quarters the demand has been exceeding supply. This

combined with falling crude stockpiles and declining spare capacity suggests that the oil

market remains quite tight. As such, unless there is a sharp escalation in U.S.-China trade

tensions or a sharp rise in global oil output, the risk remains skewed to the upside in 2019 as

supplies tighten.

IV). Fresh geopolitical worries can worsen supply-side tightness


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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Angola Iran Venezuela Libya Nigeria

in Mbpd

Crude oil has moved

into supply deficit

over the past four

quarters, which has

underpinned the

rally in price

With OPEC spare

capacity shrinking,

any supply

disruptions from the

cartel is likely to

benefit prices,

especially if the void

in disruption is not

filled by Saudi and

Russia


Earlier, we talked about shrinking OPEC spare capacity as a result of the cartel’s decision to

boost its output. Any unexpected supply outage has a potential to lift prices sharply,

depending upon the magnitude and the longevity of the disruption.

The above chart shows oil production of five countries within the cartel that remains most

prone to supply disruptions – Angola, Iran, Venezuela, Libya, and Nigeria. Output from each

of these countries remains quite uncertain at the moment.

The key of these will be Iran, the OPEC’s third largest producer, accounting for around a

tenth of the cartel’s output. If U.S. sanctions on Iran go ahead, Saudi Arabia and Russia will

have to fill the void and offset the decline.

With spare capacity already declining and with U.S. facing infrastructural issues, failure to fill

the supply void is likely to further tighten the markets, and underpin oil prices to extend their

gains further.

V). Huge Canadian discounts could slow down production


Events unfolding in Canada are quite similar to those seen in the U.S. Permian basin. The

nation’s soaring production has led to pipeline constraints, making it difficult for the smooth

flow of oil to refineries in the U.S. Gulf Coast.

This has caused the discount of the WCS crude to widen to a 5-year low of $31 over the U.S.

benchmark WTI grade. Such a significant fall in WCS differential has caused crude

movement from Canada to the U.S. via Rail to surge to a record high.

Meanwhile, an important factor that will impact the prices of global oil in the months ahead

is the International Maritime Organization (IMO) regulations that will be tightened from

January 1st 2020.

Under this, ocean-going ships worldwide will have to reduce the sulphur content in their fuel

oil to 0.5% m/m as compared with the current permissible limit of 3.5% m/m.

This would potentially put downward pressure on the prices of heavy sour Canadian crude

oil (which is high in sulphur), while at the same time underpinning demand for light sweet U.S.

and European crude oil (which are low in sulphur). This is another crucial supply-side factor

that remains positive to the price of U.S. and European crude benchmarks.

Canadian oil sands

are trading at a

deep discount to

WTI oil because of

pipeline bottlenecks

in Canada and

refinery

maintenance in the

U.S. Midwest

Tightening of IMO

rules from 2020 is

likely to pressurize

Canadian crude

price, while at the

same time support

U.S. and European

crude prices


B). DEMAND:

I). Trade tensions, emerging-market weakness could erode demand for oil

So far, we have seen the supply-side developments of crude oil. We now switch focus to the

other side of the equation – the demand-side. While developments on the supply-side are

bullish for crude oil price in general, those on the demand-side are starting to show signs of

cracks. This emanates on the back of: 1) growing trade tensions between the U.S. and China,

which could decelerate the pace of global growth, and 2) weakening currencies across key

emerging-market nations, which could reduce demand for oil from these countries as the cost

of importing oil would increase.


Emerging-market currencies have nose-dived this year, weighed down by rising trade

tensions between the U.S. and China and also due to rising interest rates in the U.S. The

plunging currencies combined with a rising dollar-denominated crude prices have caused

prices of oil in local currencies to rise sharply.

Notice above how a plunge in the Asian currencies late last century caused oil prices to

head south due to reduced demand from Asia.

If tensions between the U.S. and China escalate further and/or if the Federal Reserve

continues its hike trajectory, the depreciation trend among emerging-market currencies is

likely to continue.

This could potentially raise concerns over the growth prospects of emerging market

economies and thereby weigh on the demand prospects of crude oil.

The U.S. EIA has already lowered its estimate for 2019 demand growth. The agency now

expects global oil demand to rise by 250,000 bpd next year, as compared with its earlier

estimate of 290,000 bpd.

Asian currency crisis

of 1997-98 reduced

demand for oil from

Asia, in turn

dragging oil prices

lower. Will history

repeat itself yet

again?

Emerging-market

currencies have

been battered this

year due to U.S.-

China trade tensions

and global dollar

strength

Weakening

emerging-market

currencies

combined with oil

price at multi-month

highs could hit

demand for oil in the

coming months


II). Chinese, Indian demand are the biggest demand-related worries


The biggest risk factor for oil demand is the possibility of slowing demand for oil from China

and India. The two nations combined import over 13 percent of world’s oil, and thereby their

economic health becomes imperative for oil’s demand prospects.

Speaking of China, the nation is the world’s largest importer of oil, buying well over 8mb of oil

a day. With the nation embarking on a path of tighter environmental regulations, demand

for oil is likely to reduce in favour of other energy resources such as gas, in the long-term.

If such a structural change is also accompanied by slowdown in economic activity due to

the trade sanctions from the U.S., China’s imports of oil are likely to slow down over the

coming quarters.

Meanwhile, in India, fuel prices have surged nationwide, climbing to unchartered territories

over the past few weeks. Such a steep rise in price could negatively impact demand for oil

from India. There are already talks that oil refineries in India could cut oil imports and rely

more on available oil stockpiles.

If international oil prices continue to gain further and if Asian currencies continue their

weakening trajectory, it is hard to see demand for oil sustaining at such elevated levels. This

in turn has a potential to pressurize oil prices in the short-term.

