From Global Risk Management
The Oil Market Quarterly Outlook Apr'19
In the Quarterly Oil Market Outlook we look at fundamental, geopolitical and financial influence on oil price development over the coming quarter and we find that most parametres point to a slightly bullish outlook.
The first quarter of the year has seen steady increases in oil prices as market focus has shifted from oversupply fears to fears of supply disruptions.
OPEC and non-OPEC extended the oil production cut agreement from January and it seems to continue at least for another quarter as the parties have postponed talks about the deal to June. The cut reduces production among the participants with 1.2 mio. barrels per day. Global oil demand continues to increase even though growth among the world's leading economies is slowing somewhat.
The geopolitical risk premium remains elevated as Venezuela is subject to U.S. sanctions and the country's oil production is dwindling and the political situation remains uncertain. U.S. sanctions on Iran could cause some market jitters next month when the waivers granted to several of Iran's largest purchasers of its oil expire.
Last quarter OPEC together with allies initiated a second production cut as the first got cancelled prior to that. The cut was meant to remove 1.2 mbbl, but exports only decreased by 450 kbpd. The production cut was agreed upon to keep the oil price from declining any further on top of the 4th quarter of 2018 plummet to below $50. The cut is lead by Saudi Arabia as the country is the largest OPEC producer and exporter. Oil prices did increase after the implementation, but likely this was also led by stronger demand (see graph at end of section).
|Fact box: The 1.2 mbpd cut was in direct extension of the 1.8 mbpd cut implemented in 2016. Thus, it could be argued the new 1.2 mbpd cut was actually an increase of 0.6 mbpd.|
Higher prices and almost unchanged oil exports are a win-win situation for OPEC. Thus, OPEC is expected to continue the cut this quarter, but keeping the exports at the current level if prices do not decline. Meanwhile, the U.S. crude oil production is continuously growing with estimates indicating further production growth. Additionally, the U.S. export capacity is advancing leaving more oil available to the market.
Q1 crude production and exports' effect on the price
The cut reduced OPEC's output by 1.5 mbpd looking at average values. However, looking at exports the story is another. The exported amount from OPEC, Saudi Arabia itself and Russia has decreased by less than a third of this volume. Concluding that the market is not experiencing the stated shortage in oil available. Looking at the EU and the U.S. crude oil stocks, exactly this is observed. At below graphs the crude oil stocks are depicted to being at status quo compared to when the cut was initiated.
The price of oil did, however, increase after the cut kicked in as of January where Brent oil price rose by about $8 to about $60. Decreasing production is likely to make the market more sensitive to supply disruptions, i.e. increased risk of not having sufficient oil. Such a risk usually gets priced in and that is possibly what happened with regards to the $8 increase in the beginning of the quarter.
Below graph shows the effect on Brent oil price of OPEC reducing output. The price allegedly reacts to the change in production about 1 month later which is why the price is lagged with 1 month.
Looking at exports no remarkable change is observed meaning that the market is not supplied with less OPEC oil than before. However, should the world supply get disrupted OPEC would not be able to compensate by increasing exports. It is this risk premium which likely has been priced in rather than less oil supplied to the market.
Below graphs show the indexed values of the OPEC and Russia exports and production. The Q4 2018 values are indexed 1 and the change can thereby be observed to Q1 2019.
For OPEC this is a 2.1% decrease in exports but a 4.7% decrease in production.
For Russia this is a 1% decrease in exports and a 0.4% decrease in production.
Looking at the U.S. in the same period, production on average rose 0.5 mbpd and exports about 0.36 mbpd with the record week of exports being at 3.6 mbpd.
Here the same graph for the U.S. is presented.
For the U.S. this is a 15.1% increase in exports and a 4.3% increase in production.
