Towards the middle of the current trading year, a glut ridden oil market had started showing some signs of rebalancing. Decline in US oil production was being reflected in the data, much to the delight of the Organization of Petroleum Exporting Countries (OPEC).
So when the oil producers’ collective met at its Viennese Headquarters in June, there was some degree of satisfaction that a policy of keeping the taps open was finally hurting US shale. As such OPEC did what it has done since the supply glut came into view in July 2014, i.e. do nothing and offer no indication of its official production quota. The Saudis were even unofficially prepared to factor in Iranian insistence on pumping as much oil as they would like, as the summit reached a rather amicable end.
OPEC was not alone; the oil market was on its way to a slow, painful rebalancing towards the first quarter of 2017 in the eyes of many.
Much of the rebalancing sentiment still remains predicated on global demand growth forecasts, by OPEC, International Energy Agency and others in the range of 1.2 to 1.4 million barrels per day (bpd) for much of this year and early next year, and lower non-OPEC, especially US production. Outages in Colombia and Canada also lent further support about spare capacity diminishing.
But last month, just as these outages were showing signs of being resolved, Brexit amplified economic concerns over the European Union, with the bloc already grappling with an Italian Banks crisis, multiple terrorism threats and the never ending Greek debt tragedy.
China’s growth, already below 7% if official statistics are to be believed, is likely to stay there and its oil demand growth will not be anything like it was at the turn of the current decade. Japan and South Korea, two other major importers are also grappling with their own macroeconomic concerns, with Japanese oil imports at historic lows. Only India is offering some crumb of support, but even that is currently being questioned. Analysts at Morgan Stanley say that while the country remains a bright spot for demand, the growth is of a lower quality.
In a note to clients, they noted: “Less valuable products and an industrial petrochemical boom are lifting total oil demand, more so than high value transportation. In other words, decelerating demand for transport fuels is masked by growing demand for other products.
“Moreover, June data show a pullback in demand, which could continue to trend lower seasonally. Demand for transport fuels overall has been lackluster of late and grew by 2.3% year-on-year (yoy), the slowest rate since 2013. Gasoline led the decline, as demand was up only 4.5% yoy, the slowest rate in five years. Above average rainfall could also be a problem for gasoline and diesel.”
In short, there are now multiple concerns over oil demand. Beyond India, gasoline and diesel gluts have started emerging both in Asia Pacific (thanks to Chinese refiners cracking crude at a hectic pace) and in the US (with cheap Iraqi oil imports being cracked with much gusto by East Coast refiners).
Weighted average fiscal breakevens of selected OPEC oil producers (Graph: Natixis)
Additionally, there are signs US and Canadian players are getting comfortable with the idea of managing production in the $40-50 range, with the Baker Hughes rig count registering modest upticks in the operational rig counts of both countries for five successive weeks. If this is reflected in the rig counts for much of the third quarter, then it is pretty much guaranteed that Middle Eastern OPEC exporters would respond the only way they know - by pumping up their volumes.
As in the past, the move is likely to be as much about turf wars, as it would be about monetizing more of their barrels with the finances of most of these states suffering in the wake of the slump, and oil still lurking considerably below the average fiscal breakevens they crave for balancing their budgets, according Natixis (see chart above). Had Venezuela been included, we'd have a fiscal balancing price of well above $120.
Worst case scenario in such an event points to another mini glut. Already, the Saudis and Russians appear to be pumping more than the market anticipates. However, as oil almost always becomes a story of demand, India’s appetite alone cannot sustain price recovery at a pan-global level.
Under current macroeconomic climate, so assuming demand growth is in the region of 800,000 bpd (as Morgan Stanley forecasts) to 1.1 million bpd (as Barclays forecasts) and oil producers return to yet another turf war taking the oil surplus back above 2.25 million bpd – it would throw rebalancing right out of the window.
Agreed, 3 million bpd and above surplus of 2015 would not be replicated as some independent producers have been fatally wounded. However, even a glut of this size would be a sizeable drag on the oil price. I have maintained for much of the year that the oil price is likely to lurk in $40-50 range for some time yet. Should demand side fears escalate, we’d still stay largely within this range, with the only difference being that instead of touching $50 by Christmas, we could be struggling to stay above $40. Don’t unleash those thoughts of the worst being over for the oil markets just yet.
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The above commentary is meant to stimulate discussion based on the author’s opinion and analysis. It is not solicitation, recommendation or investment advice to trade oil and gas futures, options or products. Oil and gas markets can be highly volatile and opinions in the sector may change instantaneously and without notice.