III). EIA, OPEC has revised lower their global GDP forecast for 2019

Source: EIA, OPEC, Edelweiss Investment Research

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China Imports India Imports

in mbpd

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3.4%

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OECD Oil Consumption

Non-OECD Oil Consumption

World GDP

in mbpd

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OPEC GDP Estimates

Record high fuel

prices in India

coupled with

ongoing trade

disputes in China

could hamper

demand for oil from

two of the major oil

importing nations

EIA, OPEC expect

global growth to

slow down in 2019


The chart to the left above shows global oil consumption, forecasted by the U.S. EIA for 2018

and 2019. The agency has forecasted the 2019 global oil consumption to grow by 1.5% over

the 2018 estimate, with a major part of this increase expected to come from a 2.1% oil

consumption growth in non-OECD regions.

The OECD oil consumption is expected to increase a modest 0.8% next year.

Meanwhile, the OPEC has lowered its 2019 GDP forecast for most major oil consuming

nations, forecasting the world to grow 3.6% next year versus its projection of 3.8% this year.

The organization notes in its latest report “Rising challenges in some emerging and

developing economies are skewing the current global economic growth risk forecast to the

downside”, while further adding “Rising trade tensions, and the consequences of further

potential monetary tightening by G4 central banks, in combination with rising global debt

levels, are additional concerns”.

C). SUPPLY-DEMAND SUMMARY:

While the supply-side developments are bullish for crude oil, those on the demand-side

could pose a problem if WTI oil sustains above $75 a barrel (and Brent above $85 a barrel).

Rising interest rates in the U.S., trade tensions between U.S. and China, and emerging market

slowdown pose a key risk to the demand outlook and are likely to limit any runaway rally in

oil prices.

Given that the U.S. production is likely to decline in 2019 and the possibility that any supply

disruptions from key OPEC members are likely to put serious pressure on OPEC’s spare

capacity, we feel that oil prices will trade with a positive bias in 2019, with WTI possibly

averaging in the $75-80 and Brent in the $85-90 range.

Also, with problems in the Permian basin expected to persist in the foreseeable future and

the likelihood that OPEC supplies will tighten, we feel that the spread between WTI and Brent

will remain elevated in the next few months.

That said, we expect oil prices to first correct 6-8% from hereon because of slowing global

demand and an overcrowded derivatives positioning (see next section).

While we are bullish

on WTI oil in 2019

and foresee it

averaging between

$75-80; in the short-

term, we expect oil

to first correct 6-8%,

before beginning its

new leg higher


D). DERIVATIVES POSITIONING:

The chart on the left below shows the CFTC managed long, short, and aggregate futures and

options positions. Observe that the recent rally in price has come amid decline in both

managed long and managed short positions. This indicates at balance between bulls and

bears and thereby suggests at short-term uncertainty in price, at least from a fund positioning

point of view. However, with managed shorts currently at the lowest level since 2005 and with

managed longs not far away from a record high, we feel that in the short-term, a consolidation

with slight bearish bias looks more likely than an extension of rally.


The chart above on the right shows the divergence between CFTC managed net positioning in

NYMEX oil and the price of NYMEX oil. Observe that whenever the divergence occurs between

the two, a swift move occurs in the price chart going forward in either direction. Of late, a

divergence has been forming again with managed positioning declining and price of oil going

up. We believe that once this divergence ends, a swift move in either direction should occur in

the short-term, although over expectation is for a move lower for reasons mentioned above.

Overstretched fund

positioning suggests

that in the short-

term, we may see a

consolidation with a

slight bearish bias


E). TECHNICAL COMMENTARY:


NYMEX crude rally that started from 2016 tells us that we are still in the corrective phase as per

Elliot wave analysis. A corrective phase which has three legs of up move is shown in the above

chart marked W-X-Y. The final leg Y is under process within which we have seen completion of

sub-wave (a) and sub-wave (b). The sub-wave (c) is developing in the form of an ending

diagonal, which can either be truncated at $74 or make a new high around $80. Using different

technical analysis techniques chart, we can also see that price is nearing its multiple resistance

area near $80. An upward sloping channel combined with 61.8% retracement of the previous

fall that begun from $110 comes at $77-$80. We expect NYMEX oil to possibly make a short-term

top around $80, from where a 6-8% correction looks likely, before a sustained rally towards $90

in the medium-term.


The recovery off the 2016 lows has unfolded in the form of a three-wave corrective pattern to

the preceding larger decline in the form of a rising wedge pattern. Based on technical factors,

we expect Brent oil to face strong headwinds near $90 as a confluence of resistance levels are

seen coinciding around this region, as mentioned below:

The 0.618 retracement of fall from 2012 high to 2016 low is at $90 (not shown above)

The target of the inverse H&S pattern formed between Dec’14 to Aug’17 is around $91

The upper end of the rising wedge pattern terminates around $91

A downward sloping trend line connecting the 2012 and 2014 peaks coincides around $91

Based on a confluence of so many resistance levels in the $90-91 range, we expect Brent oil to

face significant headwinds near $91. Another thing to note is that the monthly RSI has touched

the overbought zone for the first time since 2011 and is now forming a small bearish divergence

with price, indicating at overbought conditions. Given the wave structure, we feel that oil will

potentially make a short-term top near this range and correct 6-8% before beginning its new

leg higher towards $100 in the medium-term.

We expect NYMEX

oil to face strong

headwinds around

$80, from where a

short-term 6-8%

correction looks

likely, before

beginning a new leg

higher in the

medium-term that is

likely to take price

towards $90

We expect Brent to

meet with resistance

near $90, from

where a short-term

5-8% correction

looks likely to unfold,

before the start of a

new leg higher in

the medium-term

towards $100


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Board: (91-22) 4272 2200

Vinay Khattar

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