From Global Risk Management
The Oil Market Quarterly Outlook July '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 see heavy volatility as trade war and geopolitical tensions in the Middle East take centre stage.
Oil fundamentals are basically bullish due to production cuts by OPEC and non-OPEC along with sanctions resulting in reduced exports from both Iran and Venezuela. However, the current trade war between the U.S. and China - though "ceasefire" was agreed during the G20 summit in June - could affect global economic growth and hence global demand for oil. If demand drops, so could oil prices. However, dark horses are the central banks, which could introduce new quantitative easing measures to spur economic growth - and voila - demand for oil likely picks up again. Should the trade dispute between the U.S. and China be solved, this is also potentially bullish for oil prices. The Middle East tensions are also potentially bullish for oil prices and any new development in the area could spur fears of oil disruptions.
U.S. crude oil inventories have been rising throughout Q2 2019 as U.S. production is persistent and global demand could be stagnating.
OPEC and a row of non-OPEC oil producers in the beginning of July prolonged the production cut by 9 months to end of March 2020. According to the Russian minister of finance who stated earlier in Q2 that if the cut was not prolonged, Brent could be heading toward $30.
At the moment there seems to be plenty of oil. The U.S. WTI crude is above $50 meaning that the U.S. producers likely produce above break-even costs. The OPEC cut could help keep prices above this break-even level implying that the U.S. production will continue to expand – probably not as rapid as has been. For OPEC this is a vicious circle; the organisation is cutting production to keep prices elevated, but the U.S. is able to produce above marginal costs meaning the production there could keep expanding, undermining OPEC efforts.
Since shale oil technology became feasible, probably back in 2015, OPEC has been trying to cope with the competition and keep prices at their desired level. Especially for Saudi Arabia the oil price is essential in balancing income and expenses on the state budget. As shale oil production in the U.S. expanded, crude oil inventories swelled which left room for low prices. OPEC’s solution together with Russia was in 2016 to cut production. The production cut seemed to work as inventories, especially in the U.S., were brought down.
During last year OPEC lifted the cut for the first time as the Brent price increased to above $80. At that time the U.S. re-imposed sanctions against Iran, leaving the deal from 2015 between a group of world powers and Iran with the purpose of limiting the Iranian nuclear program. The aim was to reduce Iranian exports to zero. The U.S. later imposed sanctions on Venezuelan petroleum, gold, mining and banking industries. The market expected the oil price to remain high, but the $80 level did not persist. In the meantime, Iranian exports have officially basically decreased to zero and those of Venezuela are practically trivial. OPEC and Russia are officially still cutting production, but U.S. inventories are going northwards and prices going south – not what is intended by the production cut.
Below graph shows that Iranian and Venezuelan crude exports have decreased remarkably.
Below graph depicts the increasing U.S. crude inventories and the falling crude oil prices. From June 2018 OPEC eased the production cut as prices were inching towards $80. From there the price peaked only to plummet massively at the same time where the U.S. inventories started to rise in October 2018. From January 2019 the initial cut was implemented again, and prices rose. During Q2 we have seen the U.S. inventories rise to the highest level since mid-2017 which left room for a $10 decrease in the price together with increasing inventories in North-West Europe. The cut was agreed to be lifted in June’18, but inventories did not start to increase until October’18. The reason is probably that such dynamics take time to manifest.
Theoretically the fundamentals of the crude oil market look bullish at time of writing, but the price acts rather bearishly – OPEC and non-OPEC countries cutting production and sanctioning of former large oil exporters. The missing link is to be found partly in the production cut and partly in the global demand.
From the start of this year the production cut was once again implemented by OPEC and Russia. Since 2016 the agreement was carried by the two by-far largest producers in the deal, Saudi Arabia and Russia.
Below graph shows the indexed values of Russian production and exports in Q4 2018 at index 100 with Q2 2019 being relative to that. The numbers show that the production actually is lower, but that exports have increased, meaning oil actually supplied to the market has increased.
