More light at the end of the tunnel

Opec cuts should result in a lighter global crude oil slate: As we highlighted early last year, crude oil light-heavy spreads have widened over the past couple of years following Saudi’s decision to engage in a market share war with the US shale industry.

Surging Opec output has increased the availability of medium to heavy crude grades while US light sweet production was forced to shut down on unsustainable economics. Now the tables are turning. On November 30, Opec agreed to cut output and some non-Opec nations followed suit on December 10, setting the stage for another shift in global crude oil gravity. Saudi Arabia, a producer of medium to heavy crude oil, should account for 40 per cent of the pledged cut, reducing output from 10.63 million b/d in November 2016 to 10.05 million b/d by 2Q17.

Saudi may favour selling light over medium/heavy barrels: The key question is whether Saudi will cut output evenly among its three main crude grades or favour some over others.

The historical pattern to sell more profitable (light) grades should be even more pronounced this time around as the kingdom needs to maximise revenues in this low price environment.

Elsewhere, whether it is Libya, the US, Russia or even Canada, the share of light oil relative to medium oil supplies is poised to increase in the coming months. For US refiners, the average crude slate is set to return to the patterns seen during the shale oil boom and become lighter.

In fact, given the narrowing light-heavy spreads, and potential tax reform on imports and exports from the new administration, US refiners may be encouraged to import less crude, process a lighter crude slate and export more gasoline to meet growing EM demand.

Market yet to price the upcoming shift in crude quality: In our view, such a shift in the global crude quality is not fully reflected in the market at the moment. Brent-Dubai forward spreads are currently trading at a premium to spot spreads but this trend should reverse in the coming weeks.

Similarly in the US, the LLS-Mars spread has more room to tighten in our view, especially in 4Q17, when demand for distillate products picks up seasonally. Naturally, our view implies that Opec complies with its pledged curtailments, and that WTI crude oil prices increase to the mid to high $50’s, allowing US light-sweet production to rebound gradually.

Macro outlook

Global GDP in USD terms at market exchange rates is stagnant. China’s GDP is changing, with services overtaking industrial activity as a driver of growth. US Republican win means stronger USD, higher rates, more trade barriers, and reduced US oil supply restrictions. A more hawkish Fed presents a growing downside risk to oil prices. Fed tightening cycles and a strong USD do not bode well for oil, as rising US rates and flatter yield curves hurt EM demand.