Comment: Another lost decade in the making
Hopes for a successful global oil cut deal brokered for the first time in 15 years are fading, believes Julius Baer's Norbert Ruecker
In the second half of 2014, all possible drivers of the oil market started to point southwards. The shale boom as well as the Iraqi oil boom culminated in massive supply surge. Added to this, the temporary Libyan oil export surge in mid-2014 provided the tipping point for the market balance to shift from under to oversupply.
The main driving force of the slide in oil prices, however, was cost deflation. The initial slide in oil price pushed the industry from scarcity in workers, drilling rigs among others into abundance. And as such, costs deflated, which was augmented by weakening commodity currencies such as the rouble, the Norwegian Krone or the Canadian Dollar and impressive technology-related productivity gains within the shale industry.
Low oil prices have spurred demand but it was not enough to absorb all crude produced. As a result, unwanted oil went into storage, leading to record stockpiles of over 3bn barrels. Now, the main issue we are looking at is the supplies that have been building up for longer than expected. Today’s oversupply, and the oil slide, result from structural rather than cyclical reasons. In other words, the decline in oil prices was supply-driven, namely by the US shale boom, rather than driven by weak demand.
Earlier this year, concerns about global growth and the panic on financial markets were the main forces behind pushing market sentiment in the oil market to very depressed levels. Fear has indeed been a big element in keeping oil prices at the lows we have witnessed. Swings in market sentiment from bearish to bullish, pessimistic to optimistic and vice-versa have always been a driving force of commodity prices.
That said, the past weeks’ oil price rally was from our perspective less related to a shift in fundamentals but a recovery of sentiment. The market crowd lost its interest in the supply glut, although oil inventories continued to build in recent weeks and instead focussed on the early signs of declining US oil production. The latest futures market positioning data also shows that many hedge funds closed their bets on further falling prices indicating that the past day’s up-move was augmented by short-covering activity.
The stalemate – different players, different interests
Hopes were building up for a global agreement to cut oil production and positively impact the prices. In our perspective, an agreement between the KSA, Qatar, Venezuela and Russia to freeze production at January levels is tenuous as it would freeze - not cut - production, and vague as it is conditional to other producers joining.
The agreement leaves a sour taste, as the outlook for at least Russian and Venezuelan production was in any case flat at best for the year and also as KSA’s allies in the GCC, especially Kuwait and the UA,E are not co-brokering the deal. In terms of OPEC, there are too many opposing interests and views to come up with a credible deal. In fact, any petro-nation that will accept to cut supply will lose market share because either other petro-nations would not join, or should prices increase towards and above $50 per barrel, the shale producers should ramp up investments, and the shale boom would instantly resume.
Overall, we still believe that the prospects of orchestrated supply cuts remain dim, especially as Iran returns to the market claiming its historic share of the export pie after the lifting of sanctions in January. This return adds supplies at the wrong time; Iran’s production and export uptick compensates for the decline in US oil production, leaving the oil market balanced, and in other words still oversupplied.
However, even if there would be a credible supply cut agreement involving the Middle East and Russia, it could only partially offset the running dry of petro dollar cash flows, which increases the incentive to shirk any agreed supply cut. Shale operators would likely respond swiftly by increasing supplies to any significant uptick in oil prices towards and beyond $50 per barrel. This puts the supply cut rumours into perspective and reveals how the oil market has changed with the currently fading super cycle.
Another important country that continues to shape the oil market is China, which consumes more than 10mn barrels per day in a market of 95mn bpd. So China matters, less from an absolute perspective, but more from a growth perspective. Significant parts of future oil demand growth come from China and Southeast Asia more broadly, which is very much dependent on China’s economic well-being. This growth dependence explains why the oil market’s sentiment is closely related to China’s growth outlook and the concerns surrounding it. Global oil demand growth is pivotal to rebalance the oil market and erase the supply glut. Therefore, China matters although the US and Europe still are far bigger oil consumers.