Saudi Arabia seems to fulfill a production cut along with the rest of OPEC, but question is if the production cut will have the wanted effect without the full engagement of Russia and without exports being reduced.
On July 1-2 OPEC and non-OPEC met and decided to prolong the production cut by 9 months to March 2020. Russian sentiment in favour of an extension has been increasingly shaky, but the huge oil producer remains a part of the deal. At the moment it does, however, seem like the cut without effective Russian engagement is not sufficient.
During the period of the production cut the U.S. has gained market share, and even with low prices the U.S. shale producers are still able to produce as their break-even costs are very low. Remember that the U.S. producers are looking at prices remarkably lower as the U.S. benchmark WTI throughout Q2 has been about $8 lower than Brent, meaning they are used to working in an environment with lower prices. So, flooding the market is probably not a solution for OPEC to drive out the U.S. producers, especially not with the U.S. producers manifested this much in the market. But on the other hand, cutting production even more would result in even more market share lost to the Americans.
Below graph shows the yearly average crude oil market share of U.S., Russia and OPEC in 2016 and 2019 as well as the difference from 2016 to 2019. Note that the U.S. has gained about 3% while OPEC lost more than 4%. Russia is nearly unchanged.
However, there is another reason for the increasing inventories and decreasing prices – the most basic fundamental called demand.
Demand has during Q2 decreased since the peak in February to be stagnating at around 100.5 mbpd, which is just below the average for the last year. Demand could be cooling in the time to come and this is likely what will be driving prices in Q3.
The first implications can be observed in the U.S. crude market as well. U.S. shale producers can quickly saddle up or down production equipment to meet market conditions. Producers are facing lower prices and therefore investing less in exploration. The number of drilled but uncompleted wells (DUC’s) are not increasing anymore implying that producers are not expecting demand to grow in future. Furthermore, the rig count is decreasing, indicating that some of the least productive rigs most likely have been shut.
The below 2 graphs show the slightly decreasing number of DUC’s and the decrease in active U.S. drilling rigs.
U.S. crude production is still the highest in the world, but the Energy Information Administration (EIA) just cut back expected growth figures. This is a further indication of demand growth could be cooling off.
Below graph depicts the EIA’s monthly forecasts of U.S. crude oil production growth in Q3 2019, H2 2019 and 2020. The forecast for all 3 periods fell in June from May.
The market is currently subject to bullish fundamentals in terms of supply as sanctions and production cuts are reducing supplied oil. However, inventories are still rising meaning that there must be an abundance of crude oil. Furthermore, the U.S. shale producers are slicing current production capacity in terms of active rigs and stopped developing new future production capacity in terms of DUC’s. Both pointing towards no further production increases. That being said, the production is not expected to decrease, but turn towards stagnating – at least when speaking of the U.S.
Fundamentally speaking the inventories would likely have to be sliced before prices take a move further north. If the state of the economy does not improve, demand alone is not likely to be able to slice potentially growing inventories in Q3 and thereby not able to drive prices higher. OPEC together with Russia agreed on prolonging the cut. The size and current decreases in exports seen until now is not assessed big enough for the U.S. being unable to compensate for it.
"We set fundamentals to slightly bearish"
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 and vice versa. The main economic indicators in our analysis are interest rates, the inversion of the yield curve, and the overall movement in economic figures such as GDP, PMI, unemployment rates and the participation rate.
The U.S. GDP Q-o-Q grew by 3.1% for the first quarter of 2019 increasing from the growth rate of 2.2% from Q4 2018. This changes the declining GDP trend that was otherwise forming.
U.S. retail sales rose by 0.5 percent from a month earlier in May 2019. An increase in retail sales is a sign in line with the increasing GDP, indicating an expanding economy with higher consumption. The PMI of 51.7 in June 2019 from 52.1 in the previous month still is also a sign of an expanding economy as PMI values of above 50 indicate an expanding economy and values below indicate a contracting economy.
