Bulls Run As Goldman Oil Call Sparks Rally

If everyone is being honest, forecasting commodities prices further out than say six or so months is well nigh impossible. There are just too many inputs. That goes double for oil, the most financialized of all commodities.

As I wrote last week, the market is now trading almost exclusively off crude. Sure, there are myriad catalysts that drive day to day fluctuations, but the direction of crude prices has been a key determinant this year when it comes to explaining flows into and out of risk. Take January for instance. When oil plunged into the 20s, risk sold off dramatically and equities got off to a rather inauspicious start to 2016.

Then, crude bounced. Apparently, everyone suddenly forgot about the fundamentals (which are decisively bearish) and before you knew it, the S&P rebounded and crude rallied into the mid-40s. That, despite the disaster in Doha and despite the fact that Iran is ramping production to 4 mb/d.

Through it all, Goldman has been persistently bearish on prices. A sustained rebound, the bank’s commodities team has argued, is impossible until prices stay low enough long enough to wipe out uneconomic supply in the US shale complex. Here, for instance, is what Goldman said in March:

“While these dynamics could run further, they simply are not sustainable in the current environment, in our view. Energy needs lower prices to maintain financial stress to finish the rebalancing process; otherwise, an oil price rally will prove self-defeating as it did last spring.”

In other words, if prices rise, high cost, FCF negative US producers will live to pump another day and the supply/demand imbalance will persist.

On Monday, crude is on the move. The catalyst: Goldman. Well, that’s not the whole story. There are also supply disruptions in Nigeria, but the headline of the day is the bank pulling forward their price forecasts for WTI. Here are some key excerpts:

“The physical rebalancing of the oil market has finally started. While supply and demand surprised to the upside commensurately in 1Q16, leaving the market oversupplied by 1.4 mb/d, we believe the market has likely shifted into deficit in May. The 2Q16 deficit that we now forecast is occurring one quarter earlier than we expected mid-March, driven by both sustained strong demand as well as sharply declining production. The shift in OECD stocks will be further exacerbated by the ongoing strong Chinese inventory builds.

“The recent roll-over in production is the result of somewhat offsetting cross currents. (1) Production has rolled over faster than we had expected in China, India and non- OPEC Africa more than offset upside surprises in the US and the North Sea. (2) Transient but recurring disruptions have more than offset larger than expected Iran and Iraq production. And while some of the disruptions will stop such as maintenance, fires and strikes, some are likely systemic, for example in Nigeria, and we now expect production there will remain curtailed for the remainder of the year. Net, this leaves us expecting a sharp decline in 2Q output.”

Still, Goldman notes that the supply glut will persist for quite some time:

“The shift in fundamentals has been significant over the past two months yet the price action has been somewhat muted with WTI oil prices up only $7/bbl. Over the past two weeks alone, wildfires in Alberta and attacks in Nigeria have reduced production by 1.5 to 2.0 mb/d and yet prices are up only $2/bbl with Nigerian crude prices underperforming. We believe this is reflective of today’s high inventory overhang. Since excess inventories are at historically elevated levels, in both the OECD and EM countries, current disruptions have little impact on the availability of crude barrels. In fact, high product stocks would even allow for lower refinery runs if necessary.”

That’s a sophisticated way of saying this: there’s just too much damn oil out there for prices to mount a recovery that will ultimately prove sustainable.

Don’t forget, Iran has now reached pre-sanction production levels at around 3.6 mb/d. And they aren’t done yet. Oil minister Bijan Zanganeh is determined to bring daily production up to 4 mb/d. Meanwhile, the Saudis are angling to ramp to capacity. That alone would be enough to unbalance the market by year end, according to Credit Suisse.

Still, a variety of factors could conspire to push crude higher in the short-run, not the least of which is a weak USD. As I’ve documented extensively, an unspoken (or at least unannounced) agreement at the G-20 in February has led directly to dollar depreciation. The Fed unexpectedly leaned dovish in March and subsequently, both the ECB and the BoJ refrained from adopting further easing measures, leading to gains for the euro and yen against the greenback. If the trend continues, it may be enough to drive prices higher despite the inventory overhang. Here’s Goldman on the dollar-oil dynamic:

"Oil fundamentals will drive a further flattening of the forward curve while our economists’ long-held view of a normalization in US monetary policy will strengthen the dollar and weigh on long-term prices. There is a precedent where these forces also worked against each other, in 2005, and in that case the macro dominated to push oil prices higher despite weak fundamentals characterized by building inventories and a contango market.

"And while our strategists recently pushed back the timing of the next hike and the dollar’s next rally, markets have tentatively turned already with steady USD appreciation over the past week. This comforts us in our view that long-dated prices will remain anchored with in fact a faster reversal in the USD a potential negative oil price catalyst even should timespreads continue to strengthen."

In other words: don’t expect the rally in crude prices to last, especially if the Fed surprises with a hike next month. For now though, it’s party time as stocks follow oil higher.
So you can thank Goldman for today’s exuberance. Just don’t lose sight of the bank’s overall message which, if you read the entire note, isn’t exactly bullish: “We are nonetheless lowering our 2017 forecast from $57.5/bbl to $52.5/bbl, with a 1Q17 decline back to $45/bbl.”

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