Oil Price Outlook - Brent: Q1 Weakness, H2 Strength - MAR 2018


BMI View : In Q1, the balance of risk to Brent lies to the downside, with prices overheating, record net length built into the futures market and fundamentals set to weak en seasonally. W e hold a bullish outlook for H2 . High compliance with the OPEC production cut deal, constraints on US shale growth and strong EM demand growth will pull prices up by 18.7% y-o-y, to average USD65.0/bbl in 2018.

BMI & Bloomberg Consensus* Brent & WTI Forecasts, UDS/bbl
*BMI is a contributor to the Bloomberg consensus. Data accurate as of January 10 2018. Source: BMI, Bloomberg

We have made a significant upgrade to our 2018 price forecast for Brent crude. We now forecast an average of USD65.0/bbl, up from USD57.0/bbl previously. In part this is due to base effects, with Brent starting the year on a firmer footing than we had anticipated. More importantly, it reflects our increasingly constructive outlook on global oil demand.

While our annual average forecast is strongly bullish, we hold a bearish short-term outlook on Brent and expect prices to correct in the coming months, before recovering into their longer-term uptrend. From a technical perspective, the rally in crude has begun to look somewhat stretched. Prices are approaching two key targets: USD69.6/bbl, the 100% retracement to the post-oil collapse high (in 2015) and USD71.4/bbl, the 50.0% retracement to the 2014 high, before the collapse in Brent. Tests of these levels could prove key to price direction over the coming weeks.

Prices Due To Correct
Front Month Brent, USD/bbl
Source: Bloomberg

In terms of the market fundamentals, there are a number of potential triggers for a correction. One is a seasonal reduction in crude demand from refiners, as refineries enter spring maintenance season. Based on Bloomberg data for the past five years, the H1 peak of global capacity outages has averaged 6.3mn b/d. As of January 9, outages stood at around 1.0mn b/d - significantly below their seasonal norms. The current low level of outages, a backlog of deferred maintenance works and our expectation for a sharp contraction in the distillate crack, all signal a large drop in crude throughput over the coming months.

Outages At Seasonal Lows
Global Refinery* Outages, '000b/d
*crude distillation units; five-year average = 2013-2017. Source: Bloomberg, BMI

On the supply side, US shale growth, crude inventory builds and compliance slippage by OPEC may all pressure prices to the downside in the early parts of the year. We forecast an uptick in drilling and production in the shale patch over Q118, as companies begin to deploy their 2018 capital budgets. The run up in prices over Q417 and extensive hedging put in place both signal significant gains over H118. However, bullish consensus expectations for US production growth should limit the negative impact on prices.

Shale On Track To Recover
Shale Oil Output By Play, 000b/d
f = BMI forecast. Source: EIA, BMI

Ex-US, the main driver of price action remains OPEC and its production cut deal. We expect compliance with the deal will remain high overall, with Saudi Arabia continuing to shoulder the bulk of the cuts and production in some markets - notably Venezuela - facing continued decline. Offsetting this, the current pricing environment may encourage higher output amongst other producers with capacity for growth. However, this should have a limited impact on market sentiment, assuming compliance remains strong from the deal's heavyweights, Saudi Arabia and Russia. Substantial slippage from either of these producers would be bearish for prices, given the scale of their output and their ability to swing production.

OECD inventory levels will continue to be read as a proxy for the effectiveness of the cut deal and, more broadly, progress towards the market's rebalancing. In line with lowered refining demand, OECD crude inventories tend to build seasonally over Q1 and into the second quarter. In theory, a seasonal inventory build should not be bearish for Brent. However, following counter-seasonal draws in Q4 and combined with the recovery in shale, rising inventories may be interpreted as a sign that the rebalancing has stalled and that the market is struggling to absorb additional volumes from the US. Record net length in speculative futures positions creates vulnerability, should sentiment sour and trigger a rapid liquidation of the longs.

Stocks Face Seasonal Build
OECD Crude Inventories, 2017 and 5YR-Range, mn bbl
Source: IEA, Bloomberg

While overstretched prices and positioning and seasonally weak fundamentals are bearish in the short term, the general outlook on Brent is bullish and we forecast prices to average in the USD65.0-70.0/bbl range in Q3 and Q4. In the main this is a demand story, with a continued pickup in economic activity - in particular among emerging markets (EMs) - supporting consumption.

EMs Fuelling Demand
Real GDP Growth Forecasts, %
e/f = BMI estimate/forecast. Source: BMI

We are positive on the outlook for EMs in 2018, forecasting 4.8% y-o-y real GDP growth for the basket. Buoyant demand in developed markets (DMs), firming commodity prices and warming investor sentiment will all support rising economic activity and higher demand for fuels, in particular in the freight and industrial sectors. A number of large consumer markets are set to see GDP growth accelerate, including India, Indonesia, South East Asia, Russia, Brazil, Mexico, Argentina, Egypt, UAE, Saudi Arabia, Nigeria and South Africa. Growth in China will slow, but fuels demand will remain strong, rising 675,000b/d y-o-y. Rising fuels prices pose some risk to EM consumption, given the wide-ranging subsidy reforms enacted over recent years. However, we do not see this as sufficient to derail growth.

Strength Across The Board
Annual Net Change In Refined Fuels Consumption, '000b/d
Source: BMI

DM demand growth will slow, as consumers in the US feel the pressure of rising prices at the pumps. Nevertheless, the 2018 growth outlook for DMs has improved in recent quarters, not least due to the pickup in activity in the eurozone and South Korea. In volume terms, these markets will add significantly to demand growth for the year.

Demand Outstripping Supply
Annual Net Change In Global Oil* Supply & Demand, '000b/d
*supply = crude, condensates & NGLs; demand = refined fuels. Source: BMI

Non-OPEC supply will rise substantially on a y-o-y basis, due to recovering output from US shale, large greenfield additions and softening decline rates amongst some legacy producers. However, growth is significantly less aggressive, when compared to current output levels. New projects are ramping up or rolling on stream in a number of markets, including Brazil, the UK, Canada and West Africa. However, the strength of demand should comfortably mop up the growth in supply.

US Leading Global Supply Growth
Forecast Annual Net Change In Crude, Condensate & NGL Production, 2018, '000b/d
Source: BMI

While we hold a bullish outlook on shale production growth in 2018 (+390,000b/d y-o-y), our forecast is substantially below consensus. It is our view that the market is overstating the role of productivity gains on production and underplaying the impact of rising services costs and the risks from bottlenecking and other operational inefficiencies. In addition, shale E&Ps have shifted focus from volume to margins, while increasingly prioritising shareholder distributions and debt repayment in their capital allocation decisions. Combined, these factors will somewhat restrain output growth in the face of rising prices.

Finally, financial markets are generally buoyant, supported by the improving macroeconomic backdrop. Firming sentiment and the continued hunt for yield is profiting a range of risk assets, including oil. In Brent, backwardation is offering investors a positive roll yield and may see speculative positions made relatively stickier than they have been in recent years. A tighter market has also brought risk premia back into play in oil and will offer sporadic support to Brent over the year. There are various potential geopolitical flashpoints, not least Venezuela, US-Iranian relations and heightened tensions in the Middle East.

Risks To Outlook
Source: BMI