Oil Market Intelligence Report: Regaining Balance?

Duff & Phelps 1

Oil Market Intelligence ReportRegaining Balance?

February 2017

Contents

2 Macro Factors GDP and PM U.S. Monetary Policy

5 Fundamentals “Oil Market heading toward balance” U.S. Market China Demand OPEC Production

10 Oil Distillates

12 Industry Investment

13 Derivatives Market Signals Futures Term Structure Options Implied volatility & Smile Options Open Interest

17 CFTC Trader Commitment Reports Futures Open Interest

18 Analyst Consensus

Duff & Phelps 2

Oil Market Intelligence Report – February 2017

GDPChina’s GDP growth is projected to stabilize, despite realized levels being higher than expected recently. “Many analysts believe this year’s better than expected growth in China has been the by-product of a dangerous expansion in credit, especially for real estate developments and state-backed infrastructure projects” (Yang, 2016). For this reason, the PMI index, which is recovering back to August 2014 levels, could be misleading.

However, Chinese GDP growth is on track with government’s target and policy to stabilize toward a sustainable growth, as oil usage remains strong and steady (see Figure 9).

Recent growth in U.S. GDP is largely attributable to an increase in consumer spending. This growth is expected to continue into the next quarter as incomes are expected to increase. The United States is benefiting from increased oil prices, with investment in domestic oil and gas production ramping up. This is factored into the recent PMI index, which is recovering.

The election of Donald Trump, and the new president’s emphasis on reindustrialization and revised government regulation, might support fossil fuel consumption.

For Euro Area GDP, given the high level of political uncertainty affecting the euro market, GDP growth is expected to slow. The euro and pound sterling have depreciated, and Europe is no longer able to benefit from low oil prices. This situation is, however, expected to stabilize as unemployment decreases and levels of investment increase, as illustrated in the recent increase in PMI.

Figure 1: GDP Growth Data

Source Bloomberg

Macro FactorsGDP and PMI

0

1

2

3

4

5

6

7

8

9

GD

P G

row

th Y

oY (%

)0

20

40

60

80

100

120

Apr-12

Aug-13

Dec-14

May-16

Sep-17

Feb-19

Jun-20

US GDP YoYChina GDP YoYEuro Area GDP YoY Eurozone GDP Forecast

Chine GDF ForecastUS GDP Forecast

GDP Growth data

Brent Oil price ($)

Duff & Phelps 3


Manufacturing PMI IndexChina’s PMI is recovering from Q1 turmoil. The Euro Area and the United States have similar PMI values, consistent with their respective GDP’s growth.

As shown below, with the exception of ASEAN countries and more recently India, PMI indexes are following an upward trend, signalling a stronger manufacturing activity and a higher energy demand on a global scale, as reflected in U.S. Energy Information Administration (EIA) projections (see Figure 4). The U.S. and Eurozone PMI trend is very positive and augurs a stronger economic recovery in developed countries.

The drop of India’s PMI in Q4 2016 is believed to be due to the government’s move in November to withdraw overnight the 500 and 1,000 rupee notes, representing 86% of the currency in circulation. A small rebound occurred in January seems to confirm that it was a temporary effect.

The ASEAN countries (comprised of 10 southeast Asian states, including Thailand, Singapore and Malaysia) have a PMI Index below 50, suggesting that the manufacturing sector’s confidence has been hit. The increasing inflation pressure in the region has deteriorated production prospects, but improving external conditions might have a positive impact on the manufacturing conditions.

All of these factors speak to the prospect of a mildly to steadily increasing pace of oil demand. We discuss this further in the following sections.

Figure 2: PMI Index

Source Bloomberg

Macro FactorsGDP and PMI

40

42

44

46

48

50

52

54

56

58

60

Nov-13

Jun-14

Dec-14

Jul-15

Jan-16

Aug-16

Mar-17

US Manufacturing PMIChina Manufacturing PMIEuro PMI ManufacturingIndia PMI ManufacturingAsean PMI Manufacturing

PMI Index

Duff & Phelps 4


U.S. Monetary Policy Relation with Oil PricesA good indicator of U.S. dollar strength is the Bloomberg Dollar Spot Index. This index tracks U.S. dollar performance against a representative basket of currencies; the weights take into account the various countries’ trade relationship with the United States. The basket of currencies includes the euro, Japanese yen, Canadian dollar, Mexican peso, British pound sterling, Australian dollar, Swiss franc, South Korean won, Chinese renminbi and the Brazilian real.

