Game Over – Oil Prices Are Going Higher

June 26, 2018 6:42 am

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One of our favorite movie scenes comes from the movie “Rounders.” It’s very rare to have an investing situation line up almost perfectly with your forecast because there are so many elements of the unknown. For example, “What will the future be?” is a good starting point. But in the case of the oil markets, there are two things that will never change: 1) the laws of physics, and 2) the laws of supply and demand. If the oil market is undersupplied, prices will go up. If the oil market is oversupplied, prices will go down.

The goal then is to just figure out where supply and demand are going. Because once you can handicap the variables in the outlook, then it’s just a matter of figuring out how certain you are of those odds.

We titled this article “Game Over – Oil Prices Are Going Higher” because we will break down the OPEC variable for you. Even if the Gulf Countries (Saudi and friends) increase oil production in 2019, the world will still be undersupplied because the declines from Venezuela and Iran will offset all the increases and more.

Recap of our bullish oil thesis so far

Global oil markets continue to rebalance nicely, with the latest IEA oil market report showing OECD oil storage officially below the five-year average by 1 million bbls.

Source: IEA

Are we headed for an oil shortage?

We wrote a two-part series titled “Asleep At The Wheel – No One Sees The Oil Shortage Coming.” In these two articles (Part 1) (Part 2), we explained how the global oil market fundamentals continue to illustrate a global deficit in the coming years. In addition, we wrote another piece here detailing how investors should time the oil market cycle. This was the chart we posted:

In essence, what’s happening in the oil market today is that the global oil supply and demand models continue to indicate a scenario where global oil storages will keep falling. It will fall to a level where oil prices will have to spike to the extent of demand destruction. Only then will oil prices fall back down.

How do we know this scenario will happen? What is the likelihood of those odds?

On May 14, we wrote a piece titled, “How To Differentiate Signal From Noise? Stay Focused On What Matters. We Explain 2019 Oil Market Fundamental Balances.”

We dove into the variables needed to keep the oil markets undersupplied, but a lot has changed since then. For example, Venezuela’s situation is worsening, while President Trump pulled the U.S. out of the Iran nuclear deal. There have also been rumors from OPEC and Russia that they are contemplating a potential production increase to offset the production lost from Venezuela and Iran. But just how bad will the declines be? What do the global oil market models actually look like?

OPEC production decreases, even under a scenario of Saudi increasing oil production

As you can see in the global oil market model, the call on OPEC in 2019 will be 32.4 million b/d. But we have reason to believe that OPEC’s production will actually decrease even under a scenario where the output goes higher. How?

Source: HFI Research

There are three key drivers to this assumption: 1) Iran production falls from 3.8 million b/d to 2.9 million b/d by the end of 2019 or almost 900k b/d lower, 2) Venezuela’s oil production falls from 1.5 million b/d to 0.9 million b/d by the end of 2019, and 3) Angola and Algeria will, combined, lose 400k b/d due to accelerating production declines.

All of these declines are then offset by Saudi increasing oil production to 10.5 million b/d by the end of 2019 from the current 10 million b/d. Kuwait and UAE both simultaneously increase production by a total of 300k b/d. Iraq is tapped out from increasing production, so no production increases there. Nigeria and Libya are forecast to remain stable, which might turn out to be a tall order.

As you can see from the breakdown of the variables, the one variable that swings the delta the most is the Iran assumption. How are we certain that Iran’s oil production will actually decrease by 1 million b/d?

Iran’s oil production loss could be as great as 1 million b/d

Right now, the investment community is not really factoring the potential supplies lost from Iran. Why? Some think it’s too hard to estimate the potential supply decreases. But we took the liberty of trying to figure out the changes in export by country (thanks to Kpler) and seeing where the export supplies could be lost.

In addition, IEA had an excellent chart in the latest OMR illustrating the changes to Iran’s crude sales between 2010 and 2017.

But this doesn’t really give you the full scope of things, because the IEA data only takes into account the 2016-17 period as opposed to what’s happening now. How do these figures compare?

In Europe, we’ve identified six countries that accounted for a big bulk of the increase in Iranian crude.

From 2013 to the end of 2015, these six countries averaged basically zero imports. But following the sanction lift on January 2016, the figure jumped by 473k b/d.

In Asia, we’ve identified these four powerhouses that accounted for the bulk of Iranian crude buying.

The difference from the time of the sanction and the 2018 average is 816k b/d.

Putting these two figures together, this is what we arrive at:

Source: Kpler, HFI Research

As you can see, even if China doesn’t follow through with pulling back from buying crude from Iran, the potential loss in the export market could total 1.041 million b/d.

What’s the likelihood that Iran loses these markets?

Physical oil traders along with refineries from India, South Korea, and Japan have echoed concerns that if they keep buying oil from Iran, the sanctions could severely impact their businesses. The uncertainty in the air will likely push buyers away from Iran just in time for when U.S. crude exports are on the rise.

