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Brexit: fear and volatility

The UK will probably vote to stay – but until that’s clear, markets will gyrate

OIL markets have been volatile ahead of the UK's 23 June vote on whether to leave the EU, buffeted by the vagaries of a campaign that has seen both sides claim and surrender the popular advantage repeatedly.

A week before the vote, Brent dropped to as low as $47 a barrel, shedding the gains that had taken it to seven-month highs above $50 in late May. Brexit seemed to be on the cards, and the market was worried by the macro-economic implications.

But then the polls shifted. On the eve of the vote, with the remain camp perceived to be back in charge, Brent was up again, ticking above $51/b.

Why does the Brexit vote matter to oil markets?

Think macro. Janet Yellen, chair of the US Federal Reserve, and Mario Draghi, the European Central Bank president, have both warned that a vote to leave would have a disastrous impact on the global economy, triggering capital flight from the world’s fifth-largest economy and hurting the Eurozone, to boot. Europe’s economy is growing quickly again, after years of trouble. The last thing its big economies and the rest of the EU need is a messy divorce to overwhelm the recovery.

 

Europe’s economy is growing quickly again, after years of trouble. The last thing its big economies and the rest of the EU need is a messy divorce

Yellen thinks Brexit would cause a “risk-off” flight by money managers into the perceived safety of US assets. This is another big problem for oil prices: in driving up the value of the US dollar, this would be expected to weaken crude prices on both sides of the Atlantic. Some analysts expect Brent futures would drop to the low $40s. Like the EU economy, oil producers don’t want Brexit to snuff out their own recovery just as it seems to be gathering steam.

Don’t ignore the impact on the UK economy of Brexit either – and the follow-through consequences for the country’s oil demand. Many economists think a Brexit vote would be followed by a recession in OECD Europe’s third-biggest oil consumer. This isn’t to be taken lightly. As the global financial crisis gathered steam, and the UK’s services-oriented economy slowed, its oil consumption did too. By 2012, the UK consumed around 1.5m barrels a day, down from around 1.8m b/d in 2006. A sharp fall in the value of the pound – inevitable in the event of Brexit, believe most forecasters – would also make gasoline and diesel more expensive.

If Brexit hurt the rest of Europe’s economy, too, the impact on oil demand would widen. Slow growth and recession between 2006 and 2015 has already sliced about 2m b/d of demand from European and Eurasian economies.

The impact for the North Sea, though, is mixed. For operators, a post-Brexit weaker pound might actually trim operating costs. Foreign-exchange relief would, though, be marginal – and probably insufficient to tempt big upstream investors back to the North Sea’s ageing, high-cost fields. Some might worry about the tax regime too. If Brexit shrinks the UK’s economy, tax-revenue will be lower. Finance minister George Osborne has already warned that the government would raise some taxes to cope. Would tax breaks in place for the North Sea survive? Like much else with a post-Brexit UK economy, no one can really say.

Would tax breaks in place for the North Sea survive? Like much else with a post-Brexit UK economy, no one can really say

For all the fear in the market, though, any Brexit-related price fall will probably be short-lived and overtaken by broader forces. Production outages and the sharp pull back in upstream activity mean global oil output in May was about 0.6m b/d lower than a year before, the first significant drop since early 2013.

Assuming global demand grows by the forecast 1.3m b/d this year (and is resistant to a Brexit macro shock), the market will soon start to tighten. Those fundamentals are reason to expect a price recovery, whatever the UK decides.

“If there is a Brexit, the negative pressure on oil prices would be driven by risk aversion, not fundamentals,” Societe Generale, a bank, said in a recent report. “The dramatic shift from an oversupplied to a balanced market – which is currently taking place – would overwhelm the small fundamental impact of slightly weaker demand due to currency effects.”

The bank added that while a vote for Brexit would cause weakness at the front of the Brent futures curve (a price drop of around 5%, it reckons), it expects any weakness to be temporary.

Whatever happens, equity and commodity markets are in for a busy end of week as they digest the result. It will be a volatile few days for traders. As the world’s most famous currency speculator George Soros said recently, Brexit will make a lot of people rich, even if it makes the UK poorer.

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