From Global Risk Management
The Oil Market Quarterly Outlook Oct '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 the coming period could continue to see heavy oil price volatility as trade war and geopolitical tensions in the Middle East remain in centre stage.
As uncertainty in the financial markets increase, central banks throughout the world are trying to stimulate economies by lowering interest rates. Further initiatives are being taken by the European Central Bank, by officially restarting their quantitative easing process, which we commented upon in our last quarterly.
The geopolitical issues surrounding Saudi Arabia, Iran and the U.S. fundamentally suggest a bullish market, however, the above-mentioned economic uncertainty could limit oil demand growth.
OPEC and the extension of the group known as OPEC+ are still set to cut their oil production until March 2020. At time of writing, the cut of 1.2 million barrels a day has been going on for 32 months. Since June we have seen the price of Brent slump 8% indicating that the cut in oil production must be maintained to keep the price level higher.
The U.S. WTI crude is settling at above $50, which likely means that the U.S. producers still can produce above break-even costs. We experienced the biggest ever intraday surge in oil prices after Saudi Arabia was attacked by drones, decreasing the world supply by 5%. Since the attacks oil has declined to its initial value before the attacks.
The competition that U.S. crude producers have faced in shale technology seems to have diminished. This is a combination of shale oil producers having failed to meet shareholder’s expectations and low crude oil prices at the same time, which have led to fewer investments and all in all a stagnated shale market supply for the time being. The decline in prices and the rising inventories suggest that the demand for oil is currently not growing at the same rate as supply.
From Q2 into Q3 we saw a decline in the production of crude oil, which suggests that we should see lower inventories ahead. So, what is the reason for the increase in inventories and decline in prices? The answer among others is to be found in the demand for oil.
The demand for oil has been growing slowly during Q3. Economic slow-down, geopolitical tensions and the trade war between the U.S. and China have left their marks on the overall economy. The OECD has reduced its world growth expectations by 2.9% and the demand for oil seems stagnating, though still expected to be slowly increasing. OPEC’s forecast for world oil demand in 2019 is currently expected to grow by 1.02 mb/d. Both the OECD and non-OECD demand growth forecast was also lowered for Q3.
The curve shows only a slight increase from Q2 and into Q3 in demand for oil as uncertainty rules the economic markets. Fear of recession seems to be a drag on demand. The flattening in demand also explains the decline in Brent prices and the increasing inventories. This is also the reason for shale oil producers being unable to deliver expected revenue, the demand isn’t high enough. U.S. shale producers can easily saddle up or down production to meet market sentiment. The lack in demand is also viewed in the number of US drillings rigs. The first graph is of the DUC’s, which is the number of drilled but uncompleted wells, which have been decreasing since April this year.
The same picture applies for the number of U.S. oil rigs counted in Q3. The amount has steadily declined. The ongoing decline in rigs and DUC’s could be a sign from the producers that they do not expect demand to rise in the nearest future. Part of the explanation could also, however, be that productivity pr. rig has increased. Thus, the need for rigs to maintain current production is lower than last year.
The market is still subject to bullish fundamentals as sanctions from geopolitical issues and attacks on oil producers together with production cuts are reducing the supplied oil. However, like Q2 the inventories are still rising suggesting that there still is an abundance of oil n the market. At the same time the number of active rigs is still declining and so is the developing of new future production capacities DUC’s.
All in all, the state of the economy hasn’t been improved enough since Q2 to drive oil prices north. Demand growth is slowing, due to low economic growth numbers, while the increase in inventories, even with production cuts, and decline in rigs and DUC’s sets the market somewhat bearishly.
"We set fundamentals to slightly bullish"
The following subchapter is our analysis of different financial developments happening around the globe. Expansions and contractions in different parts of the financial markets have great impact for demand on oil as consumption often increases with improved economic outlook and vice versa. The main economic indicators in this analysis paint the picture of overall movement in economic figures including GDP, PMI, unemployment rates and other.
Growth, production figures and interest rates
As seen by the graphical illustration below, GDP growth for both year-on-year and quarter-on-quarter has declined.
Since our latest quarterly, the interest rates throughout the world and especially in the U.S. have been given much focus. The U.S. central bank (Fed), has continuously tried to raise interest rates. However, in late July the head of the Fed and the board decided to lower interest rate for the first time in a decade. Increasing worries of economical contractions are happening throughout the world causing governments to put efforts into place to continue the expansion by stimulating the economy. In September, the Fed decreased the rate by -0.25% to the current level of between 1.75% - 2.00. Furthermore, traders are expecting that the Fed might decrease interest rates once again at a meeting in October and a 50% chance of the last one of the year at a meeting planned for December meeting.
