After Vienna, term structure of oil shows a humpback

BOFA MERRILL LYNCH REPORT

Crude oil prices have responded to the recent OPEC and non-OPEC deal in Vienna by bouncing firmly into the $50+/bbl range. Notably, the term structure of the Brent crude oil market has pushed from a very steep structural contango into a humpback shape, showing a discount in near-dated contracts but backwardation past the September 2017 contract. Why? The agreement to cut output may push the oil market into deficit as soon as January. Yet, stocks remain exceedingly high and it should take months to normalize them. Meanwhile, producers keep selling paper oil forward into 2018, anchoring longer dated contracts. Producer, consumer, passive investor, storage, and spec positioning flows all feed into this awkward oil curve. We refer to it as “the hunchback of Vienna”.

Is this oil curve shape new? No, the crude oil market developed a similar shape that lasted for 28 months in 2005-07. Could it persist? Yes, we believe it could persist for the next four months and possibly longer for four reasons. First, we expect large-scale high yield and investment grade oil producer forward selling to continue in Calendar 2018. Second, high inventory levels will likely keep depressing front-month oil contracts until the crude overhang is partly cleared in 2H17. Third, a possible surge in passive investor flows next year could dampen a shift to backwardation in front-to-third month oil spreads. And fourth, on the consumer side, airlines may not come back in size into the market unless spot oil prices spike above $75/bbl, an unlikely event.

Given the relentless selling pressure of shale producers, US nat gas provides a good template for oil structure. Since US shale gas output started 9 years ago, the front-to-thirteenth month curve has moved from contango into backwardation three times. Each contango period lasted for at least 2 years. For Brent to move into backwardation, we estimate total OECD crude oil inventories would have to drop to 1.1bn barrels. With stocks currently at 1.18 billion bbl, this rotation will likely take at least 6 months of crude inventory declines of 440 thousand b/d. Said differently, the “hunchback of Vienna” may not depart until the July Brent contract becomes prompt on April Fools’ day. Should OPEC and Russia fail to deliver deep cuts in 1H17, it could very well take a lot longer.

Macro outlook

Global GDP in USD terms at market exchange rates is stagnant. China’s GDP is changing, with services overtaking industrial activity as a driver of growth. US Republican win means stronger USD, higher rates, more trade barriers, and reduced US oil supply restrictions.

Fed tightening cycles and a strong USD do not bode well for oil, as rising US rates and flatter yield curves hurt EM demand. Global oil output was unchanged YoY in 3Q, as OPEC growth offset again non-OPEC field decline rates of 5.0 percent. We project non-OPEC supply to contract by 910 k b/d this year and 30 k b/d in 2017, compared with an average 20-year expansion of 710 k b/d. We see shale oil output bottoming out in 1Q17. Efficiency gains are flattening out everywhere except in the Permian, which is set to lead the output recovery as prices rise.

With global inventory trends diverging, our work shows Light Louisiana Sweet (LLS) is turning into the global oil bellwether 2017 global oil demand growth will average 1.2mn b/d in 2017 while supply is roughly unchanged, resulting in a 2017 Brent price of $61.

OPEC agreed to cut crude oil output by 1.2mn b/d with key non-OPEC producers indicating a 558k b/d curb, a first since 2001. Country quotas and an independent production monitoring committee are also part of the deal, so we expect firmer compliance.

OECD demand will grow by 80k b/d this year as Americans drive over 3tn miles, but we project flat OECD demand in 2017. Yet we see EM oil demand expanding by 1.2mn b/d in 2017 but acknowledge downside risks on the back of higher US rates. OPEC’s action won’t propel prices much above our $70 mid-year target. Longer-term, we estimate global oil demand will increase by 1.2mn b/d per annum over five years at $55-$75, and by 1.7mn b/d at $30/bbl. Peak global oil demand lies beyond 2050 if oil stays below $100, as transport demand offsets efficiency and substitution. Faster EV adoption or efficiency gains, e.g., due to higher oil prices, could alter this path and bring peak demand by 2030.

2017 Energy Outlook

Refining margins have rebounded from their September lows across all regions on planned and unplanned refinery outages. Yet we now see margins falling as refining costs structures rise and global crude stocks rebalance faster than product stocks. Also, we project CDU capacity additions globally of 960 and 860 thousand b/d in 2017 and 2018, and remain bearish distillate. While the demand bounce in 2010 was cyclical and diesel-geared, today’s petroleum demand is consumer-and thus gasoline-geared.