HFI Research:The oil bull thesis is just getting started
With WTI at multi-year highs, the real oil bull thesis is just getting started.
If there's one commonality you will find in our oil market dailies in the last 18 months, it's that we, HFI Research, have been one of the loudest oil bulls in the market. Thankfully, with WTI hitting a multiyear high, our voice has resonated with readers and those who take a more logical approach to the market. But if our bullishness wasn't backed up with hard data, readers could easily dismiss our arguments as to why oil prices will rise. That's why in the latest IEA oil market report, our test for Q1 2018 played out exactly as we thought it would.
Source: IEA, created by Giovanni Staunovo
In IEA's latest OMR report , the energy agency noted that OECD storage is now just 30 million bbls above the five-year average in February.
Preliminary March results also saw OECD storage draw, with the U.S. representing the entirety of the draw while Japan and Europe saw builds. As a result, IEA says that by May 2018, OECD storage will fall to the five-year level or below it. IEA's latest storage balance now shows consistent draws for all four quarters in 2018.
But for our subscribers and any readers of our articles, this report from the IEA was the equivalent of watching paint dry. The estimates for Q1 2018 storage were so blatantly off by the end of 2017 that we wrote two articles addressing the flawed thinking.
In the first article, " IEA Is Underestimating The Potential Storage Deficit In 2018 ," we said:
The 2018 balance will be very obvious by the first three months of 2018. Historically, we see large global storage builds take place as refineries go into their typical maintenance season. But with the balance tightening as we head into the end of 2017, will Q1 2018 surprise to the upside showing materially less build than the average or even a draw? Yes, we think so.
It won't be long before we see the consensus catch up to what we see happening at the start of 2018.
We then followed up with our favorite piece, " Sentiment Setup: How Will The Oil Rally Play Out In 2018? " In it, we outlined our thinking in these four quarterly projections with Q1 as follows:
Q1 2018: Consensus is bearish heading into Q1 2018, anticipating big global storage builds only to see a draw. This sudden sentiment flip will prompt underweighted portfolio managers to buy up energy stocks in a hurry.
Again, coming into 2018 - for one reason or another -- we could not understand the logic behind IEA and the sell-side analysts' assumptions for big storage builds in Q1. Every data point we looked at pointed to the opposite direction. If everyone said 1+1 equaled 11, would you believe them or do your own work?
Yet, that's how the market analyzed the oil fundamentals for the last 16 months. We still remember the number of articles addressing how OPEC would cheat on the production cut agreement, or how the deal was fake. Yet, the average compliance OPEC's production cut since January 2017 has averaged above 100% . If you can't accept facts, then perhaps you shouldn't be in the business of oil market analysis.
But now that WTI is at a new multiyear high, and Brent is solidly above $70/bbl, if you think the oil rally is over, you are mistaken. It's just getting started.
It's only getting started - you haven't seen the good stuff yet
For the last two years, we have hammered away at a few important points that are still yet widely understood by the markets. Our favorite one continues to be an article we wrote titled, " Keep Your Eyes On Shale, We Will Just Watch The Rodney Dangerfield Barrels Fall ."
Every analyst you talk to today whether about how oil market fundamentals will be in 2018 or how they will be in 2019 will start with something along the lines of:
- U.S. Shale
- OPEC cut agreement
Rarely will you see analysts bring up the consistently disappointing production results out of Mexico, Brazil, Norway, China, Angola, Algeria, Colombia, or any other non-OPEC ex-U.S., Russian and Canadian oil producers.
It's all about U.S. shale today, and this is the hottest topic everyone should discuss. Every sell-side analyst spends hundreds of research hours devouring over how Permian well X produced this much oil on IP 30, or how this producer is going to increase productivity. Yet, if just only a fraction of these analyst hours were spent on the other ~35 million b/d of global oil supplies, they would see how truly disastrous the upstream capex landscape looks like today.
Take Brazil, for example, a supposed supply growth engine for 2018. On January 2017, this was IEA's forecast for Brazil's oil production growth by the end of 2017:
IEA January 2017 forecast
This is where it really ended 2017:
If the lines are hard to discern, December 2017 oil production supposedly finishing around ~2.9 million b/d ended up finishing the year at ~2.7 million b/d. No big deal right? It's only 200k b/d.
But when you take Brazil's historical track record of consistently disappointing annual growth guidance, you start realizing that something strange might be occurring instead.