Typically, when central banks try to stimulate an economy by cutting interest rates, it will eventually be seen in the stock market. However, as seen on the graph below, the first cut by the Fed, only stimulated the S&P 500 index, the broadest stock index in the U.S.to increase only to decrease later. After the second cut of the interest rate, however, the S&P has gone back to levels before the drop. As will be mentioned in the geopolitics article later in this report, the trade war between China and U.S. has huge effect on the value of the stock market, now apparently leaving monetary stimulus be a limited tool confirming which the slowing GDP numbers indicate.
The inverted yield curve in the U.S.
In our earlier reports we have had some focus on the yield curve in the U.S. The inversion of the 3 months and 5-year treasury rate curves has extended through Q2 and we still see inversion in the curves.
The inversion is a sign that investors still see more risk in the short run than they do in the long run. As with most investments, the investors tend to want more in return, the further and higher the risks are. This does not seem to be the case now, where we see a higher return on short run investment (3 months) than we do in the long run (5 years).
Fact box: Inverted yield curve
Campbell Harvey, professor at Fuqua School of Business at Duke University, has studied yield curve inversions for more than 30 years. He showed the reliability of this indicator in his doctoral dissertation at the University of Chicago in 1986. The dissertation was reviewed by a committee of future Nobel Prize winners Eugene Fama, Merton Miller, and Lars Hansen. It shows that an inverted yield curve would have anticipated the previous four recessions. After its publication, the model predicted the next three recessions — 1990-91, 2001, and 2007-09 — so it has a perfect track record going back about 40 years.
Critics of this argue that the 3 months treasury rate is so heavily influenced by the Fed and therefore we will not see the 3 months treasury rate drop as fast as longer term, but we see the 1 year and 5-year spread being inverted as well.
Growth and production figures
Growth in Europe has been slowing since 2017 and the trend is ongoing. Recent GDP numbers show that growth was rising in Q2 but has since fallen to the same level as at the start of the year. Even the OECD has manifested with its official reduction in its growth for the near future.
The reduction in GDP growth could be a sign that the economy is halting. The PMI index is another indication of where the economy is heading. As the graph depicts below, we see PMI levels of well below 50, which further supports the GDP growth indication as being the start of a recession in Europe. The PMI levels as of September were as low as 45,7. The PMI levels provide information about current business conditions. It takes into consideration five survey areas: new orders, inventory levels, production, supplier deliveries and employment.
The European Central Bank - ECB is aware of the issues within Europe and thus has resumed purchasing bonds throughout Europe, continuing what is known as quantitative easing. The quantitative easing carries on in Q3 and the ECB is resuming buying up eurozone government bonds. Also, the ECB has chosen to lower interest rates, even though they’re well below 0, trying to stimulate the economy by demanding fees from banks with deposits surplus. The wider banking sector already suffers as a result. Banks and financial institutions are trying to change their way of business, by trying out new operating models.
The graph below shows the ECB having reduced the deposit rate to around 0 back in 2014, since then the deposit rate has been steadily set around 0. Since 2016 the deposit rate has been negative and in Q3 2019 the ECB reduced the rate even further to -0.5% stimulate growth figures.
The monetary policy that the ECB has implemented is unseen territory, never has the rate been this low, and only time will show if the negative deposit rate will have the wished-for effect on the economy. The ECB has called upon European governments to back up the monetary stimulus with fiscal stimulus, such as large-scale infrastructure projects.
The biggest economy within the Eurozone, Germany, has been suffering from declining production figures and might enter a technical recession, which is indicated by two contracting years of development in GDP. This is also one of the reasons that the Euro is depreciating in value compared to the USD. A disbelief in the economy in Europe and numbers that point to a recession in Germany is what seems to drive the main depreciation.
The Chinese GDP growth rate has been declining further in recent months. The decline follows the overall picture of world demand as economic growth slowdown is present in China as well as Europe. The GDP growth Y-o-Y shows a number of 6.2 compared to the previous number of 6.4.
In the meantime, the Caixin China General Manufacturing PMI index has increased from 50.2 in Q2 to 51.4 in Q3. The manufacturing numbers show a slight increase and thus it is a small sign that the economy might expect increased demand in the nearer future.
