Two big sell side commodity houses, Goldman Sachs (GS) and Morgan Stanley (MS) , back to back have raised their oil price forecasts yet again calling for $70/bbl. Brent by Q2, nudging it higher by $10/bbl. Apparently the rise of 30% in Brent Oil price since the start of the year compels them to do so. Anyone could be forgiven for thinking they missed the "Super cycle" and rush to upgrade their numbers and forecasts before they "look too out of sync" with screen prices. Most generalists who trade oil futures may not understand the structure and dynamics of contango vs. backwardation and physical market dynamics. Today that is the state of the oil market as most trading it are just trading the spot due to the commodity reflation trade as yields tick higher, but not seeing what producers are doing at the back end of the curve. Let's ask ourselves what is going on.
Taking a little trip down memory lane. Last year when hints of Covid was striking the world and oil prices started easing from highs of $70 down $60/bbl., we all remember how Saudi Arabia decided to launch an oil production war, at possibly the worst time in the history of oil, as Russia did not play ball to cut production back then. They opened the taps full on at a time when the world was shutting down slowly as pandemic induced government wide lockdowns and travel came to a halt. That sealed oil's fate, we all know what happened, and the rest is history. The aim was to teach Russia a lesson which severely backfired. Fast forward this year, as OPEC - mostly Saudi Arabia - needs much higher oil prices to balance their budgets, decided to take an additional 2 mbpd of oil out of the market in February and March, the peak of winter heating demand! Forgetting Covid, this is the time of year when demand picks up anyway due to heating oil. We all know how bad things can get, look at the Texas freeze, as heating demand surged through the roof. Even though the market was "normalizing" as prices rallied to $50 from $38/bbl., they decided to tighten the market anyway just to make sure prices stay supported. Low and behold oil prices have risen so fast, this brings a whole new set of problems.
Non-OPEC will and is starting to produce more. Take a look at rig counts. To keep OPEC+ happy they will need to release their voluntary cut of 2 mbpd which means about 2.35 mbpd of more oil coming to the market towards April. The irony is this is a time when demand tends to fall off anyway, we lovingly in the industry call it "shoulder season". It means just that, between two strong demand seasons, it is a time when things cool off, and demand pulls back a bit. Seasonality is extremely important for oil, and more than people think. It is not just an inflation, commodity super cycle spot play. It is an extremely big physical market that dictates its prices. The oil market just tightens or loosens in a short period of time. Unfortunately, or fortunately, it fell and rallied much harder given Saudi barrels.
The OPEC+ meeting is taking place on March 4-5th. OPEC+ members are itching to start increasing their production as they watch the entire world monetize on such fabulous higher prices while they have been waiting since $38/bbl. and holding out. Russia is already suggesting that. Saudi may not have a choice to release more oil. It would have been much timelier to have taken oil out of the market during April than February. Now that vaccines are rolling out globally, we are still far from fully opening up. Do we really think global travel and demand will normalize by April this year?
Morgan Stanley talks about 2.8 mbpd of oil drawdown in Q1 that tightened the markets. We wonder what would have been the case if it were not for Saudi's cut. Demand is still about 5-6 mbpd lower than last year pre-Covid levels. We are nowhere near normal. Yes, there will be a recovery, but that could be six months away. That is a lot in an oil trader's investment horizon. Those blindly chasing the reflation trade tick for tick, better pay heed to physical market fundamentals. When micro ties in with macro, that is the sweet spot. But when fundamentals go the other way, macro does not stand a chance.
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