Looking at economic numbers can potentially be misleading as both GDP and retail sales are historical numbers, meaning that moving into Q3-2019, only Q1-2019 GDP data is available. However, GDP allows readers to get an overview of entire countries or continents. GDP is defined as the total value of goods and services produced within a country.
Hence, it is no good for measuring short term fluctuations in future oil prices, but it provides an indication of whether the economy is expanding or contracting which affects the demand for oil.
Looking at real time prices; stocks, oil, or other financial markets will give a more up-to-date picture of what is going on. However, this still has its limitations – which will be explained and emphasised below.
Since the Fed’s announcement in end-December 2018 to reduce the number of interest rates hikes during 2019, U.S. stocks have been recovering until the U.S. administration went against expectations which reduced markets’ belief in a U.S. - Chinese trade deal. The markets went red. As elaborated in the geopolitics section we consider the trade war the most influential topic regarding economic growth at the moment.
The latest recovery (last two months) is mainly driven by a general market expectation of a reduction in interest rates. This comes after Chairman Jerome Powell stated that the Fed will “act as appropriate to sustain the expansion”.
The CME FedWatch tool shows 0.0 % probability of staying at current target rates, 76.5% probability of a rate cut to 200-225 bps, and 23.5% probability of a rate cut to 175-200 bps as of 2 Jul 2019 03:30:10 CT. Compared to one month before where the expectation was 46.9% probability of staying at current levels, 44.8% probability of a rate cut to 200-225 bps, and 8.3% probability of a rate cut to 175-200.
Investors expect that the market cannot sustain a hike and therefore expect the Fed to lower the rates instead. Whether the Fed will cut rates or keep them unchanged is difficult to say, but it seems that the market is confident that interest rate hikes are not going to happen in 2019.
This is an unhealthy turn of events as Fed is trying to normalise money markets and this seems to have failed - proving the uncertainty in the markets, plausibly reasoned in the huge amounts of corporate and government debt.
As markets are bullish, but on unsolid grounds, this illustrates how real time markets, too, can be tricky to use to evaluate the state of the economy.
The inverted yield curve in the U.S.
As mentioned in our last edition of the quarterly oil market outlook, the 3 months and 5 years treasury rates spread inverted on the 14th March 2019 and have now passed a full quarter of inversion.
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.
Intuitively, an inversion can mean that investors see more risk in the short run rather than in the long run. It also is an indicator of a disconnect in the outlook between the Fed and the market. Both things seem to be adequate now.
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.
The U.S. unemployment rate is at a record low of 3.6 % and at the surface this seems very bullish on oil as high employment indicates high production and demand in the economy. This calls for higher demand for oil and thereby increasing prices. However, looking closer we realise that the number cannot stand alone:
The unemployment rate is the number of unemployed people as a percentage of the labour force. Meaning, if an unemployed person leaves the labour force this person is no longer included in the statistics.
When we look at the participation rate, the picture is different. The participation rate is the number of people working or actively seeking work as a % of the working population (16-65). Hence, if people decide stop looking for a job, they are no longer accounted for in the unemployment rate, but it will still lower the participation rate.
The expectation is that the participation rate and the unemployment rate should move in opposite directions. Low unemployment and high participation rate go hand-in-hand. From 2000 to the Financial Crisis, the correlation was -0.568 between the unemployment rate and the participation rate which means that they have been negatively correlated, and thereby is in accordance with the expectation. However, from 2010 until today the correlation between the rates were 0.88 which is close to perfectly correlated. This is rather odd and could indicate that people stop applying for jobs which could be for several reasons. No matter the reason, less people overall are working despite the excellent unemployment rates – 4 %-point less of the American population are no longer participating. The participation rate has not been as low as current levels since 1978 where 63% participation rate was reached for the first time.
Conclusion - U.S.
Summing up we see healthy economic figures; GDP, retail sales, and unemployment rates that all indicate a high level of production which is bullish on oil. However, the inversion of the yield curve and the enormous, increasing amount of debt are considered highly risky. Combining this with the low participation rates and the underlying tendency in the stock market of investors driven by the expectation of interest rate cuts by the Fed, it seems reasonable to argue that we are at a top in the business cycle with high risk ahead.