Take, for example, what India’s Reliance Industries, owner of the world’s biggest refining complex, said this week:

India’s Reliance Industries Ltd., owner of the world’s biggest refining complex, plans to halt oil imports from Iran, two sources familiar with the matter said this week, in a sign that new U.S. sanctions are forcing buyers to shun oil purchases from Tehran. Reliance’s move is expected to take effect in October or November.

Total (NYSE:TOT), the French Energy giant, has also said that it will abandon the major gas project in Iran following the sanctions. Even Lukoil (OTC:LUKOF) is pulling back plans to develop Iranian fields in the wake of the sanctions.

In our view, Iran’s oil exports to Europe should be a given. European refineries deal with U.S. counterparts all the time and, as a result, the 473k b/d or so of increase should completely go away once November comes along. It’s the export figures to Asia that are giving analysts a feel of uncertainty. However, our belief is that India will tone back oil imports from Iran and in line with Reliance’s recent comments. Japan should remain steady, and South Korea will show a pullback.

In all, we think there are at least 1 million b/d of oil exports at risk. If so, we would see Iran’s oil production reflect this by Q4 2018 and well into 2019. Floating storage will likely build in the meantime as exports fall, and once storage capacities hit their limit, then the fields will have to be shut in.

What about the idea that Iran exports its oil through Iraq?

Earlier this week, we wrote an update on Iran. At first, we thought Iran’s oil production wouldn’t be severely impacted because it will simply export oil through Iraq. But following queries from Aaron Bradley, our head analyst, we looked at the data and it contradicted completely our original presumption.

The above chart is the crude exports combined total from Iran and Iraq. As you can see, following January 2016, the combined exports increased. If the assumption that Iran’s crude exports were going through Iraq was right, then we should have seen only a small bump, but that wasn’t the case. In addition, if the original premise was right, we should have also seen Iraq’s crude exports fall following the sanction, which also wasn’t the case.

As you can see in the chart above, Iraq’s exports actually trended higher after the Iran sanction lift, which invalidates our original assumption.

Now taking these two data points and combining the data points we are seeing on an individual country export basis, we have reasons to believe that once the sanctions are reimplemented, Iran’s oil production will have to be halted given the limited market it can sell its oil into.

What does this mean for oil prices?

The setup now looks even better than we previously thought. Now the situation is that even if Saudi and its GCC allies ramp to full throttle, the oil market deficit will increase – leaving the oil market precariously low on spare capacity. Our analysis shows that Kuwait and UAE’s oil production increase will be offset by declines in Algeria and Angola. Iran’s production lost will be offset by Saudi Arabia. And Venezuela’s production lost will be partially offset by Russia, but a drop to 0.9 million b/d will send the deficit shock to the rest of the world. All of this will be coming at a time when Permian takeaway capacity is being tested to the brink and Brazil’s oil production is disappointing to the downside (the CEO just resigned at Petrobras (NYSE:PBR)).

Non-OPEC ex-U.S. and Canadian supplies are also starting to surprise to the downside, with IEA forecasting year-over-year production losses everywhere:

Source: IEA

In our view, this supply/demand forecast indicates that sometime in the next one to two years, oil prices will have to move to a level where serious demand destruction takes place.

Using the chart Morgan Stanley has created called the “global oil burden,” which measures global oil consumption as a percent of GDP, this indicates that oil prices will have to materially surpass the previous highs in 2011-14 (blue line) in order to start severely dampening oil demand. This would put the oil price forecast in the $140+ range.

But the path to $140+ oil won’t be smooth at all. Markets will remain jittery on the prospects of increasing oil production from OPEC while the investment community remains uncertain of how Iran’s oil production looks in 2019. But our analysis indicates that as we get closer to the sanction date (Nov. 4), oil analysts will start doing the same analysis we did instead of throwing out a pie in the sky figure and realize quickly that Iran’s oil production could fall severely. Governments around the world will likely release SPR once oil storages reach critical levels that will help dampen any sudden oil price spikes, but if our analysis is right that OPEC’s spare capacity will be nonexistent following Iran and Venezuela’s collapse. The scenario of an oil price spike is unavoidable.

Game over, there’s no avoiding this now

The global economy looks like the Titanic right now. The iceberg is the incoming oil price spike and the complacent investment community won’t even know what hits them. We will be following the developments closely as to how global oil supply/demand balances play out over the coming months. Our forecast shows a steepening deficit to 2020 as Venezuelan, Iranian and non-OPEC ex-U.S. and Canadian production losses increase. This scenario will play out even if Saudi and GCC allies increase oil production alongside U.S. shale. Once OECD storage reaches a critical level, the market will have to spike oil prices to the extent that oil demand destruction starts to take place. This could also send risk assets spiraling downward, which we think we will be well-positioned to take advantage of.

The game is up, and there’s no avoiding a rising oil price environment now.

Disclosure: I am/we are long CRC, GXE.TO, MEG.TO, CVE.TO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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