Morgan Stanley’s Adam Longson has been one of the most bearish sellside analysts on oil, and overnight he confirmed he isn’t going to change his opinion any time soon, and instead warns that while “a profit taking and short covering bounce in oil late in the week has led some to declare that the troubles are behind us” he believes that “very little has been addressed fundamentally to correct these problems. Greater headwinds lay ahead, especially for crude oil. In fact, we would argue that recent price action and developments may have exacerbated the situation.” Putting a number to his call: oil prices will slide to $35 in the next 1-3 months.
The key point in Longson’s latest note is a simple, and recurring one: “Fundamental Oil Issues Have Not Been Addressed” and that “Physical market stress due to fundamental headwinds is still ahead.”
This is what he says:
A profit taking and short covering bounce in oil late in the week (partly on a US gasoline draw driven by lower imports) has led some to declare that the troubles in oil are behind us. However, while the market began to price in some of the headwinds prematurely via flat price, very little has been addressed fundamentally or through physical market indicators to correct the material problems in oil markets.
Greater headwinds ahead, especially for crude oil. In fact, we could argue that recent price action and developments may have exacerbated the situation.
- The fall in oil prices has only lifted refinery margins, which should support product oversupply: Refinery margins (p.38-39) are not at a level to cause distress or the large run cuts that will be required, despite lower product cracks. The issue is that lower oil, fuel oil and natural gas prices globally reduce operating costs, while a strong USD has lowered general opex and G&A for Europe and Asia on a relative basis.
- A cut in Saudi OSPs reinforces Asian crude oil demand, which should delay necessary run cuts. Asia and the Middle East were the primary incremental contributors to the oversupply in global gasoline and diesel. Expectations had been for Asia to see economic run cuts, but efforts from oil suppliers to support crude demand and refinery margins reduce that probability. Hence, product markets may need to, and are likely, to deteriorate further before corrective actions are taken.
- Returning supply is a boon to refiners. The crude oil oversupply has shifted more refiners to spot purchases where new distressed cargoes can provide opportunities.
- Refiners are reluctant to capitulate. During earnings season, a number of refiners admitted that run cuts may be needed, but few were willing to make economic run cuts themselves. In fact, the global fall maintenance schedule looks surprisingly light at this point. We expect more maintenance or unplanned outages (e.g. Whiting) ahead.
Separately, US crude oil stats are likely to trend bearish over the coming months. US waterborne imports are likely to stay elevated for 1-2 months given sailing times and prior price signals. However, Canadian supply is returning and refinery demand should fall seasonally (we are past peak runs). With the market trading much more closely on weekly DOE developments, a larger build in US crude oil stocks in Aug or Sep could weigh on sentiment, and WTI time spreads at a minimum.
How does this analysis translate into what happens to the future price of oil, and where Morgan Stanley see oil going next?
The bottom of our trading range remains $35. Although our 4Q16 Brent average is $40, which is an important psychological level, we also provide a trading range for our base case around our forecasts. Despite the recent bounce, we see the prospect for lower oil prices in the next 1-3 months and a deeper contango. However, we see a soft floor around $35/bbl. There is no intrinsic value or physical market response that will prevent prices from breaking that level, but we see a setup for why the mid-30s could be a critical level.
A rising short position into the mid-30s could make the market more susceptible to OPEC discussion and other headlines. If oil prices fall to the mid-30s with a large build in short position, it should begin to limit downside risk and provide a soft floor. At such levels, the risk-reward to lower prices is not attractive without a major fundamental change. As a result, investors who have earned profits on their shorts may unwind them or be reluctant to press them in the face of any potential bullish headlines.
The primary catalyst for a short-covering floor would likely be OPEC talk of intervention. Press reports of renewed talks within OPEC are already starting, with Venezuela leading the charge. If prices continue to languish, other producers may be open to the idea, particularly after the market reaction to freeze discussions earlier this year. While some investors may be dismissive of OPEC, the market continues to respond to members’ commentary. Moreover, the probability of some intervention (although still low) rises heading into the Dec 2016 meeting given sustained stress and the full return of Iranian volumes.
Reaching our $30 Brent average bear case would likely require greater fundamental changes and macro stress. The risk to move below $35 would likely need to come from a large fundamental change (such as Libyan supply returning) and/or macro concerns on top of already poor fundamentals – as we witnessed in Jan 2016. These issues have the potential to change investors’ perception of the rebalancing point, or result in macro positioning liquidation. Within these risks, the probability is rising for a return of Libya, which alone could offset most of the increase in crude oil demand (not refined products) for 2016.
Option positioning and upcoming expiry could be important near term events. We see a notable open interest for Sep WTI puts in the $38-42 range expiring next week. Closing these positions could add some upside buying, while the negative gamma could reinforce any larger down moves by creating forced selling from dealers.
As a reminder, Adam was among the first to point out, back on April 26, that oil prices will retrace the pattern observed last year, with a substantial bounce into the summer, and a subsequent, and seasonal, fade heading into the fall and winter.
So far he has been correct.
But if he is also correct about what happens to oil next, there may be a problem, because as JPM pointed out over the weekend, oil sliding below $40 would be not only a breach of a key psychologcal support level, but also the level below which SWFs would be forced to resume selling equity assets all over again.
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