There is a strong correlation between the U.S. dollar and oil prices. The following chart includes the WTI Crude Oil price, the Bloomberg Dollar Spot Index and their correlation, which is calculated using daily returns. In the past 10 years, the correlation has been almost always in negative territory.

Between July 14 and March 15, while the USD Index rallied, the correlation with WTI went from almost 0 to –30%. We can expect to see the correlation remaining negative while the Fed continues to head toward normalization of interest rates. The consensus is both a stronger dollar, thanks to increasing Fed fund rates, and a mildly bullish oil price (see Figure 19). This dynamic is likely to maintain a negative correlation.

Figure 3: The WTI Oil Price and the Bloomberg USD Index and graphs,

along with the correlation coefficient for movements over the last 9 months:

0

20

40

60

80

100

120

140

160

US

D/b

bl

900

950

1050

1100

1200

1250

1300

Dce-05

Sep-08

Jun-11

Mar-14

Dec-16

WTI Oil ($/barrel)Bloomberg USD Index

1150

1000

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

Corr

ela

tion

Source Bloomberg

Macro FactorsU.S. Monetary Policy

Duff & Phelps 5


Fundamentals“Oil Market heading toward balance”

Global supply and demand should meet in Q3 2017In its last report, the U.S. Energy Information Department (EIA) forecasted that a balance in oil supply and demand will be achieved in the second half of 2017. Existing surplus has already reduced significantly, and the recent OPEC agreement to cut oil output in 2017 will move the market to a deficit more rapidly than forecasted.

On the production side, oil supply rose to 97.8 million barrels per day (mb/d) in October, according to the latest IEA. World oil output was 800,000 barrels per day higher than it was a year ago. This is mainly explained by the production recovery in Nigeria, Libya and Iraq.

Oil demand growth is now seen at 1.4 mb/d in 2016, driven mainly by the stronger than expected growth in Europe and China. In 2017, demand growth is expected to remain strong at 1.6 mb/d. India and China are expected to be the main drivers in the increase in oil demand in the coming years.

Global production surplus declined sharply from 2.14 mb/d in Q415 to a deficit of 420,000 barrels per day in Q316. Whether OPEC producers and Russia respect their agreement to reduce oil output will be a key driver of the market supply/demand balance. A decrease in the oil stockpile and the associated increase in oil prices might make additional U.S. shale oil producers economically viable and result in increased production. In Figure 4, the values in dark blue are EIA projections.

Figure 4: World Consumption vs. Production

Q1 2012

Q3 2012

Q1 2013

Q3 2013

Q1 2014

Q3 2014

Q1 2015

Q3 2015

Q1 2016

Q3 2016

Q1 2017

Q3 2017

Q1 2018

Q3 2018

88

86

84

82

90

92

94

96

98

100

World Production World Consumption

World consumption vs Production

Mill

ions

bar

rels

per

day

Stock Change

0.74

0.17

-1.0

8-1

.57 -1

.22

-1.3

5-0

.62

0.32

1.19

-0.0

40.

23

0.95

0.60

0.45

-0.4

5-0.0

3-0

.21

-0.4

2

1.46

2.14

1.45

1.96

1.52

-0.6

0-1

.12

0.40

1.56

0.00

Source iea

Duff & Phelps 6


FundamentalsU.S. Market

In the United States, oil stocks seem to stabilize around 494 million barrels, down from 512 million in April, reflecting global trends.

U.S. oil production is stabilizing to 9 mb/d (Figure 6), adding more than 5500 kb/d from the lowest production level seen in 2 years, which was reached in July this year. The evolution of OPEC production, as well as production in Russia, will shape the growth of U.S. production.

