Wednesday, June 8, 2016

The Short-Term Energy Outlook

On a monthly basis, the Energy Information Agency releases the Short Term Energy Outlook which looks at data and analysis of recent trends in the oil and gas industry. In addition to looking at the near-term historical trends, some projections for price, supply, and demand are presented for the use of industry officials, economists, and investors. The fifty-page report presents many insights that are worth looking into for any analyst interested in the world's general economic growth. This article will extract what it can from the June 2016 Short-Term Energy Outlook and provide its own opinions and insights along the way. All pictures and data are based on the report from the EIA linked above.

One of the main functions of the STEO is to produce a projection of the West Texas Intermediate spot price over the next couple of years. By the end of 2017, the EIA sees prices approaching the $60 level although their range of possibilities is quite large. Even though traders are trading with optimism, there is still a lot of uncertainty regarding the choices of OPEC and the changes in U.S. production in the latter half of 2016. In fact, the recovery could be its own undoing as firms will look to boost production as soon as it becomes economical. A volatile tone is still evident in the leading U.S. energy agency as it predicts $46 a barrel by September 2016, $4 below what spot prices closed at today. Still variation in the futures spread "suggests the market expects WTI prices could range
from $36/b to $69/b (at the 95% confidence interval) in September 2016." Contango patterns in the WTI futures market has been heavy throughout 2015 and the beginning of 2016, but the recovery has seen this formation reduced by "59 cents/b and 52 cents/b for Brent and WTI, respectively, since May 2."

WTI contango had gotten as bad as $10+ when the markets were trading oil as low as $30 a barrel. With bullish hedging and more activity on the market, merchants and position traders have pushed up futures prices causing the spread between the front month and the 13th month to fall as shown by the chart. The normalization of the futures curve should signal to oil and gas firms that volatility is starting to taper off and selling contracts can help realizations in the long run. Downstream firms will be more competitive as well, looking to find the cheapest barrel that can get their hands on. The EIA expects high refinery utilization to "contribute to continued price strength for North American crude oils over global crude oils." As U.S. producers cut operations and the WTI spot price shows some upside, its international doppelganger, Brent, might feel more downside with Russia and OPEC members opting for higher production levels and consumption falling in Europe and stalling in emerging economies.

The spot price spreads, which fluctuated wildly in 2015, have finally settled down between $2/b and -$2/b. Almost a year ago, Brent prices were almost $8/b higher than WTI stressing the oversupply in the United States at the time, but the trend reversed and pushed the spot prices closer together. Smaller differentials will have a bullish impact on investors who are encouraged by less uncertainty in the market. Converging prices discourage arbitrage and encourage export and import opportunities as suppliers and their customers feel safer from sudden shifts in the market. The EIA attributed the recent decrease in the spread to "the large, temporary decline in a major source of crude oil supply" caused by the Canadian wildfires. While the deviation could be corrected in the next couple of weeks, the brief bullishness certainly adds optimism to a market with growing momentum. If traders see that energy prices are vulnerable to these short-term events, they might build up in anticipation of an uptrend and accelerate the move with greater volume.

Group psychology that represents the dynamic just explained helped to propel energy securities to an impressive rebound in April and May 2016. After recorded one of the worst years in history in 2015, "energy prices increased 29%, whereas nonenergy commodities and the S&P 500 index increased only 6% and 3%, respectively." It appears that betting against the trend would have, once again, been the correct position for a trader in late 2015. In short, the contrarian prevails. The consistency bullish supply news has helped drive the trends seen above which is "reflective of less concern over a slowdown in global economic growth" according to the EIA. Contrarians looking for the next trend to defy might point out that the market is still oversupplied and higher prices will worsen that side of the market. Their argument garners some legitimacy and deserves to be heeded as equities and commodities investors trade into the third quarter.

On the demand side, the EIA sees consumption growing steadily through the next two years. Global consumption grew 1.4 million b/d in 2015 with an "increase by 1.5 million b/d in both 2016 and
2017." Despite falling into quasi-crisis mode during the global slowdown, emerging economies are expected to remain the solid base of global consumption through 2017. China's is expected to grow by 400,000 b/d in 2016 and 2017 while India's is forecast at 300,000 b/d in 2016 and 400,000 b/d by 2017. Developed economies will grow at slower rates with Europe and Japan dragging down the growth in the United States and Korea. In 2015, consumption growth was 500,000 b/d, but predictions for 2016 and 2017 have growth shrinking to 200,000 b/d and 100,000 b/d respectively. Oil markets in the near future will look to focus their attention on these emerging nations as oil and gas firms from every country will fight to secure contracts there.

On the supply side, things start to get interesting. Suppliers are divided between OPEC and non-OPEC with a different trend emerging in either camp. Non-OPEC production grew by 1.5 million b/d in 2015 fueling the glut that caused the oil price crash. In 2016 and 2017, the EIA projects output to fall by 600,000 b/d and 200,000 b/d respectively. Of the plays that are expected to slow, "the largest declines are forecast to be in Asia and in the North Sea." The trend in the non-OPEC camp will be offset by changes in OPEC production. As member nations start to implement their own policies, they will seek to maximize output in order to bolster their revenue streams. In 2015, OPEC production grew by 800,000 b/d, and the EIA forecasts growth in 2016 and 2017 at 800,000 b/d and 700,000 b/d respectively. Iran will be the cause of most of the growth in the oil cartel. Disruptions in Nigeria, due to military conflict, are expected to last through 2017 which could cushion the bearish pressure from supply change.

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