Still, the Brent oil price has gained another $7 since February which likely is an indication of demand being rather strong. Below graph shows the world oil demand and supply as well as the Brent price. It is observed that in December demand outgrew supply and the same applied for February where supply was quite a lot short of demand. The price reflects these imbalances and in March the demand has likely been keeping up concluding in the price reaching the $68.5 level.
What to expect of Q2
OPEC was to hold an official meeting in April to discuss if the production cut was to be prolonged or not. That meeting was cancelled in March and instead the oil prothey stick to the ordinary meeting on June 25-26 where the cut will be revised. The cut comes in a time where the U.S. output and exports are rapidly increasing. As a consequence, OPEC is in a position where market share quickly could be lost especially in an environment where demand is increasing, and peak demand is assessed to not have been reached yet. Incentives for OPEC to resume the cut is clearly there, if they can provide the market with the same amount of exports but reduce production to feed more risk into the market and thereby higher prices - the situation is a win-win. Therefore, OPEC will likely continue the cut throughout this quarter but as well keep up the exports with the possibility of a modest decreases.
|Fact box: even though many market analysts expect the U.S. shale production to still expand a lot, some jitters suggesting the opposite have started to emerge. Sclumberg an Halliburton sees a big drop in shale oil services as producers are running into financial and technical difficulties. Allegedly some of the larger producers have cut their headcount, with others expecting to do the same. The rig count has dropped lately, but it is still too early to say if this trend will gain traction across the industry and manifest in stagnating U.S. production.|
What is almost certain is that the U.S. will keep expanding production and exports. In 2019 the International Energy Agency (IEA) expects the U.S. crude production to increase by 1.5 mbpd.
The Permian Basin (the fastest growing crude production area and the largest in the U.S.) has been subject to severe bottlenecks, which has now started to ease up. The first new pipeline expansion got fully online last quarter and increased the flow out of the Permian Basin likely allowing for a new export record. As production is increasing so is the need for even more takeaway capacity and export terminals, which will be a factor closely monitored during 2019.
The driver of this quarter’s oil price is likely going to be demand as OPEC is expected to provide rather stable exports, modestly below that of last quarter. Only the U.S. could weigh down on prices if production and/or exports were to take a huge step up during this quarter, this is however less likely. For now, the oil price is likely driven by demand which is affected by the global economic environment and therefore expectations are slightly bullish.
"We set crude fundamentals to slightly bullish"
In this section we analyse the economic outlook of the U.S., China, and Europe. The global economic environment has a huge influence on oil demand as oil consumption often increases with improved economic outlook. The main economic indicators in our analysis are interest rates, the inversion of the yield curve, and the overall declining trend in main economic figures such as GDP, retail sales and PMI.
The U.S. economy grew at an annualised 2.2 % QoQ in the fourth quarter of 2018. This was revised down from 2.6 and far below previous quarter’s GDP growth of 3.4 %. Personal consumption expenditure and non-residential fixed investment rose less than expected, and public spending declined. U.S. retail sales fell by 0.2 percent from a month earlier in February 2019, and the ISM Manufacturing PMI in the U.S. rose to 55.3 in March of 2019. A decrease in retail sales is a sign in line with the declining GDP, indicating a slowing economy, whereas the PMI indicates growth. While the GDP growth of 2.9 % for full 2018 is above the 2.2 % of 2017, the trend within 2018, seems to be of a decreasing kind. Growth is expected to slow in 2019 as the stimulus from the $1.5 trillion tax cut package and increased government spending fade. Lower global growth, the continued U.S.-China trade war and the unknown fate of Brexit are all hurdles looking forward.
Since the release of our Annual Report in the first days of January, the stock markets have increased, which was assessed as one of our major dark horses regarding the U.S. financials.
Trying to raise interest rates has not been without bumps for the Fed. Especially the latest December’18 hike (see the grey line on charts) took the breath out the financial markets, as depicted below. After this decline the Fed signalled it would lower the frequency of interest rate hikes for 2019. This signal led the recovery.