Figure 5

Nov 18, 2

010

Apr 01, 2

012

Aug 14, 2

013

Dec 27, 2

014

May 10, 2

016

Sep 22, 2

017

Weekly U.S. Ending Stocks of Crude Oil (Thousand Barrels)

Weekly U.S. Ending Stocks excluding SPR of Crude Oil (Thousand Barrels)

0

200,000

400,000

1,189,841

494,762

600,000

800,000

1,000,000

1,200,000

1,400,000

Source eia

Figure 6: Weekly US Field Production of Crude Oil

0

2,000

4,000

6,000

8,000

10,000

12,000

Oct 10, 2

006

Feb 22, 2

008

Jul 06, 2

009

Nov 18, 2

010

Apr 01, 2

012

Aug 14, 2

013

Dec 27, 2

014

May 10, 2

016

Sep 22, 2

017

Weekly U.S. Field Production ofCrude Oil (Thousand Barrels per Day)

Source eia

Duff & Phelps 7


“Price recovery” since Q1 brought back some rigs to productionThe number of rigs operating in the United States rebounded from 316 in May to 566 on January 27, which is consistent with the U.S. oil production rebound described in Figure 6.

If oil prices remain in a range between $40 and $60 per barrel in 2017 and 2018, Bloomberg Intelligence suggests that the number of rigs operating in the United States will increase sharply, reaching more than 1,000 rigs by the end of 2018.

Figure 7: US Oil Weekly Rig Count

0

200

400

600

800

1000

1200

1400

1600

1800

0

20

40

60

80

100

120

WTI price ($)

Nov-10

Apr-12

Aug-13

Dec-14

May-16

Sep-17

Oil Rig Count

US Oil Weekly Rig Count

Source: BakerHughes

Figure 8: US Rig Count Forecast

4Q16e

1Q17e

2Q17e

3Q17e

4Q17e

1Q18e

2Q18e

3Q18e

4Q18e

Crude Oil Price within $50-60 ‘17; $55-65 ‘18

US Rig Count Forecast

400

500

600

700

800

900

1000

1100

1200

Crude Oil Price within$40-50 ‘17; $50-60 ‘18

Source Bloomberg

FundamentalsU.S. Market

Duff & Phelps 8


FundamentalsChina Demand

ChinaIn China, the pace of oil consumption growth is slowing down, following the same pattern as GDP growth. Demand for gasoline has been a strong driver, increasing from 2 mb/day in mid-2013 to 2.7 mb/day at the end of 2016. For diesel, demand remained strong and steady. While manufacturing activity is picking up, we can reasonably expect the Chinese consumption dynamic to remain strong.

Figure 9: China Apparent Oil Consumption

May-05

Oct-06

Feb-08

Jul-09

Nov-10

Apr-12

Aug-13

Dec-14

May-16

Sep-17

Total

China Apparent Oil Consumption

GasolineDiesel

0

2

4

6

8

10

mill

ions

bar

rel p

er d

ay

12

Source Bloomberg

Duff & Phelps 9


FundamentalsOPEC Production

OPECThe following chart shows two different but consistent estimations aggregating producers’ data and data from secondary sources. OPEC supply has increased by more than 10% from 30.5 mb/d on November 14 to 34 mb/d on November 16. The recent deal between OPEC and Russia should reduce production by 1.8 mb/d, counting for 2% of the global supply. As a result, Brent oil prices have surged approximately 20% in December, helped also by the stronger-than-expected economic outlook in Europe and the United States.

Figure 10: OPEC Production Output Estimates

May-05

Oct-06

Feb-08

Jul-09

Nov-10

Apr-12

Aug-13

Dec-14

May-16

Sep-17

OPEC Production Output Estimates

Bloomberg EstimatesEnergy Intelligence Group

0

5,000

10,000

15,000

20,000

25,000

Pro

duct

ion

in th

ousa

nds

of B

arre

l per

day

35,000

30,000

40,000

Duff & Phelps 10


Oil Distillates

U.S. DistillatesU.S. distillates and gasoline prices have been stable over time. They have been driven by neither seasonal demands nor crude feedstock costs.

