Although the oil price rally is plain to see on the short-term portion of the price curve, it has failed to materialize at the back: the term portion of the forward curve is vastly undervalued, RBC believes.
A market fixation with spot oil prices
On the front end of the forward curve, it looks good: WTI spot oil prices have gone up some $20/bbl from last-summer lows. However, the picture is murkier towards the back end of the curve, where the rally has somewhat failed to materialize. Prices on the term portion of the forward curve (calendar 2020 and beyond) remain stuck in the low to mid $50/bbl range. What is driving this phenomenon is the market’s erroneous belief that low-cost, short-cycle, US shale can fill supply gaps in the years ahead with minimal input from traditional large-scale projects. However, global oil companies require visibility on term prices in order to commit to long cycle investment decisions. If this situation does not evolve, RBC believes that low term prices will lead to many global projects being sidelined - irrespective of spot pricing.
What the forward curve augurs
Remember: the forward curve is not a forecast of future prices. Term pricing is, however, a reliable indicator of where one can buy or sell a barrel of oil today for future delivery and how the market perceives the global marginal cost of future production. RBC notes that the past two decades have seen the long dated portion of the forward curve move through four distinct cycles with periods of stability, followed by episodes of variability where shocks to the market untied prices from prior expectations of the long term marginal cost of production. RBC believes that the CAPEX decline of the past years will persist as long as the low term structure remains subdued. Term prices would have to get closer to the $65/bbl mark for oil companies to be more willing to be commissioning of future global projects.
Lack of liquidity = air pockets
Prices remain low in the term portion of the curve - but so does liquidity. Undoubtedly, algorithm trading has helped pushed spot volumes to record levels. For contracts five years out, however, it is a very different story: liquidity is currently about half of what it used to be. This liquidity squeeze partly results from a shift by companies in their hedging strategies. When oil prices were falling and the credit environment tightening, they favored shorter-dated tenors (6, 12, and 18 months) rather than the previous 24 to 36-month terms. Another factor is the large number of specialist energy hedge funds that have exited from the market. This liquidity slump means that price discovery has worsened. RBC warns that sizable producer or consumer hedging programs can create air pockets, so beware.