The latest announcement from the U.S. central bank states that it projects no interest rate hike during 2019. This surprising turn of events has left investors anticipating what will happen next. This has sent the 10-year U.S. treasury rate to its lowest level this year and has caused the yield curve to invert. This means that the short-term interest rates are now higher than the longer-term interest rates, which has been caused by demand for higher yield. This drives up the price of the bonds and thereby lowers the yield.
An inversion can mean that investors see more risk in the short run rather than in the long run. Further, it is an indicator of a disconnect in the outlook between the Fed and the market.
|Fact box: When investors buy bonds, they basically lend bond issuers money. In return, bond issuers promise to pay the investors interest on the bonds and to repay the face value of bonds at maturity.
The yield curve is the difference between interest rates on short-term and long-term United States government bonds.
Historically speaking, the inverted yield curve has been a predictor of trouble. As there is no single yield curve measure, the yield curve is not inverted regardless of which spread is used. However, the spread between the 3 Months and 5 Years treasury yields was already shown in 1986 to be a predictor of a recession. It has proven consistent in 1991, 2000-2001, and in the global financial crisis when inverted for a full quarter, according to Professor Campbell Harvey. This spread has been inverted since 7 March 2019. Besides this spread, the spread between the 3 Month and the 10 year has been inverted in seven out of seven recessions since the 1960s, 12-24 months before the recession has begun and has been inverted in the period 22 March to 29 March.
Obviously, the Fed is aware of this phenomenon, and is unlikely to want to drive the U.S. into a recession. Knowing this, a decrease in the interest rate is possible to occur if financial markets turn sour to counteract a recession. This expectation will weigh on longer-term yield, inverting the yield curve further. How the stock markets react over the next few weeks, is likely to have large impact on the Fed’s next step.
Looking at the U.S. financials as of this writing and earlier highs, the numbers are not yet unhealthy but in a declining trend, which is clearly depicted in the graphs. The inverted yield curve should be taken seriously and ahead lies real risk. Combined this is troubling.
We thereby assess U.S. financials as slightly bearish on oil prices.
The Chinese GDP growth rate is decreasing and has been since 2010. The economy advanced 6.6% considering full 2018, which is the weakest pace since 1990 – i.e. 28 years. Note that the GDP has exploded from $341.35 to $8,552.86 per capita (current prices).
Impressive as it is, it does not change the fact that growth is slowing and has been since 2010. The return to single-digit growth is natural for any growth country; however, it is important for China not to be caught in the ‘middle-income trap’. This trap refers to a developing country which has lost its competitive edge because of rising wages and is unable to keep up with more developed economies in the high-value-added market.
Retail sales (YoY) rose 8.2 % from a year earlier in January-February 2019. This is the same growth rate as for the previous two periods, but much lower rates than a year ago. For comparison, from 1993 until 2019, Retail Sales YoY in China averaged 13.90 percent, reaching an all-time high of 37.40 percent in December of 1993 and a low of 4.30 percent in May of 2003. This emphasises the rates from above; no actual cause for concern, but lower rates than earlier.
The Official NBS Manufacturing PMI in China surprised with a March PMI of 50.5 – an increase from 49.2 and the first increase since August 2018. This is a sign of increased business confidence and a leading indicator for GDP. While business grew, the trade surplus decreased sharply to $4.12 billion in February.
Paying attention to China is crucial to knowing how oil prices could develop as the energy market in China is huge. Even 40 % larger than in the U.S. Assuming China can continue to grow its economy at a mid-single digit growth rate, it will remain the single largest contributor to global energy demand growth.
Market consensus of Chinese oil demand growth is between 2.4%-3.3% over the next five years, yielding higher oil demand growth than the overall demand. The overall demand is expected to reach 106.4 mpbd in 2024 from 99.96 mpbd today. Therefore, despite lower growth rates, China is still expected to increase demand for global oil.
We thereby asses Chinese financials to slightly bullish on oil prices.