Figure 11: US Distillate Fuel Oil Supply Demand

Jul-09

Nov-10

Apr-12

Aug-13

Dec-14

May-16

Sep-17

Monthly Average of US Distillate Fuel Oil Demand

US Distillate Fuel Oil Supply Demand

Thou

sand

s of

Bar

rel

Monthly Average U.S. Refiner and Blender Net Production of Distillate Fuel Oil

0

1,000

2,000

3,000

4,000

5,000

6,000

Source eia

Figure 12: US Gasoline Supply vs Demand

Jul-09

Nov-10

Apr-12

Aug-13

Dec-14

May-16

Sep-17

Monthly Average of US Gasoline Production

US Gasoline Supply vs Demand

Thou

sand

s of

Bar

rel

Monthly Average US Gasoline Demand

0

2,000

4,000

6,000

8,000

10,000

12,000

Source eia

The correlation between distillates (RBOB and heating oil) and crude oil is generally close to one. We can see some seasonality effects that tend to reduce the correlation between the refined products and crude oil.

Figure 13: Refined products vs Brent: Correlation

0

0.2

0.4

0.6

0.8

1

1.2

Sep-2014

Dec-2014

Apr-2015

Jul-2015

Oct-2015

Jan-2016

May-2016

Aug-2016

Nov-2016

Mar-2017

RBOB/Brent CorrelationHeating Oil/Brent Correlation

Refined products vs Brent: Correlation

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Industry Investment

Global Oil and Gas Industry InvestmentFollowing the supply glut that started in 2014, companies have been cutting investments quite significantly. The following chart reveals this trend and also shows that CAPEX is expected to increase in the coming months. While oil prices stabilize around $50 per barrel, the Oil and Gas industry seems to prepare for higher levels of investment in 2017.

Figure 14: Oil and Gas Goal Upstream company CAPEX history and forecast

0

100

200

300

400

500

600

Oil & Gas Gloal Upstream company CAPEX history and forecast$bn

Consensus

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source Bloomberg

Oil Cost of ProductionInvestment in oil production and exploration has returned since the increase in oil price. In a study published last year, Wood Mackenzie estimated that 98% of oil fields were generating positive cash flow above $40 a barrel.

Oil Sector Market SentimentIn November and December 2016, the S&P Oil & Gas Exploration & Production Industry Index has been over-performing the S&P 500 index, moving from 5,300 early November to 6,100 by the end of January (+15%). The energy market sentiment has been quite bullish since the OPEC/Russia production cut deal.

Figure 15: S&P Oil and Gas Exploration and Production Industry IndexS&P Oil and Gas Exploration and Production Industry Index

0

1000

2000

3000

4000

5000

6000

7000

10/2

7/16

11/6

/16

11/1

6/16

11/2

6/16

12/0

6/16

12/1

6/16

12/2

6/16

01/0

5/17

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Fiscal Breakeven in the Middle EastIn last October’s report, the IMF published updated data regarding the fiscal breakeven oil price for Middle East oil producers. This fiscal breakeven oil price is the oil price at which the fiscal balance is null.

This enlightens the financial challenges those countries have faced since the pump-at-will oil policy adopted by Saudi Arabia 2 years ago. Saudi Arabia’s government budget went from a 13.6% GDP surplus in 2012 to an estimated 15% deficit in 2015 due to the slump in oil prices. This data shows how crucial a deal to cut production and support oil prices was for those countries.

Figure 16: Fiscal Breakeven oil exporters country

0

50

100

150

200

250

2000–122013

20142015

20162017

Fiscal Breakeven oil exporters countryMENAP region

AlgeriaIranIraqSaudi Arabia

$49

$89

$108$111$116

$206

$197

$216

$164

$93 $91 $87

$78

$61

$54

$80

$58

$55

$65

$60

$135

$113$106

$100

$115

$47

Libya

$111

$

Source IMF

Industry Investment

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Derivatives Market SignalsFutures Term Structure

Future Term StructureThe spread between WTI and Brent crude oil prices has widened significantly from zero a year ago to around $2 currently. The high level of crude stocks in the United States has put a downward pressure on WTI futures.

The shape of the term structure (Brent and WTI) has flattened. The spread stands below $2 for the closest expiries; a year ago, the time spread was above $25 for the latest expirations.

