The oil market's basic problem is not going anywhere

Photo by Joe Raedle/Newsmakers

Oil prices have been staging a bit of a recovery, but Morgan Stanley doesn’t think it’s going to last.

Cross-asset strategy analyst Adam Longson, like so many others, has lowered his forecasts for the Brent crude price in the period ahead.

Longson has based his downward revision due to four factors: slowing demand, the decision from the US to lift its crude export ban, resilient global supply and a faster US dollar appreciation, as forecast by the bank’s FX strategy team.

Based on those factors, Longson believes the rebalancing of the crude market will now now take longer than first envisaged, keeping prices under pressure.

“To rebalance the market, we maintain that demand must ‘catch up’ to supply, as production is unlikely to retrench materially,” wrote Longson in a research note released overnight.

“The challenge is that demand growth is slowing. When combined with seasonality and lagged data, confirmation of large draws and rebalancing now may not be apparent until mid-2017 in our base case. Thus, we see this low price regime persisting until 2Q17, with a more muted initial recovery post-rebalancing. In the interim, volatility should remain elevated, with the trade-weighted USD, headlines and macro concerns continuing to drive oil prices.”

As shown in the chart below, Morgan Stanley believes a rebalancing in the crude market – supply equalling demand – may not occur until Q1 2018.

With the market oversupplied, Longson suggests that foreign exchange movements, headlines and market positioning will continue to dictate market pricing.

Those who watched the wild 8% bounce in Brent crude futures on Wednesday received a lesson first hand on what Longson is talking about.

“In an oversupplied market, there is no intrinsic value for crude oil,” says Longson.

“The only guide posts are that the ceiling is set by producer hedging while the floor is set by investor and consumer appetite to buy. As a result, non-fundamental factors, such as USD, have arguably been the most important price drivers in 2015. With the oil market likely to remain oversupplied throughout much of 2016, we see no reason for this trading paradigm to change.”

Under Longson’s “base case” scenario, he sees Brent crude averaging just $US30 per barrel over 2016, with the lows likely to come in Q4 2016 and Q1 2017.

However, as the table below shows, he doesn’t expect those low prices to last.

As the crude market rebalances, he forecasts Brent could average $US85 per barrel in 2019, or $US95 per barrel under his “bull case” scenario.

“Brent could trade back into the US$80s or higher by 2019, as long as demand holds up.”

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