Mind the gap: Oil’s shifting dynamics

By: Steve Bonnyman • December 12, 2018
Steve Bonnyman: North America is the hub of the logistics glitch, evidenced by the volatility of the price differentials across and within regions.

The oil market has been on a rollercoaster ride for most of the past dozen years with traditional factors like supply and demand, foreign exchange rates and geopolitical risks fueling oil’s price volatility.

However, as production growth moves to newer regions, these factors, as well as the logistics challenge of getting raw crude to market are creating more uncertainty in the sector.

North America is the hub of the logistics glitch, evidenced by the volatility of price differentials across and within regions. The explosive growth of production in West Texas Intermediate (WTI) crude has outpaced pipeline capacity in the region, resulting in US$10 price per barrel differentials even within a few hundred miles. We believe these price differentials should narrow over the next year as new pipelines come on stream. But supply has currently crowded transportation capacity to the key Gulf Coast demand/export center, creating price differentials throughout North America and record price discounts for Canadian oil production in recent months. 

What’s the Difference?

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Source: Bloomberg LP, December 11, 2018. U.S. Oil represented by WTI and Canadian Oil represented by WCS in U.S. Dollars.

 

Beyond this ongoing headwind, the most recent price decline is a clear example of a combination of market balances as well as geopolitical risk, which is expected to continue to drive variability in oil prices. The existing low US$60 Brent price for oil is not adequate for Saudi Arabia to balance their budget, suggesting a strong incentive to encourage OPEC to manage production for higher prices. Additionally, provided that the Trump administration’s policy regarding the Middle East is unchanged, the Iran sanctions will be enforced and another 800,000+ barrels per day of production will be taken off the market. Either of these factors could tighten the market substantially, supporting higher prices. With the continued production risks in fragile economies like Venezuela, Libya or Nigeria, the market has little room for error before swinging into deficit.

Barring a major slump in demand, oil prices will only drop to a point in which “swing” producers in the Continental U.S., and notably in West Texas, remain profitable. What the market will lack going forward is the easily accessible idled capacity which used to reside in OPEC but has been replaced with short cycle unconventional production from the U.S., which is expected to result in continued high levels of price volatility.

Commentaries contained herein are provided as a general source of information based on information available as of December 7, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), Highstreet Asset Management Inc. (Highstreet), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI and Highstreet are registered as portfolio managers across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

Publication date: December 12, 2018