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March 31, 2017

Energy Update: A Lot Can Change in a Year

Executive Summary

In just over a year, crude oil prices have nearly doubled from the decade lows reached in early 2016. In this Energy Update we take stock of the near term supply and demand dynamics which support our constructive outlook for oil prices. In short, we believe production cuts by the Organization of Petroleum Exporting Countries (OPEC)  have moved the global oil market from a surplus to a deficit of supply relative to demand. We expect this dynamic to support higher oil prices in 2017. We also summarize opportunities across fixed income as a result of our outlook.

Fundamental Support: Good Compliance, Firm Demand

So far this year, OPEC countries have made significant progress in cutting oil production (Exhibit 1). Saudi Arabia has been a notable advocate of price stabilization in the oil market and has made significant strides already to address the market surplus. So far this year, the Gulf nation has reduced production by more than agreed upon—resulting in its largest cut amount in eight years—while also expressing willingness to reduce production beyond the scheduled time period. Supply cuts from other core OPEC producers have also been larger than anticipated.

Alongside the initial evidence of OPEC compliance, we have observed better-than-expected global macroeconomic data. Global manufacturing activity grew at its highest rate since 2011 in February1 and the economic gains have been broad-based across both developed and emerging markets, with Chinese industrial activity also picking up. We think the improving growth outlook provides a supportive backdrop for oil demand that is likely to persist through 2017.

Exhibit 1: OPEC Has Made Significant Progress on Cutting Production to Meet New Quota

energy update_ex1

Source: Bloomberg. As of February 2017


Over the last couple of years, GSAM’s Commodity team estimates that global oil demand has grown on average by about 1.5 million barrels/per day per year. Based on recent momentum in positive global economic data, we expect demand to rise by an additional 1.25 million barrels/per day in 2017. We calculate a metric called ‘inventory days cover’, which estimates how many days it would take to draw down inventories based on global demand. For 2017, we forecast a material decline in this metric by the third quarter of 2017 (see Exhibit 2) as demand outpaces supply. Our expectations for increased demand err on the conservative side of broader market expectations. Even so, we think these results paint a bullish backdrop for oil prices through 2017.

Exhibit 2: Oil Supply Cuts are Likely to Drive Meaningful Inventory Drawdowns by Q3 2017

energy update_ex2

Source: GSAM. Based on reported inventory levels in the US, Japan and Europe. As of February 2017


The Outlook for Oil Prices

Despite OPEC production cuts and a supportive economic backdrop, oil prices have retreated from the highs that followed OPEC’s announcement (see Exhibit 3). To some degree, the recent moderation in prices is a market correction following the initial post-announcement excitement, and to a lesser extent a reality check that good compliance should be expected and not necessarily rewarded. The recent uptick in the US oil rig count may also be tempering some of the bullish sentiment in the oil market.

Exhibit 3: Oil Prices Have Reversed their Post-OPEC Announcement Gains

energy update_ex3

Source: Bloomberg. As of March 23, 2017


We expect oil prices to break beyond their recent range once hard data begins to reflect a drawdown in inventories. For now, inventories remain elevated, but we think this reflects the high level of OPEC oil production prior to the January cuts and the subsequent increase in US oil imports.

Our Commodity team believes the drawdown in inventories will become apparent over the next couple of months, as OPEC production cuts lead to lower US imports and refinery demand rises ahead of the summer driving season (see Exhibit 4). We expect this to support oil prices through the summer period and possibly beyond. While we recognize a pickup in US supply is a key risk to our positive yield on oil prices, in the near term at least, we expect robust oil demand to outpace the US shale producers’ supply response.

EXHIBIT 4: LOWER OIL IMPORTS, RISING REFINERY DEMAND LIKELY TO DRAW DOWN US INVENTORIES

energy update_ex4

Source: Bloomberg. As of March 2017. Left chart is showing a five-week moving average.


Investment Implications

In the near term, we expect the oil market has moved from surplus to deficit due to the OPEC supply cuts. Accordingly, we believe we are in the midst of a constructive environment for oil prices, commodity market indices and commodity-oriented assets. Within our commodities strategy we are overweight crude oil. We also see value in commodity-oriented emerging market currencies such as the Russian ruble.

Within corporate credit markets, we see opportunities in high yield energy-related sectors, such as exploration and production (E&P) companies and oilfield services. Within E&P, balance sheets appear healthier due to equity issuance last year and we see the sector benefiting from contained financial conditions, lower costs and productivity improvements, as well as a pick-up in mergers, acquisitions and divestures activity. We do not expect oilfield companies to experience a meaningful improvement in fundamentals until 2018 or later, as demand is likely to remain depressed. That being said, we see relative value opportunities in certain long duration credits, where former investment grade companies have taken steps to improve their balance sheets. We also view the liquidity profile of these “fallen angels” as relatively resilient to external shocks.


RELATED INSIGHTS

January 2016
Emerging Market Debt in 2016: Turning the Corner?

As we enter 2016, China concerns and oil prices have (rightly, in our view) occupied investors’ minds. We believe those factors, combined with (geo) politics, will remain key drivers behind EM asset prices in coming months.

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