Oil Strategy – Redefining the Supply Risk Premium

By Michael Tran
Published October 18, 2019 | 2 min read

Managing Director and Global Energy Strategist, Michael Tran believes that it may be premature for participants to suggest that the market no longer needs a risk premium, particularly if geopolitical conflicts persist or even intensify. Although the financial market no longer pays for disruption risk, he expects the premium to simply shift to the physical market.

Trendless Short-Term Volatility

 

Despite steady escalation of tensions ranging from shot down drones and ship seizures this summer, leading to a parade of escalating disruptions, the market has long forgone a supply risk premium, emboldening the skeptics to question the need for this premium going forward. Tourist traders have also distorted fundamental signals in both directions and have helped to create, what we see as a vicious cycle of trendless short-term price volatility.

Oil Price Revision and Indicators of Physical Tightness

 

The market has spent the past month laser focused on the supply disruptions and the resiliency of Saudi Arabia, but have largely overlooked the vulnerability of the consumer. What if the recent outages serve as a catalyst for major consuming countries to fortify inventories and hold a greater degree in storage? RBC’s Commodity strategy team has revised lower its oil price outlook for both WTI and Brent, expecting it to averaging U.S.$56.50 and U.S.$62/bbl, respectively, through the balance of this year and U.S.$58 and U.S.$63.50/bbl next year. This is not due to a bearish view, but the market’s inability to accurately reflect the fundamental backdrop.

Crude Quality Matters! Physical Market Tightness

 

Physical markets are tight, globally. While major financial benchmarks have been weakening over recent weeks, medium, sour benchmarks such as Oman and Dubai have rallied sharply relative to global light, sweet markers. Oman is pricing at a 70¢/bbl premium to Brent, a telling development given that the sour benchmark historically priced at a $3.50/bbl discount prior to the Saudi attacks last month. The upcoming IMO 2020 spec change is expected to punish sour crudes on a relative basis. In other words, sour barrels should set the price floor, globally. The developing premium from the major sour benchmarks to Brent suggests that one of the crudes is mispriced and that the physical market is tighter than Brent futures implies. Given the tightness in medium sours, we see Brent prices re-rating higher on both an absolute and relative basis over the coming months.

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Michael Tran
Managing Director, Energy Strategist, Global Research


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