On Friday 22 March, very worrying PMI numbers were released in Europe. 47.6 in all of Europe and 44.70 in Germany – both numbers being below 50 indicate a contracting economy. This large fall in PMI is said to be due to a sharp contraction in factory activity, with Germany leading the fall. Export orders declined the most since August 2012, factory output fell, while employment only rose marginally at a weak pace. Overall, this was the lowest Markit PMI release in Europe since 2012.
In early March the Italian GDP growth rate QoQ of -0.1% was released, same a previous. As this was the second straight quarter of negative GDP growth, the country is now in a recession for the third time within 10 years.
Uncertainty is the theme in Europe at the moment. Overall,we asses European financials to bearish.
Financial growth rates in various parts of the world are either dropping or increasing at lower pace than earlier. The situation could spill over to the oil market and affect oil demand.
"We set financials to slightly bearish"
During last quarter the U.S. imposed sanctions on Venezuela directly targeting the country's oil sector and thereby the primary income. No deal has been struck in the Chinese and U.S. trade war (yet), and the U.S. looked to India for additional trade barriers. The U.S. does, however, not go unaffected through these politics and the U.S. is taking centre stage on the geopolitical scene.
Meanwhile, the UK is looking to exit the EU and China is trying to revolutionise its oil infrastructure as oil demand likely has not peaked yet.
A lot is playing out during this quarter, but the U.S. sanctions are assessed to have a major potential impact on the crude oil market.
During this decade the U.S. has been using sanctions as a political and economic tool especially against Russia after the situation in Crimea, again against Iran, and latest against Venezuela.
With regards to the oil market the sanctions against Iran and Venezuela are influential as these countries have an abundance of oil and are highly financially dependent on income from oil exports. These exports have now come under sanctions potentially putting upwards pressure on the oil price. But the U.S. does not go unaffected through such sanctions. Since the current administration took office, low oil prices have been a conspicuous case for them, but so has economic expansion and the following reduction of the trade balance. The sanctions are affecting both cases heavily.
As a result of the controversial politics by the disputed president of Venezuela, Nicholas Maduro, the U.S. has imposed several sanctions against the country. The national oil company PdVSA is included in these sanctions prohibiting any U.S. person or entity of doing business with the company. As a result, exports have plummeted.
However, for the U.S. itself this is a constraint as Venezuela is producing a lot of heavy and sour crude which a lot of U.S. refineries are set up to process. Not only is the U.S. getting hit by increasing oil prices in general because of less supply, but as well the fact that the specific grade of crude got relatively more expensive during last quarter.
Last year the U.S. imposed economic sanctions on Iran which directly hit the oil sector and especially exports. The U.S. sought to reduce Iran’s exports to none thereby crippling the country economically. Several waivers were granted though, so effectively these sanctions have not affected the price as the market was expecting.
The waivers expire in May and rumours are that the waivers will not be prolonged as long as the price of oil is not higher than the current level. Initially the waivers were allegedly granted in order to keep prices down for the U.S. consumers. On the other hand, Trump has pledged to restrict Iran even more with regards to the nuclear agreement.
Is a removal of the waivers going to affect the market? Saudi Arabia is probably not going to offset the potentially missing barrels as the country did last year when the sanctions were announced. Already the Saudis are pushing for prolonging the cut so less barrels on the market would result in less need for longer cuts.
The largest importers of Iranian crude are China and India. Together they imported about 750 kbpd last quarter out of Iran’s 1400 kbpd export. China and the U.S. are not on the friendliest terms due to the current trade dispute and the U.S. has expressed a less friendly tone towards India with regards to trade. Should the U.S. renew the waivers, China and possibly India are somewhat likely to find a solution to keep importing some Iranian crude. A removal of the waivers could potentially remove a large amount of Iran’s export, but it is unlikely that it will remove all. Furthermore, Iran in March exported the largest amount of oil since the sanctions were implemented. A removal of the waivers is assessed bullish if the rest of OPEC or Russia is not going to offset anything.
