Daily Management Review

Goldman Sachs: Backwardation will save the oil market


05/22/2017


The OPEC’s key to success in balancing the oil market. It lies in an ability to turn "curves" of movements of the futures quotes.



Lindsey G via flickr
Lindsey G via flickr
Goldman Sachs warned that while oil futures are in a state of backwardness, the OPEC can struggle to significantly reduce reserves. To date, contango in the market allows shale producers to hedge their future production and fix high delivery prices at a later date. This provides shale companies with confidence in their future earnings, and allows them to develop drilling. The end result is a surge in supplies in the short term, which eventually restrains the ultimate goal of restoring equilibrium.

The OPEC’s goal is to transfer the market into a backwardness state - the opposite contango. This means that the futures contracts of the next month of supply will be traded at a premium to oil futures with delivery in six or twelve months. In this case, storage of oil becomes unprofitable, since the trader not only has to pay the cost of storage, but also sell the commodity cheaper in the future.

Backwardness causes a sharp decline in inventories. In addition, without being able to hedge, shale drillers may not be able to increase the scale of drilling.

"OPEC is too big to hedge, so they get lower spot prices, which will allow them to turn the curve", said Jeffrey Currie of Goldman Sachs. Backwardation is a key condition for OPEC not only to reduce inventories, but also to keep the US shale industry busy.

That is, the logic underlying the unexpected statement - Saudi Arabia and Russia want to expand production cuts before the end of the first quarter of 2018 - will not only allow further cuts, but should also have a psychological impact. This is expected shock the market and increase chances of a stronger transition to backwardation.

It is unclear whether this statement will reach its goal. At present, experts from institutions such as the IEA and Goldman Sachs will face an expansion of the agreement within nine months, which is likely to be a strong move aimed at reducing inventories to an average level in 2018, but not earlier.

In the short term, the announcement of a nine-month expansion in OPEC/Russia cuts has only led to a very modest price jump. The OPEC announcement was made on time, and oil prices shifted again over the past few years, but the rhetorical power of the Saudi Energy Minister in his influence on the market is weakening. Only significant and noticeable reductions in inventories will affect prices in the future.

The complicating factor for this calculation is the prospect of a new US shale production. If there is a strong jump in backwardation, US oil shale production will continue to grow. The EIA recently revised its forecast for oil production in the US, which, he says, will grow from 8.9 million barrels per day in 2016 to 9.3 million barrels per day this year, and then you can still expect a massive increase to 10 million barrels per day in 2018.

In fact, Bloomberg suggests that shale drilling may be delayed due to a lack of teams conducting drilling. Despite the fact that this may hinder shale production in the short term, it will last only until next year.

At the same time, WTI and Brent showed weakness on Wednesday and Thursday, despite two consecutive weeks of strong inventory declines. Analysts attribute the sale to political instability in the US, with a scandal that engulfs the Trump administration. The US stock markets placed their worst trading indicators on this day of the year, as the prospects for tax cuts faded against all the political contradictions. Oil has been sold out.

sourse: cnbc.com






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