U.S. Financials are assessed slightly bearish.
The Chinese GDP growth rate is decreasing and has been decreasing almost continuously since 2010. The latest GDP growth Y-o-Y the Chinese economy advanced 6.4 percent Y-o-Y in Q1 of 2019, the same pace as in the previous quarter and slightly above market expectations of a 6.3 percent expansion. The latest GDP reading remained at its lowest since the Global Financial Crisis.
Retail sales (YoY) increased by 8.6 percent year-on-year in May 2019, following a 7.2 percent advance in April and beating market expectations of 8.1 percent. The Caixin China General Manufacturing PMI was unchanged at 50.2 in May 2019, slightly above market consensus of 50.
Auto sales is an important indicator of the strength of an economy as it employs a lot of people and is indicative of how willing consumers are to spend.
On 12th June, the China Association of Automobile Manufacturers (CAAM) announced vehicle production and sales results for the month of May, 2019. Overall vehicle production in May totalled 1.848 million units, reflecting a 9.9 % M-o-M decrease and a 21.2 % Y-o-Y decrease, while sales totalled 1.913 million units, reflecting a 3.4 % M-o-M decrease and a 16.4 % Y-o-Y decrease. YTD production January through May totalled 10.237 million units with a 13 % decrease compared to the same period in the previous year, while sales YTD were 10.266 million units, a 13 % Y-o-Y decrease.
Currency - the yuan
The USD/CNY has been increasing from around January 2018 which is making commodities as well as servicing debt much more expensive, as most are nominated in dollars. Similar patterns are seen in all countries within emerging markets (BRICS, Mexico, Turkey). Higher financing costs and more expensive commodities are both growth stoppers.
Conclusion - China
The Chinese numbers are overall in a slowing-growth trend, which is not unseen after decades of immense growth. However, continuous growth is needed in years to come if China wishes to catch up completely with the economies of the western world.
Chinese financials are assessed neutral.
Growth is slowing in Europe with growth rates of 1.2 % for the past two quarters.
The PMI of Europe has been in a declining trend since end-2017, and even passed below 50 in February 2019. PMI values below 50 indicate that the economy is contracting. The PMI (Purchasing Managers’ Index) is an indicator of economic health for manufacturing and service sectors. The purpose of the PMI is to provide information about current business conditions and is based on five major survey areas: new orders, inventory levels, production, supplier deliveries and employment.
Hence, a PMI of less than 50 is bearish on oil. As of June 2019, the PMI was as low as 47.6.
The EUR/USD has also been in a decreasing trend indicating disbelief in the EUR or increased belief in the dollar. As depicted in the graphs below we see increasing dollar stregth. Either way, as most European trade will be carried out in dollars, and against the dollar, the EUR is depreciating.
The topic of economic stimulus in the Eurozone has received much attention over the past couple of months. As briefly mentioned above, a declining quarterly growth rate followed by a decreasing PMI may call for some sort of stimulus for the European economy.
As the lender of last resort in Europe, the European Central Bank (ECB) possesses different tools at the disposal to help with just such inducement. As of now, policy makers from the European Central Bank favour using interest-rate cuts as their first choice of stimulus.
Another approach would be to continue increasing the balance sheet of the ECB. This tool is known as quantitative easing (QE). ECB can continue to expand the volume of the balance sheet, since QE consists of issuing new money, purchasing assets from other banks, and thus the cash that the banks receive from the ECB, should be loaned to borrowers. As of now ECB holds more than €4.500.000 million worth of assets in the balance sheet, which is why some favour using interest rate cuts over a further addition of QE.
The president of the ECB, Mario Draghi, implied that he is open for implementing stimulus in the absence of any improvement in the economy. However, to continue the process of QE, the ECB would have to raise self-imposed limits, which some argue will crush markets and crossing the line between monetary and fiscal policy.
