Crude Oil: What Happened?

A perfect storm of events has hit oil markets, but mostly just a sentiment move for now.

We have been concerned about a number of headwinds and downside risk in oil markets heading into 3Q15 for some time, but our base case has been for Brent to be volatile within a high-50s to high-60s range for 2H15. However, with macro concerns and the supply risk from Iran growing, prices are starting to trade closer to the bottom-end of our range. As of now, this outsized is mostly being driven by sentiment, fund flows and FX, in our view. Global oil fundamentals are challenged, and investors have justifiable concerns about the outlook for both supply and demand going forward given current events, but we have not seen any notable deterioration as of yet.

Understanding the oil correction: Inside we discuss several factors that are behind the sharp sell off in oil.

1. Turmoil in China and Greece may put recent robust demand growth at risk.
2. USD strength and risk of more appreciation related to Eurozone troubles.
3. Growing supply risk from Iran and OPEC.
4. Apathy and frustration about global supply resilience, especially from the US.
5. Possible producer hedging at even lower levels as prices fall.

Physical markets not yet showing the same stress as flat price. We continue to worry about seasonal demand effects and returning supply from Canada or Libya, but for now, we see few signs of incremental deterioration in global oil fundamentals. Despite the sell off in flat price, Brent prompt structure – a better real time indicator of physical markets – has not confirmed the weakness. Global crude oil demand is near a seasonal peak, and even unsold Atlantic Basin barrels are now finding a home. Product markets, especially gasoline, remain healthy, and we see healthy global crude runs ahead. Thus, if headline risks subside, oil could potentially see a healthy bounce.

A potential buying opportunity for long term investors, but material upside may be limited for now. We still view global oil prices as too low on a 3-4 year time horizon, and Brent in the mid-50s would likely discount much of the bad news. However, recent concerns, if realized, could alter the pace and level of recovery. Iran could delay recovery by 6-12 months, a demand shock would be detrimental to rebalancing efforts, and a stronger USD directly impacts oil prices. That said, material downside would likely require many of these fears to come to fruition at once.

Anything is possible in the short run, but we see little reason for Brent to revisit YTD lows. More likely, we would expect to see a modest price recovery from here followed by range-bound prices for 2H15 as the market continues to work through supply overhangs.

Adam Longson, Elizabeth Volynsky – Morgan Stanley Research