Over the past three years, oil prices have been relatively stable. Brent crude has averaged within $1.50 per barrel (bbl) of $110/bbl each year, and volatility has been steadily declining. Given the instability in the MENA region (Middle East and North Africa), the changing nature of crude oil supplies driven by increasing shale oil production in the U.S. and fluctuations of both economic fortunes and central bank policies, this relative stability is remarkable.
Indeed, these factors seem to be offsetting one another; for instance, increased U.S. production has counteracted declines in Libya and Iran. As we look to 2014, energy prices continue to exhibit many of the same cross-currents, but with somewhat greater downside risk. North America’s supply outlook is robust, with growth potentially equaling trend demand growth alone. In addition, Federal Reserve “tapering” will likely provide a headwind to commodity prices through a stronger U.S. dollar. Geopolitical risks, which recently have been a tailwind for prices, are more symmetric in 2014 than in past years, with potential for incremental supply of Libyan and Iranian crude to pressure prices lower.
Despite the prospect of higher downside risk, we caution against being too bearish. It is important to realize that the modest change in Fed policy is due to an improving U.S. economy. PIMCO also expects some improvement in the global economy, a positive for oil demand that should limit downside price pressure. In addition, recent increases in violence in Iraq, South Sudan and Libya, as well as upcoming elections in Iraq and Nigeria, are supply risks that should not be discounted. Our baseline outlook expects core-OPEC (Organization of the Petroleum Exporting Countries) will continue to be able to manage any imbalance in supply and demand and maintain prices modestly below the $108/bbl averaged in 2013. Note this is still above the current forward curve. Therefore, commodity index investors, who gain exposure to an index via the futures market, should continue to benefit from positive roll yields in the oil portion of the respective indexes.
The U.S. and Canada to contribute the most to oil production growth
Growth in shale oil has been a powerful moderating force for prices by both filling an important gap in global supply and demand and by anchoring the back end of the futures curve. The global supply outlook for 2014 is shaping up to be one of the best in the past few decades. Our baseline forecast calls for oil production growth of roughly 1.4 million barrels per day (b/d) in Non-OPEC and OPEC natural gas liquid (NGL) supplies (see Figure 1). Of this growth, we expect the U.S. and Canada to contribute just over 1 million b/d. This growth forecast is before any additional Iraq supplies resulting from the completion of maintenance at southern loading ports as well as the completion in the north of the KRG pipeline from the Kurdish-controlled areas to Ceyhan, Turkey. Although the impact on energy supplies will be negligible over the next 12 to 24 months, Mexican reforms offer promise for future growth and will likely help keep an anchor on futures prices. All told, this production growth, if realized, would continue to serve as a headwind to prices in the coming year.
One of the key supports to oil prices the past few years has been the sharp reduction in actual oil production due to civil unrest (Libya, Yemen, Syria and Sudan/South Sudan) as well as oil sanctions on Iran. Declines in output from these producers alone have curtailed supplies by nearly 3.0 million b/d at their peak. While geopolitical risks remain high in 2014, particularly with elections upcoming in Iraq and Nigeria, they are more symmetric for oil prices than in recent years, largely because Libyan output is already so close to zero and Iranian output could improve through negotiations. While the interim nuclear deal does not allow for a resumption of normal energy trade with Iran, it will likely allow for some additional “leakage” in 2014 since Iran’s key oil importers feel less pressure from the U.S. A key risk will re-emerge toward the end of the second quarter of 2014 as the expiry for the current deal approaches, requiring either an extension of the interim deal, a more permanent solution or a complete collapse of the process. That last scenario would be highly unnerving to the oil market and could quickly add $10/bbl to prices. We currently see a renewal of the interim deal as the most likely outcome, which will likely ensure at least continuity of Iranian supplies.
While the supply outlook tilts the balances toward bearish in 2014, an improving global economy is a positive for oil demand and a support for prices. Although the Fed’s tapering could lead to a stronger U.S. dollar and hence weaker oil prices (particularly given that oil prices are already elevated in many non-USD currencies), it is important to realize that the Fed and most other central bank policies will still remain incredibly accommodative. PIMCO’s own forecast for 2014 is for the global economy to pick up from 2% to 2.5% in 2013 to 2.5% to 3% in 2014 on an inflation-adjusted basis, adding an additional 300,000 b/d to demand. This growth should allow organic oil demand to grow at the fastest pace since the middle of the last decade (controlling for 2010’s sharp rebound). As long as the global economy does in fact accelerate, we would expect core-OPEC to manage the supply/demand balance, suggesting the downside is rather modest.
Positive roll yields could benefit investors
Over the past few years, core-OPEC has withdrawn supplies when demand has dropped, preventing large storage builds and allowing the market to remain in backwardation (when a futures contract trades at a higher price as it approaches expiration compared to a contract that is further away from its expiry date). When backwardation occurs, commodity index investors earn positive returns through rolling futures despite the price staying constant. In fact, the roll yield in the GSCI Brent sub-index added, on average, 5% per year to investor returns over the past three years. Roll yields in petroleum products on average over the past three years were also positive contributors to performance. This is a big change from much of the last decade, when roll yields were a notable detractor for returns (see Figure 2). While the Brent roll yield has been positive over the past three years, the West Texas Intermediate (WTI) roll yield has been negative. This, too, is changing as infrastructure investment has improved connectivity between onshore U.S. crude oil and the global markets. The impact is already evident, with the drag from roll yields in WTI going from greater than 10% in 2010 and 2011 to only 1% in 2013. Given we expect core-OPEC will continue to manage the supply and demand balances, we expect roll yields will provide the opportunity to benefit index investors in the coming year.
Although we have a small negative bias to oil prices in 2014, we expect any imbalance in the market to be manageable by core-OPEC producers. With roll yields positively contributing to returns, investors ultimately could be paid to hold a security that hedges both global event risk and any resulting shock to inflation.