Still, it is not clear how much further the interest rate can decrease. Banks throughout the Eurozone complain that they can’t easily pass their deposits onto customers, and at some point, they’ll cut back on lending, which will hurt the European economy further.
Many economists expect that the ECB will decrease the interest rate even further soon. Since Mario Draghi will end his service as president of the ECB in October, he will be the first president not to increase interest rates while holding office.
Conclusion - Europe
As depicted in the above the European economy is heading in the wrong direction with declining economic figures and investors losing trust in the Euro. The ECB could potentially interfere, but not without a high cost associated. We asses European Financials as bearish on oil.
Overall conclusion on financials
The overall financial outlook is assessed slightly bearish as riskiness is increasing through the inversion of the yield curve in the U.S., expectations of lower interest rates by the Fed, and declining economic figures in Europe and slower, but steady growth in China. In case the Fed decides to lower interest rates or use QE tools this could potentially buoyant the market for now.
"We set financials to neutral"
U.S.- China trade war, Iran and the Strait of Hormuz conflict, and Venezuela and how these centres of attention are influencing oil prices are the topics of this section.
U.S./China trade war
Unilateralism and trade protectionism are on the rise making the global economic development uncertain. The trade war is considered the topic of highest geopolitical risk regarding economic growth and thereby oil demand and prices. The attitude in the market is clear, in case additional tariffs are added, further economic slow-down is expected and a recession is a possibility.
So far, the U.S. has imposed 25 % tariffs on $250 billion of Chinese goods and China retaliated with tariffs of up to $25 % imposed on $60 billion of U.S. goods. China has previously imposed tariffs on 5,140 U.S. products. Further, the U.S. administration is threatening to apply the same elevated levy on the rest of the imports from China worth approximately $300 billion. For now, truce between China and the U.S. has been announced, and a new round of talks has already been planned while the U.S. administration has expanded a list of European products that may get hit with tariffs. The statement might be that a truce has been reached, but we still assess the trade tensions as highly risky and able to slow economic growth.
The impact of Beijing's tariffs on U.S goods is not expected to be large enough on U.S. economic growth by itself to corner the U.S. administration as China at max. is able to tax around $120 billion worth of U.S. goods which is the amount China imported from the U.S. last year.
What can China do if an agreement is not reached and upheld?S everal options lie ahead for China in case the truce is not sustained.
A. Foreign debt sell-off
China is the biggest foreign holder of U.S. Treasuries. At the end of February, China’s declared holdings of U.S. Treasuries amounted to U.S. $1.1 trillion out of the $6.4 trillion foreign investors hold in total.
In March China stepped up sales of these treasuries to the quickest pace in two and a half years - according to data from the U.S. Treasury department. What happens if China disposes their U.S. Treasuries? Increasing supply will decrease bond prices, which brings up the interest rate – as they move in opposite directions. This brings up costs of U.S. debt which is destabilising and could potentially erode global investor trust in the dollar. The U.S. relies on bonds to finance government budget deficit
As this is likely to decrease the value of the dollar, U.S. imports become more expensive and exports cheaper for U.S. consumers and producers and this could hurt China.
Also, it risks starting a fire sale that would hurt China’s own portfolio as well. Hence, it could potentially be very expensive.
B. Currency - weaken the value of the yuan
China could devalue its currency as it has done before.
The weaker the Chinese currency, the less expensive its goods are in the U.S and this will result in more U.S. import of Chinese goods as these become relatively cheaper.
The downside is that China's imports will become more expensive too - which will affect goods such as oil and other raw materials that it needs to keep growth rate high.
Also, Chinese leaders have repeatedly stated that they will not use yuan depreciation to boost exports, and the central bank has said it will not use the currency as a means to handle trade frictions.
C. Avoid the U.S.
A third option is to fully circumvent the U.S. Since the start of 2018, the average Chinese tariff rate on U.S. products has jumped to 20.7%, and within the same periods China has reduced tariffs on competing products from other countries to an average of just 6.7%.