Figure 17: Brent and WTI Term Strucutre YoY comparison

0 10 20 30 40 50 60 70 80 90

10

20

30

40

Pric

e ($

)

Nb of Months for expiry

50

60

70

Crude Oil, Brent, 1/31/2017Crude Oil, Brent, 1/29/2016

Crude Oil, WTI, 1/31/2017Crude Oil, WTI, 1/29/2016

Brent and WTI Term Structure YoY comparison

The Brent forward curve flattened significantly since November for long-term expirations. For closer expiries (i.e., Feb 2017 to Dec 2017), the spread with the Front Month has decreased, and the market anticipates tighter oil outputs for that period. Traders are certainly anticipating a production cut in OPEC countries and Russia following their agreement.

Figure 18: Brent Forward Curve

0

5

10

15

20

Spr

ead

($)

25

Crude Oil, Brent, 1/31/2017Crude Oil, Brent, 12/30/2016Crude Oil, Brent, 11/30/2016

Crude Oil, Brent, 7/29/2016Crude Oil, Brent, 1/29/2016

10

Nb of Month Spread

20 30 40 50 60 70 80 90

Source Bloomberg

Duff & Phelps 14


Derivatives Market SignalsOptions Implied volatility and Smile

Implied Volatility Term StructureAs illustrated below, at-the-money (ATM) implied volatility surged in November 2016 and eased in December and January. This was pushed by both the American election and the deal between OPEC and Russia to cut production in 2017. The shape of the ATM implied volatility also reveals that market risk sentiment is focused on the shorter term of the curve. ATM implied volatility for options expiring in 6 months is lower than ATM implied volatility of options expiring in 10 days. Even from a historical standpoint, the 6-month ATM implied volatility is significantly low.

Figure 19: At-the-Money Volitility

10

0

20

30

40

50

60

At-the-Money VolatilityWTI Options

Impl

ied

Vola

tility

(%)

3M Implied Vol30D Implied Vol 1Y Implied Vol6M Implied Vol

Dec-16Jul-16Jan-16 Nov-16 Jan-17

Source Bloomberg

Figure 20: At-the-money Volitility

20

10

0

30

40

50

60

70

At-the-Money VolatilityBrent Options

Impl

ied

Vola

tility

(%)

3M Implied Vol30D Implied Vol 1Y Implied Vol6M Implied Vol

Dec-16Jul-16Jan-16 Nov-16 Jan-17

Source Bloomberg

Duff & Phelps 15


Implied Volatility SmileFigure 21 successfully illustrates the increase in the implied volatility in November 2016 following the aftermath of the U.S. election. It also shows how the implied volatility has eased since November, with a sharp decrease to 28% in December from 40% for the ATM volatility.

The shape of the volatility smile for WTI options expiring in a month has changed as a result of the recent OPEC and Russia deal to cut production in 2017 and the U.S. election. The volatility smile was quite flat, with 2% implied volatility premium between the highest (39%) and the lowest (37%), and almost no difference between the 10% delta Call and 25% delta Call, or the 10% delta Put and 25% delta Put. Market participants were hedging their positions against all potential risks, attributing almost no difference between downside or upside risks.

Since December, the implied volatility shape remained a reverse or negative skew pattern. Out-the-money puts (lower option strikes) have a higher implied volatility than out-the-money calls (higher options strikes), meaning that more investors are seeking protection against downside risk.

The oil market volatility level is reverting to lower values, suggesting a more balanced and less stressed oil market.

Figure 21

Jan-17Dec-16Oct-16Jul-16

2010 DC 25 DC 40 DC 50 D 40 DP 25 DP 10 DP

In-the-Money CallOut-the-Money Call Option Deltas

25

30

35

4038.13

37.05 37.0538.02 37.53

32.39

39.0739.07

36.86

28.67 29.06 29.76 30.09

30.9132.22 34.55

24.9326.37

25.17

28.05

29.95

31.56

38.13 38.1339.23

40.5141.76 41.76

45

Impl

ied

Vola

tility

(%)

Source Bloomberg

Derivatives Market SignalsOptions Implied volatility and Smile

Duff & Phelps 16


Derivatives Market SignalsOptions Open Interest

Option Open Interest and Call/Put RatioOverall, options open interest has decreased significantly since October. Generally, declining open interest combined with rising prices is considered a bearish sign. Price increase is driven by short sellers covering their positions rather than new investment being placed into the marketplace.