Since February we have seen the USD/CNY increase more, which is making commodities as well as servicing debt denominated in dollars more expensive.
The numbers from China suggest that the Chinese economy is still in a 6% year-on-year growth continuing the trend seen in Q2. The economic volatility is not too worrisome as it seems rather natural. It is also notable that China has entered this stagnating period at the same time as many of the world leading countries have.
The trust in the Euro and the economy in the Eurozone seem to fade more and more even while the ECB taking drastic measures to stimulate the economy. As China is still an emerging market, even though a very large one, the higher financing costs and more expensive commodities both are a reason for concern as they are potential growth stoppers. For U.S., GDP growth data has declined and the central bank has reduced interest rates in an attempt to spur economic growth.
"We set financials to neutral"
Concerns and developments in the Middle East.
Uncertainties keep arising in the Middle East these months. The latest disruption to the oil markets happened on the 14 September. Facilities on two major oilfields placed in Saudi Arabian were hit by drones and likely missiles. Half of all oil production produced within Saudi Arabia flows through one of the fields, causing the kingdom to momentarily discontinue 5.7m barrels of crude or roughly 60% of total Saudi Arabian output. The attack caused an instant 5% disruption in global oil supply. Prices roses as high as 10% above previous day’s trading prices, however, as Saudi Arabia responded promptly, by 17 September, 2m barrels of crude oil were restored and production was almost back to normal as Saudi Arabia draw in inventories to stabilise prices. Because of the draw in inventories, Saudi Arabia allegedly managed to revive output to previous level by the end of September. However, confirmed production numbers are still to be seen.
The U.S. and sanctions against Iran
The Iranian economy is suffering even more since our last quarterly report as Iran's crude oil exports currently below 500 kbpd barrels per day, down from 2.8m barrels a day since April.
Further trouble has been brewing in the Strait of Hormuz, especially between Iran, the United Kingdom and the United States. Pressure have been increasing especially since 19th of July When Iran seized a vessel from Great Britain as it was passing through the strait. The market speculate that the capture of the vessel was some sort of retaliation from Iran as British Marines held an Iranian oil tanker that were reportedly headed for Syria. The rising tensions in the Strait did cause some countries including the UK, the United States and Gulf states to worry about energy supply in the region, as the strait is responsible for 20% of global oil trade and 25% of trading done in liquefied natural gas.
However, developments are in scope for the easing of sanctions on Iran. As world leaders met at the annual G7 summit, the president of France announced that a meeting could take place between the United States and Iran a couple of weeks after the official announcement. The meeting should allegedly have been held at the United Nations General Assembly, however, in the end the two parties did not meet. There is much uncertainty regarding the future of talks between Iran and the U.S., but as of now developments seem slowly in progress.
The U.S. - China trade war
On the 6 July 2018, the U.S. president engaged in what would turn out to be back and forth banter with China. Tariffs thrown in both directions turned into a trade war, still running strong to this date. Global stock markets have been hugely affected by the back and forth trade talks, sending stocks, fixed income and commodity markets into one of their most volatile periods in recent years. As of the latest updates on this trade dispute, the U.S. president has suspended adding a 10% tariff on $300 billion worth of goods from China, which would affect laptops and other electronic products. As both China and the U.S. are two of the biggest economies in the world, so is their demand and use for crude products. China, however, is mainly an importer of crude products, both importing from the U.S. and from organisations such as OPEC. As can be seen in the graphs below and in accordance with the previous section, oil imported from Iran to China fell drastically in May, but has since been kept somewhat constant at 200 kbdp.
The Treasury of the U.S. officially designated China as a currency manipulator. Thus, the U.S. accused the Chinese government of devaluing its currency to gain an unfair advantage in international trade, since exports come cheaper, thus causing foreign countries, hereunder the U.S. to import more goods. It is the first time the Treasury has made such an accusation in over 25 years. The motivation behind the administration’s claim was that the Chinese yuan has been falling in value against the dollar, and on 5 August dropped past the psychologically significant value of seven to the dollar for the first time in over a decade. However, The People’s Bank of China set in to fix the psychological value within a few days, again trading higher. Negotiators from the both the Unites States and China prepare for further trade talks.
As negotiations in the trade war between the U.S. and China have dragged for long, more attention is being tied to developments in the Middle East. Some world leaders do hope for development between the U.S. president and the president of Iran, and a further hoping for a meeting between the two powers. The situation in the Middle East, however, remains fragile.
"We set geopolitics to 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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