Chinese exporters are diversifying overseas sales, raw materials are being located from other places, and soybeans (once China’s biggest import from the U.S.) are being imported in increasing scale from Brazil. This process is likely to take time – and is likely to be costly - but could be a way for China to push the U.S. administration to a deal.
Hence, there are available options, but all of them come at a price.
Iran and the Strait of Hormuz
The Saudi-Iran conflict dates back to the Iranian Revolution in 1979, but looking at the more recent picture the U.S. stirred up things in May 2017 when the U.S. administration declared a shift in U.S. foreign policy favouring Saudi Arabia at Iran’s expense. This was in opposition to the previous U.S. president’s approach.
Several major developments drew concerns that the conflict might escalate into a direct military confrontation between Iran and Saudi Arabia. Last year the U.S. imposed economic sanctions on Iran which among others hurt the country’s oil exports. The sanctions were imposed to reduce Iran’s exports to zero, hurt the country economically and thereby induce Iran to unarm any nuclear weapons. In anticipation of the withdrawal, Iran indicated it would continue to pursue closer ties to Russia and China.
Several waivers were granted for countries importing Iranian oil, which means that until recently these sanctions have not affected the market as first expected. However, now more countries are finding other places to buy oil. Lately, Turkey, has announced that it will comply with the U.S. sanctions against Iran and has stopped importing Iranian oil from May and buying instead from Iraq, Russia and Kazakhstan.
The sanctions took effect from November 2018 and as seen above exports fell leading up to this point, as waivers were granted, causing exports to rise again. As depicted in the graph above, the Iranian exports are now moving at a rapid pace towards zero.
The largest importers of Iranian crude have been China and India, but their imports of Iranian oil have gone down, while their overall import is ever-high adding to the evidence of the effect of the U.S. sanctions.
Since mid-May, six tankers have been attacked including two ships caught on camera. The U.S. claims that this is done by the Iranian Revolutionary Guard Corps (IRGC), but Iran denies this. Further, IRGC has shot down an U.S. surveillance drone, claiming that it entered into Iranian territory.
The Iranian government has periodically threatened to close the Strait of Hormuz and is now threatening to increase production of radioactive materials. However, neither proves their guilt in this and can therefore only be interpreted upon.
The current policy of the U.S. is to try to squeeze Iran as hard as possible through sanctions. However, analysts fear that this could escalate into military actions.
Escalation of the situation in the Strait of Hormuz is likely to be bullish on oil prices until resolved.
For years, growing political discontent further fueled by skyrocketing hyperinflation, power cuts and shortages of food and medicine have been the everyday life in Venezuela. More than three million Venezuelans have left the country in recent years. The socialist governments have been in power since 1999, taking over the country at a time when Venezuela had huge inequality. Many things have happened since then, such as making basic goods more affordable by laws resulting in businesses earning no profit and shutting down, foreign currency control for a flourishing black market in dollars – with Venezuelans unable to freely buy dollars, they simply turned to the black-market making matters worse. However, the biggest problem in Venezuela seems to be the hyperinflation that has reached 1,300,000 %...
Due to the controversial politics by the current president of Venezuela, Nicholas Maduro, the U.S. have imposed sanctions against Venezuela. The sanctions prohibit any U.S. person or entity from doing business with the national oil company PdVSA. Production, as seen below, has plummeted.
The U.S. / China trade war is bearish on oil until a potential trade deal is reached as it otherwise potentially hampers global economic growth which is a key driver of increasing oil demand. This will be trendsetting in the longer term.
In the Middle East we see growing tensions with a possibility of escalation which is likely to cause short term price swings.
Even with a well-supplied market, escalation in tensions between Saudi Arabia and Iran with the U.S. taking part could have large impact on the oil supply and on prices due to increased risk - at least in the short term.
Geopolitics are estimated to be neutral mainly due to the current trade war between the U.S. and China. If the trade war is not solved, however, the escalating tensions in the Middle East seem to be offsetting the trade war issues for now.
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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