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Goldman Sachs: Inventory Drawdowns Will Not Continue

Nick Cunningham

The September oil price rally was predicated on improving oil market fundamentals, bolstering confidence that the rebalancing process was accelerating. But the inventory declines reported in the third quarter might be “as good as it gets,” with inventories returning to small increases next year, according to a new report from Goldman Sachs.

The third quarter appeared to finally be the turning point for an oil market suffering from a more than three-year downturn. The OPEC deal was finally bearing fruit—inventories started posting substantial declines after a few years at or near record levels. That translated into a newfound bullishness in the market, and sizable price increases for WTI and Brent, particularly in September.

But Goldman says that the third quarter could have been the peak for drawdowns, due to a variety of factors that could partially reverse going forward. For example, oil production outside of OPEC (excluding the U.S.) fell in recent months, largely due to maintenance in the North Sea, Azerbaijan, Kazakhstan and Brazil.

Also, OPEC compliance was particularly high in the third quarter, with moderating output in Libya and Nigeria combining with stepped-up efforts in Iraq. Goldman said that oil production from OPEC (excluding Libya and Nigeria) and Russia hit 41.55 million barrels per day in the third quarter, adding just 110,000 bpd from the quarter before. That was less than half of the 230,000 bpd increase that the investment bank originally predicted.

Another reason why the bullishness over the past few months may prove to be fleeting is that demand was unusually robust, averaging a 2.3 mb/d annualized increase in the second quarter, followed by a “still robust” 1.6 mb/d growth rate in the third. In other words, demand grew by 300,000 bpd more than Goldman predicted earlier this year.

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Finally, U.S. shale’s growth was “delayed,” perhaps by the growing backlog of drilled but uncompleted wells (DUCs), but also because of Hurricane Harvey, which temporarily knocked U.S. oil production offline.

All of these trends combined to significantly tighten the oil market in the third quarter, leading to impressive inventory declines.

However, these trends may not be durable. U.S. shale, for example, is expected to resume growth, adding 290,000 bpd of new supply in the last three months of 2017, according to a Goldman Sachs forecast. Meanwhile, with several oil fields in the North Sea, Brazil, Azerbaijan and Kazakhstan set to resume after maintenance, non-OPEC supply will pick up.

Moreover, OPEC compliance could have possibly hit a high watermark. Preliminary data for September looks like OPEC oil exports jumped by 0.5 mb/d, month-on-month, as shipments rose in Iraq, the UAE and Nigeria. Libya might also add supplies back into operation in the fourth quarter.

Put all of these factors together, and the inventory decline rate will narrow sharply from 795,000 bpd in the third quarter to a modest decline of just 180,000 bpd in the fourth quarter. Then, inventories start to build again in the first quarter of 2018 at a rate of 60,000 bpd, Goldman predicts.

It’s a rather bearish conclusion. Essentially, the markets began to think that rebalancing was accelerating in the third quarter, but the pace of tightening could have simply been at its strongest point.

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Nevertheless, the exceptional stock drawdown in the third quarter erased a lot of excess supply on the market. Inventories are dramatically lower than they used to be, and even if the rebalancing effort loses some momentum, few expect oil prices to drop substantially from current levels.

Goldman highlighted one particularly encouraging development in its report. Brent oil futures are still in a state of backwardation, which it sees as proof that market conditions are much tighter than they used to be. “[As] we have argued previously, timespreads don’t lie about fundamentals,” Goldman analysts wrote, pointing out that a fundamentally weak oil market would not be able to support backwardation for very long. “Today’s spread levels tell us the rebalancing has progressed significantly.”

By Nick Cunningham of Oilprice.com

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