Source: BCA Research
But again, this shouldn't be anything new to anyone that follows the oil markets closely. We wrote about this here as well .
With global oil storage expected to soon fall into a deficit by the second half of 2018, people will have to start caring about the stuff they didn't care about before. Sure, focusing on U.S. shale might score investment fees for their banks, but if non-OPEC ex-U.S., Russia and Canada keep disappointing, an impending supply shortage will be the hottest discussion on Wall Street.
And it's not just Brazil where we're seeing the production disappointments happening, it's every country inside what we would call the "Rodney Dangerfield club" (oil supplies that "get no respect").
It won't just be disappointing supplies - higher than expected demand will help push us into deficit too
For 2018, the thesis gets a second tailwind not just from impending supply disappointments, but a demand surprise as well. We have written repeatedly that IEA's current demand forecast of ~1.5 million b/d will be far too low. We start off with the fact that 2017 base oil demand of ~97.8 million b/d is too low, because instead of counting the storage declines as a result of higher demand than supplies, IEA bundles it in the so-called "miscellaneous storage."
If you did the work and removed the misc storage segment, base oil demand for 2017 was ~98 million b/d, or some 200k b/d higher than IEA's figures. This, if taken at face value, already shows demand to be understated. Once IEA revises base demand higher for 2017, it will inadvertently have to revise 2018 oil demand higher as well if the same ~1.5 million b/d y-o-y delta is kept.
In addition, the 1.5 million b/d demand growth is also low because it does not take into account that 2017 saw India's demand growth stall due to a liquidity crunch. And judging by the counter-seasonal OECD storage draw in Q1 2018, we think demand has further surprised to the upside already.
What we see going forward
The writing is already on the wall for 2018. Q1 2018, the supposedly super bearish quarter, showed a global oil storage draw vs. the build that everyone expected. And because Q1's seasonally storage build normally helps cushion the storage declines in the next three quarters, the oil deficit will only worsen as we enter the second half of 2018.
OPEC has already started to shift its target for a "rebalanced market" from one that's storage-driven to one that's capex-driven. Again, we make the point that OPEC's production cut is not a cut whatsoever, but a mere pullback from max capacity. As a result, you will see historic offenders of OPEC production cut agreements like Iraq and Iran comfortably agreeing to another cut extension even as global oil storage falls into deficit.
And even while all of the fundamentals are screaming bullish, market participants think the recent rally is related to geopolitical risks as opposed to actual fundamentals. In fact, if you look at recent sell-side price forecasts, most are expecting prices to fall:
JPMorgan analyst Christyan Malek even went on to say that "$70 is as good as it's going to get." This is why we also have a new thesis for the second half of 2018, which is that Saudi will purposely lower crude exports more to further magnify the oil deficit. The logic is that market participants are reactive, and most won't believe higher oil prices until they see higher oil prices. Price is in itself a great reflexive feedback loop, and as sentiment usually goes, higher prices will force people to realize higher prices are here to stay. We explained our logic on why that will be the case in this article .
The goal of higher oil prices will go toward accomplishing something that has befuddled market participants for the last 16 months, which is that energy stocks have severely diverged from oil prices . Once market participants get hit by this reflexive feedback loop of higher oil prices leading to higher oil price assumptions, investors will then underwrite energy stocks with higher oil prices. This will lead energy stocks that have been cast aside and neglected for the last two years to become the leading performing sector in the market, something most investors can't even contemplate today.
In our view, we believe WTI has upside to $85/bbl this year purely on fundamentals . The severity of the forecast storage draws by the second half of 2018 will shock and awe market participants. This will come at a time when U.S. shale will be growing production, and the market participants will find it puzzling that storage can keep trending down at such a rapid pace despite higher supplies.
This, alongside higher than expected oil demand growth and disappointing production out of the "Rodney Dangerfield Club," will help sway sentiment away from the "lower for longer" to the "higher for longer" crowd. As always, IEA, sell-side analysts and the media will be late to this party.
HFI Research specializes in contrarian investment analysis. Petroleumworld does not necessarily share these views.
Editor's Note: This commentary was originally published by Seeking Alpha , 04/13/2018. Petroleumworld reprint this article in the interest of our readers and does not necessarily reflect the opinion of Petroleumworld and its owners.
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Petroleumworld News 04/16/18
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