CL1 Comdty Jan-17 Nov-16 Oct-16

Call Options 321,906 494,182 828,367

Put Options 367,452 341,996 596,210

Put/Call ratio 114% 69% 72%

CO1 Comdty Jan-17 Nov-16 Oct-16

Call Options 190,034 103,948 455,295

Put Options 179,594 113,647 394,597

Put/Call ratio 95% 109% 87%

Source Bloomberg

Duff & Phelps 17


CFTC Trader Commitment ReportsFutures Open Interest

Open InterestThe CFTC conducts a market surveillance program that consists of collecting confidential data from traders. The CFTC groups the traders into four different categories: “Producers” (which also includes “Merchant,” “Processor” or “Users” of a commodity), “Swap Dealers,” Money Managers” and “Other Reportable.”

Where CFTC classifies Trader in the four categories mentioned above, we wanted to highlight producers’ exposure; hence, the three other categories have been aggregated into “Others.”

CFTC defines “Producers” as “entities that predominantly engage in the production, processing, packing or handling of a physical commodity and use the futures markets to manage or hedge risks associated with those activities.”

In Figure 22, we aggregated Open Interest in WTI Crude Oil exchanged on the ICE exchange and NYMEX Exchange.

Data show a steady increase in Open Interest up to December, the Total Open Interest (including Futures and Options) of WTI Crude on NYMEX reached the highest open interest since August 2011. As illustrated in Figure 9, this is consistent with the higher level of volatility in November amid the election of Donald Trump and the negotiation within OPEC for a production cut deal.

This increase has been fuelled by a sharp increase among producers +65,000 since September; the prospect of an increase in prices following the OPEC agreement could explain that movement.

Figure 22: Crude Oil WTI

500,000

1,000,000

510,773

1,808,402

1,587,164

1,826,997 1,905,2081,923,812 2,026,223 2,082,097

1,500,000

2,000,000

2,500,000 800,000

700,000

600,000

500,000

400,000

300,000

200,000

100,000

00

Crude Oil WTI Open Interest by Traders category

Op

en In

tere

stJan-17Dec-16Nov-16Oct-16Sep-16Aug-16

Long SpeculatorsShort Speculators

Producer (right axis)Consumers (right axis)

477,178445,164 455,578

506,125467,753

1,648,1421,723,807

1,784,151 1,830,682 1,861,360

713,083 702,230 669,070

751,826719,168

757,881

Source: CFTC

Duff & Phelps 18


Analyst Consensus

Oil Price ConsensusThe Bloomberg analyst consensus is slightly bullish, with an oil price reaching $63 by 2020. Analysts are expecting the global oil surplus to reduce, but they remain reserved and cautious as the upward trend appears to be rather timid.

There are still concerns that the production cut target from OPEC or Russia won’t be met and that U.S. shale production will increase if oil prices remain around current levels, putting some downside pressure on the prices. On the other hand, a stronger-than-expected recovery in Europe and the potential fiscal stimulus in the United States might increase oil demand and, as a result, push up oil prices.

Figure 23: Analyst Consensus on WTI Price

10

0

20

30

40

50

60

$52 $55 $56 $58$55

$60 $60$64

70Analyst Consensus on WTI Price

WTI

Oil

Pric

e ($

)

Q217Q117 Q417 2017 2018 2019 2020Q317

Source Bloomberg

Using the individual data from Bloomberg with a focus on last month’s analysis, the overall market forecast remains the same. The table below provides more details. No analyst predicts an oil price below $45 on average for the next 4 years.

Q1 17 Q2 17 Q3 17 Q4 17 Q1 18 2017 2018 2019 2020 2021

Average 52.9 53.7 55.2 56.3 56.6 50.5 54.0 58.0 58.0 58.0

Median 53.0 53.0 54.0 56.0 56.5.0 50.5 54.0 58.0 58.0 58.0

Std 1.8 3.1 4.4 5.5 6.3 0.0 0.0 0.0 0.0 0.0

Max 57.0 60.0 62.0 65.0 68.0 50.5 54.0 58.0 58.0 58.0

Min 49.0 48.6 47.5 45.5 45.5 50.5 54.0 58.0 58.0 58.0

Number of Analysts 19 19 19 19 16 20 18 12 10 7

Duff & Phelps 19


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Oil Market Intelligence Report: Regaining Balance?

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