Wrap up of sanctions
The U.S. imposing sanctions which affect the oil output and exports from the affected countries seems to have had the side effect that the U.S. is now the world’s largest oil producer (when measuring Oil+Gas), and looking to become a net exporter of oil. But on the other hand, foreign politics may hamper this alleged agenda as especially Russia is looking to extend cooperation with China. Additionally, Venezuela and Iran are allegedly offering preferable conditions for importing their oil, meaning that the rapidly expanding oil markets of India and China could be filled with oil from elsewhere and not the U.S.
At the beginning of the year a tariff-cease-fire between China and the U.S. was agreed upon. The truce was planned to last until March 1st but since then a lot of meetings were held in order to reach some kind of agreement between two of the world's largest economies. So far, no deal has been struck as the U.S. demands an enforcement mechanism overlooking if China is actually complying with the demands. Even though the U.S. president has stated that there is progress, a deal fulfilling all U.S. terms is less likely. The president's latest statement was that even if a deal was struck the sanctions would have to apply further for a substantial amount of time to ensure China is living up to the deal. Chinese and U.S. delegates assigned to striking a deal are counting on a meeting in April.
The likelihood of a stable long-term deal is assessed fairly low. Both leaders have pledged to strengthen the economic situation in their respective countries, and China would want to export as much as possible, and the U.S. would like to shrink the huge trade deficit to China.
Disputes between India and the U.S.
The current U.S. administration looks to end a decades-old preferential trade treatment with India allowing India to export goods worth $5.6 billion tax free into the U.S. The reason is apparantly that India has too high tariffs which is a barrier and causing unequal access to the Indian market.
So far there has been no effect on oil from this decision, and India has responded rather friendly stating that it would not impose any retaliatory tariffs.
At the moment the Brexit situation seems uncertain. The UK prime minister has tried to come up with a deal with the EU making the transition out of the Union smoother with some strings still attached. The proposal was rejected for a third time in a vote leaving UK without any deal. The UK has until the 12 April to leave the EU. Until that date the UK will likely have to fight for even more time to decide what to do before leaving the EU.
It is still highly unclear what is going to happen. With regards to the financial markets Brexit has still not had any severe impact besides spurring volatility in the GBP exchange rate.
China expanding oil infrastructure
China is expanding the country's oil and gas infrastructure and incorporating all pipelines under a single state-owned firm. The pipeline network itself is to be expanded and new investments in exploration are sought as well. Especially the gas infrastructure has been insufficient as homes have been without gas in peak periods. All pipelines are to be gathered under the so-called China Pipelines Corporation. The goal is to achieve more independence of imports and to do it faster. The 3 major national companies have allegedly not moved fast enough, therefore President Xi seeks to raise more private capital. If these expansions and rearrangements are going to impact the market is still too early to say but it does send a statement to the global market that China is looking to be less dependent on imports.
The U.S. sanctions against Iran and Venezuela are likely still going to be a hot topic during this quarter, especially around May where the waivers from the Iran sanctions expire. If the waivers are not prolonged exports are likely to decrease even further which may have an impact on prices. Saudi Arabia is less likely to try to offset these barrels because of the production cut, but other actors including the U.S. are likely to try to win that market share.
China expanding oil infrastructure is probably a process lasting several years and is therefore less likely to impact the oil market during this quarter. Politics such as Brexit and the trade relationships are effects that gradually affect over a longer period of time and are difficult to predict.
Because of the uncertainty about whether the U.S. waivers are going to be prolonged or not geopolitics are assessed slightly bullish.
"We set geopolitics to slightly bullish"
Oil price forecast (average)
Please note that the forecast is the AVERAGE price per quarter. Thus, prices during the quarter will likely be both higher and lower.
How is the report structured?
The report is divided into three parts – each part elaborates on three main topics which are influencing the oil prices:
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