Black Gold

13/11/2015 at 5:31 pm

Many of the headlines this week have considered weakness in equity markets. Since last month’s rally stocks have certainly come off the boil: the FTSE 100 is down by more than 3% at the time of writing, the S&P 500 by a little over 2% and the Euro Stoxx 50 by about the same. There have been glimmers of light from the Far East and a handful of emerging markets but in general sentiment is about as gloomy as the London weather.

Amid the focus on stocks it has been easy to lose track of what oil has been up to: the near Brent crude future has fallen by 12% this month and at under $44 is within a dollar of its low for the year so far. Now the collapse in the price of crude was the most important financial development of 2014 and its effects are still being felt in all sorts of ways today. (A lot of the weakness in UK equity has been attributable to the >30% fall in the All Share Oil & Gas index since September last year – and still the sector comprises about 10% of the whole market.) So what are the drivers of the oil price? What are its prospects? And what are its key influences likely to be in future?

Starting with the basics, world demand for crude oil stands at 95m barrels per day (bpd) on Energy Intelligence Group estimates. Supply is a little over 98m bpd. Overall, demand has risen by about 1m bpd per year over the last ten years, and has correlated almost perfectly (r = 0.94) with the World Bank estimate for global GDP over the last twenty. Since 1995 there has been an average excess of supply over demand of 0.2m bpd and supply too correlates near-perfectly with economic activity. The six month average excess of supply, however, now stands at 2.4m bpd: this is the highest it has been for at least 20 years (and possibly since the early 1970s – comparable data is hard to find).

It is easy to pin down what has changed. Demand over the last 12 months has risen exactly in line with the trend established since the end of the Great Recession. Supply, on the other hand, has been more volatile. Total world production flattened off in 2013 before accelerating during the second half of last year. (Since last September the average rate of growth in supply has been 53% higher than the average over the last six years.)

It is again easy to pin down the underlying production dynamics. The shale revolution in the US hit the oil market with a vengeance in 2012: total crude production in the USA has risen from about 5.8m bpd at the beginning of that year to 9.8m bpd today. Initially the shale boom effect was offset by supply constrictions elsewhere – some deliberate (Saudi Arabia), some long term (North Sea), others the result of chaos (Libya). Since last year, however, Saudi policy in particular has shifted, and it is this which has pushed the supply / demand balance to its present extreme.

So much for history. What of the future?

Starting specifically with futures, the market is currently pricing in a steady rise in Brent crude to about $50 over the next 12 months. This is a little unusual; the normal pattern over the recent past has been for the market to be “backwardated”, i.e. to be pricing in falls (the 12-month gap has averaged -$0.31 so far this century). Notable exceptions include 2005-6, when oil was treading a well-entrenched upward path; the recovery of 2009-10 which saw similar upward movement in the spot price; and today.

Turning to the outlook for supply and demand, it is clear that the latter will be driven by global activity and this is expected to continue to increase – and indeed to do so at a faster rate next year. Supply is a knottier area on which to take a view. One moving part is policy in Saudi Arabia and this is rather enigmatic. (Over the last five years it has also been worth 2m bpd of production.) The expectation that shale production in the US would fall away dramatically has not been borne out, clouding the outlook for this new source of crude as well: the States was producing about 0.5m bpd more last month than at the beginning of the year. At the same time, countries have been taking advantage of low prices to build their strategic reserves, and shipping companies have seen tanker business boom as a result of the unexpectedly robust activity.

Look forward however and supply can be expected to grow further. The prospects for Iranian oil exports in the wake of this year’s diplomacy are well established: Iranian production is about 1m bpd below where it was a few years ago and the Persians are expecting to increase exports by about that amount in 2016. Half a decade later there may be even bigger news with the development of the Great Rift Valley and the Uganda-Kenya Crude Oil Pipeline allowing the nascent east African oil industry to join the export market.

Before leaving the brass tacks of supply and demand it is worth observing that China has nothing to do with any of this. On IEA numbers Chinese demand for crude has grown very steadily over the last five years from about 8.5m to 11m bpd, and this at a time when her rate of economic growth has fallen in real terms from 10% to 7% per year. Neither current oil demand numbers nor the shape of the futures curve suggest that existing or imminent growth declines in the Chinese economy are responsible for the fall in oil prices beyond the transmission mechanism of market sentiment.

China aside: given the supply outlook it is difficult to make a short term bull case for crude. And that brings us on to the consequences of cheap oil as observed this year and as are priced in for the year to come.

Firstly the negatives: there will be casualties. If you are an oil exporter or a production company the value of your asset has gone down materially – bad news. On the other hand, oil importers have been experiencing a stimulus. In descending order by net import volume the Top Ten importers are the eurozone, the USA, China, Japan, India, South Korea, Singapore, Taiwan, Turkey and the UK. Macroeconomically, then, cheap oil has been great news for the Far East and most of the developed world.

As this blog has long observed the effects of oil on inflation will be transient unless the price continues to fall indefinitely. So when it comes to monetary policy oil has exerted an influence but this is almost certain to dissipate soon into next year.

In conclusion, the scale of the collapse in the price of oil has caused a lot of pain but has also been, and will continue to be a major benefit for key areas of the world economy. Saudi politics have been more important than Chinese economics in steering the market’s fundamentals. Cheap oil has kept inflation off the radar for a year, but this effect will fade.

The death of oil has long been exaggerated and recent events have disguised its importance. There might well be further surprises to come. But understanding what has happened already, which is all we have for sure, can often be enough – especially when it is disguised or even misunderstood.



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