Analysts See Oil Rising To $80 As Saudis Say Supply Glut Over

The great crude debate continues unabated.

Earlier this week, Raymond James made the case for $80 crude in 2017. What’s particularly amusing there is that while the firm will look ridiculous if they’re wrong and if we have, as some analysts contend, entered a “new oil order” where prices will remain subdued indefinitely, one of the analysts’ rationale is sound as it can be. Here’s what he told CNBC in an interview:

"There is no clear-cut, obvious linkage between what's happening to supply and demand and the price of oil. If there were, you wouldn't need analysts. The reality is predicting oil prices is like predicting stock prices. It's more of an art than a science.”

He’s right. Geopolitics and other factors play just as much of a role - if not more of a role - than “fundamentals” when it comes to determining crude prices. Where analysts get it wrong is failing to acknowledge that geopolitics is part of the “fundamental” picture. The eternal sectarian dispute between the Saudis and the Iranians isn’t some exogenous factor unrelated to Riyadh’s decision making about output. When Sunni-Shiite tensions flare, the ideological war spills over into the oil market. That’s why you have the Saudis and the Iranians pumping at full tilt. If you think the Saudis care more about bankrupting US shale than they do about keeping prices low so that Iran brings in as little new revenue as possible now that sanctions are lifted, you don’t know much about Mid-East politics.

Having said that, Raymond James sure does place a lot of emphasis on fundamentals for a firm whose analyst told the most watched financial news network on the planet that fundamentals don’t matter. Here are some excerpts from the note:

"Over the past few months, we've gained even more confidence that tightening global oil supply/demand dynamics will support a much higher level of oil prices in 2017. We continue to believe that 2017 WTI oil prices will average about $30/barrel higher than current futures strip prices would indicate." Here’s a graphic which the firm uses to explain why it sees supply constrained:

 

     

Here’s the thing, Saudi Arabia can still ramp production. They’re sitting on as much as 2 million b/d of spare capacity. And Iran has promised to keep the pedal to the metal “even if prices drop to $20/bbl.” The focus on US production is misguided and yet it too plays a role in keeping a lid on prices. Here’s Bloomberg, citing Raymond James:

“U.S. shale producers won't be able to get their DUCs in a row to respond to higher prices by ramping up output, the team reasons, citing bottlenecks that include a limited available pool of labor and equipment.”                                                                                           

Citi doesn’t necessarily agree. Here’s what the bank had to say on Wednesday:

“Producers may choose to clear their backlog of drilled-but uncompleted wells (DUCs) before adding new rigs. Hence, rig counts could be less responsive to price changes than forecasted, given the substantial backlog of DUCs. Inventories of DUCs have grown considerably in the last two years as prices collapsed, incentivizing “in-ground” storage of oil in the form of uncompleted wells. According to our DUCs cost curve, practically all DUCs are economic at a $50/bbl price level, so we should expect to see a meaningful workdown of the backlog over the coming months, if prices remain near current levels. Indeed, some notable US producers have given explicit signals to the market that they have begun to complete DUCs.”

(Charts: Citi)

The takeaway: “...on an annual average basis, DUCs (assuming IP of 600-b/d) could add some 400-kb/d of oil production in the first year of clearing. On a monthly basis, DUCs could add as much as 600-kb/d to total US oil production at the peak month of production.”

(Charts: Citi)

But once again, the focus on US production is probably misplaced. On Tuesday, new Saudi Energy Minister Khalid Al-Falih gave his first newspaper interview since taking the reins from legendary oil minister Ali al-Naimi. In comments made to The Houston Chronicle, Falih said the following of the supply glut:

"We are out of it. The oversupply has disappeared. We just have to carry the overhang of inventory for a while until the system works it out."

"The question now is how fast you will work off the global inventory overhang. That will remain to put a cap on the rate at which oil prices recover. We just have to wait for the second half of the year and next year to see how that works out."

Sure. Of course the Saudis continue to produce at a record pace. And virtually all of the Gulf monarchies are now borrowing to fund their budget gaps in order to keep a lid on reserve burn. That doesn’t exactly scream “recovery imminent,” and neither does renewed US production at $50/bbl.

The bottom line: between DUC completion and rising rig counts and the heightened tensions between Saudi Arabia and Iran, betting on $80 oil could be a fool’s errand. By the way, if you want to know how worried the Saudi banking system is, have a look at the Saudi interbank offered rate:

(Chart: Bloomberg)

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