Morgan Stanley: How we predict oil prices

Looking ahead to the second and third quarters of this year, how will oil prices move?

Morgan Stanley analyst Martijn Rats' team pointed out that currently, the market believes that oil demand is still growing, but at a much slower pace after the completion of the post-pandemic recovery. In this context, the continued production cuts by OPEC and Russia, along with the supply growth from non-OPEC countries such as the United States, Brazil, Guyana, and Canada, have offset each other, maintaining market balance.

Although at the beginning of the year most market participants were cautious about the supply and demand outlook for this year, better-than-expected oil demand in January and February has brought a glimmer of hope to this slowing market. Oil inventories are expected to decrease at a "reasonable pace" in the second and third quarters, thereby supporting oil prices.

Based on supply and demand forecasts, Morgan Stanley further analyzed the impact of inventory levels on oil prices. Analysts specifically focus on commercial inventory levels in OECD countries and use this data to predict time spreads (the price difference between near-term and forward contracts). Analysts found a long-term stable relationship between inventory levels and time spreads, which can be used to predict future oil prices.

In the end, Morgan Stanley concluded that Brent oil prices will remain around $90 per barrel in the second and third quarters.

How to predict oil prices?

How was this conclusion generated? Analysts detailed the forecasting method in the report:

First, analysts acknowledge that the oil market is a noisy system with a lot of inaccurate data and obvious blind spots, so forecasts may have a large margin of error.

In practice, oil price forecasts are usually divided into two steps: 1) Forecasting oil supply and demand; 2) Converting it into price forecasts.

Morgan Stanley further divides price forecasts into two stages: 1) Comparing inventory and time spreads; 2) Comparing time spreads with spot prices.

Step One: Supply and Demand Balance Forecast

Morgan Stanley first updated its forecast for the balance of oil supply and demand. Analysts expect that due to the improvement in aviation fuel prospects, global oil demand will increase by 1.5 million barrels per day in 2024.

Analysts point out that while OPEC and Russia are limiting production capacity, early-year data shows that oil production in non-OPEC countries such as the United States, Brazil, and Canada was lower than expected. The bank expects non-OPEC countries' production to increase by 1.5 million barrels per day this year.

The latest data indicates strong oil demand in India in February, a slight increase in recent gasoline demand in the United States, and an accelerating rebound in aviation fuel demand.

Based on this, analysts infer that the oil market will experience a moderate supply deficit in the second quarter, which will further expand in the third quarter. Specifically, the deficit in the second quarter is estimated to be around 400,000 barrels per day, while the deficit in the third quarter will increase to around 800,000 barrels per day.

Step Two: Price Forecast

1. Inventory and Time Spread

First, analysts need to convert supply/demand (and inventory) forecasts into time spreads (i.e., price differentials between different delivery months of crude oil futures). Currently, from the inventory perspective, OECD inventories are expected to decrease by about 600,000 barrels from the end of February to the end of September, which will support Brent crude futures spreads.

Analysts point out that the relationship between oil inventories and time spreads has been very stable over the past 30 years.

As shown in the chart below, the blue line represents the percentage difference between the front month and the 12th month of Brent crude futures. The yellow line is based on commercial oil inventories in OECD countries.

Inventory is plotted on the reverse axis, meaning that when inventories rise, the time spread of Brent crude futures will decrease, and vice versa.

2. Time Spread and Spot Price

Next, Morgan Stanley begins to convert time spread forecasts into spot price forecasts.

The chart below shows the relationship between the average Brent crude price over the past 12 months and the 12-month Brent crude futures spread. It can be seen that the trend of time spreads and spot prices moving together, but this often only occurs over a relatively short period of 1-2 years in the past.

The analyst writes:

In contrast to the stable "inventory - time spread" relationship that has been maintained for 30 years, the "time spread - spot price" relationship often drifts over time. The regression line in the chart below tends to move up and down, the slope becomes steeper, and then gradually flattens out over the years.

The analyst further points out that the reason for this phenomenon is that in the past two years, with the rise in industry costs, even at the same time spread, spot prices need to be higher for new projects to move forward.

Combining the above data and logic, the analyst indicates that based on the current supply and demand situation, OECD commercial inventories will decrease, which will lead to the 1-12 month Brent crude futures spread expanding to about 10%, a level historically consistent with a spot price of around $90.

The latest statistical data from the IEA shows that as of the end of January 2024, commercial inventories of crude oil and oil products in OECD countries amounted to 2.76 billion barrels. Given the supply and demand outlook, we estimate that by the end of September, these inventories will decrease to 2.71 billion barrels In the next 6 months, the forward demand is expected to increase by 1.03 million barrels per day, which means that the remaining inventory will be about 26.2 days in the following 6 months. This will be 9.5% lower than the 5-year average level. Historically, under these conditions, the Brent oil futures price spread over 12 months is typically 9.8%, compared to the current 8%.

If we assume that the "time spread/spot average price" relationship of the past two years holds true, then the 9.8% spread will support Brent crude oil prices at around $90 per barrel.

The analyst also discussed the impact of geopolitical risk premiums and OPEC production cuts on oil prices. Morgan Stanley believes that although the market may have an additional premium on oil prices due to tensions in the Middle East and Ukraine, the lack of unity within the OPEC organization suggests doubts about the discipline of production cuts, and the current oil price may already reflect a discount level after some member countries have "released water". However, as OPEC continues to maintain production cuts, oil prices will continue to rise to reflect the actual levels of inventory and time spreads.

Using the above method, Morgan Stanley has forecasted that Brent crude oil prices could reach $90 per barrel in the summer