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Bottoming out: the fragile recovery of the oil market

The good news is that the fundamentals should start to improve. But speculation abounds that oil could get caught in the wider market downdraft

For anyone in the industry the numbers barely need restating. Brent, now down almost 75% since mid-2014, suddenly looks as likely to test $20 a barrel as it does to begin a recovery. Fear of a lasting depression has gripped the industry. Saudi Arabia is battening down the hatches, adjusting its economy to cope with a prolonged slump. BP boss Bob Dudley, who has been sacking North Sea workers with abandon, says things look a lot like 1986. Talk to hard-pressed oilmen in Alberta, home to the world’s third-largest trove of oil but also its highest-cost barrel, and the gloom is contagious. Some producers in the oil sands, where wellhead prices struggle to reach $12/b, are running at a deep loss. Many conventional drillers, still pumping to convince lenders they can operate their asset, are near bankruptcy. Only the brave are yet willing to gamble on a revival in Alberta’s oil patch.

Eighteen months in the making, oil’s dive should be nearing its nadir. Yet even optimists see more short-term pain before non-Opec production starts to contract, stocks retreat, supply and demand approach equilibrium and the market tightens. This is expected in the second half of 2016.  But macroeconomic headwinds are now building. Even if the market’s fundamentals improve, oil could be caught in the backdraft of wider financial distress, stalling the price recovery.  

Supply and demand still offer a bearish picture that is likely to last for the next few months. In January, the International Energy Agency (IEA) said OECD stocks, now almost 3bn barrels, had built for nine consecutive months, leaving the rich-world’s inventory about 300m barrels above the five-year average. The agency expects global stocks will build by another 285m barrels in 2016, implying an average oversupply through the year of about 0.78m barrels a day, mostly weighted to the first half of the year.

This looseness in the market mostly explains the price collapse in the fourth quarter of 2015 and the beginning of 2016, in which Brent dropped from October highs above $50/b to sub-$30/b lows as Petroleum Economist went to press. For Q4 as a whole, the oversupply came in at 1.83m b/d above the quarter’s demand – about the equivalent of Nigeria’s entire output, pumping straight into storage.

Despite the price, production continues to grow, albeit at a slower pace. In December global output was 0.6m b/d higher than a year before. Even in high-cost regions like Alberta’s oil sands, fresh barrels are hitting the market – the legacy of decisions on long-term projects taken when prices were buoyant and optimism high. The North Sea is holding on: Norway took output above 2m b/d in October for the first time since 2012, according to the IEA. Even the UK’s battered oil sector, where sackings are announced by the day, increased production. The resilience of Russia’s oil sector in the face of sanctions and the price collapse continues to defy expectations.

Free-market anarchism

Having abandoned even its nominal output ceiling in December, Opec is pumping at will. Production is now 32.28m b/d (including Indonesia) – a level that will only come into line with demand for its crude by the end of the year, the IEA says. Having watched the group’s basket price lose almost $10/b, to $22.48, in the first 20 days of January, Venezuela sent an official letter to Vienna asking the secretariat to arrange an emergency meeting. It won’t happen. Saudi Arabia remains committed to its policy of letting the market find the floor. Cutting now would subsidise non-Opec output and make the whole plan of the past year – to restore group market share – a meaningless and costly mistake. Anything short of shock-and-awe cuts like those agreed in Oran in December 2008, when the group removed 4.2m b/d from supply, would be rumbled by a sceptical market. Nothing of the kind is mind now. “It would be far worse if they met and decided to do nothing,” says an Opec insider.  

Saudi Arabia will hold fast at least until it knows how much oil Iran adds to the market this year. Iran’s oil minister, Bijan Namdar Zangeneh, has said his country will not consider cuts until it has restored pre-sanctions production capacity of 3.7m b/d. So it is unthinkable for Riyadh to cut and make room for its rival. Instead, the kingdom is preparing for prolonged strain. It has increased domestic fuel prices and announced plans to tap international bond markets to raise debt. The deputy crown prince, Mohammed bin Salman, has even talked of listing part of Saudi Aramco– an unlikely move, but another signal that the kingdom is thinking of other measures than market intervention to beef up its budget.

Iran and Libya both still offer downside risks to prices. If Iran comes good on its immediate plan to lift output by 0.5m b/d now that the sanctions have been lifted and double this by year-end, this supply alone would more than account for the 0.6m b/d or so the IEA expects to be lost from non-Opec production. Worse still, Iran will need to discount its barrels to place them, exacerbating a price war that has seen Saudi Arabia, Kuwait and Iraq offer cheap cargoes. In January, state company Nioc was already offering European buyers shipments at discounts of $4.85-6.55/b to Brent. Any partial recovery in Libyan output – hamstrung by political dysfunction and Islamic State’s control of the producing centre – would also weigh on prices, especially in the Brent market. 

Producers elsewhere can cling to the uncertainties in these outlooks. Iran may struggle to lift production as quickly as it – or the market – expects: 300,000 b/d, not 0.5m b/d, looks more likely in the coming months, and Iran may struggle to best even the higher number by year-end. Much of its stored oil is condensates, which will be more difficult to market. Nor should the short-term storage release and some production gains at fields where Nioc has been preparing for the embargo’s end mask difficulties to come. Once the early flush is over, international investment will be needed; and hazy contract terms, bureaucratic stasis and pushback from Revolutionary Guards and others who did well in the sanctions-era “resistance economy” can be expected to slow the upstream opening. In the meantime, though, whatever volumes come from Iran will be entering the market just as it needs even less crude. Refinery turnarounds in Q2 2016 will reduce crude demand by as much as 3m b/d, says Citi, a bank.

The clearing process

As Opec’s supply rises with Iran’s return in the coming months, market balance can only emerge from a contraction outside the group or higher-than-expected demand growth. Of these, the supply-side offers a better case for bulls. Opec expects 0.66m b/d to be wiped from non-Opec production in 2016 – “the year when the rebalancing process starts”. Citing consultancy Rystad Energy, the group pointed to postponements affecting 62 megaprojects, or $222bn of spending, since the price collapse began. But this may be too low. While Opec expects US oil production to fall by 380,000 b/d this year, the US’ Energy Information Administration (EIA) sees a drop of almost 0.7m b/d. Opec also forecasts flat output in China, but domestic producers are already cutting back. Opec also sees no material drop in Russian production in 2016 – in line with most forecasts. But the sector’s gravity-defying act so far is unlikely to last as tax hikes, sanctions and weak prices start to bite. 

Rosneft’sand Lukoil’s production began to slip last year. Chris Weafer, a founding partner of Moscow-based advisory firm Macro-Advisory, believes Russian output will drop by 300,000 b/d in 2016.

These supply losses could amount to output cuts of around 1m b/d from just two countries, plus smaller falls in Asia and Central Asia, bringing some balance to the market in the second half of 2016. Stocks would remain high, but the disappearance of the daily supply overhang could be expected to shift sentiment. For now, speculators remain deeply bearish, and again reduced their net-long positions in the market during the first few weeks of 2016. But money managers’ positions – and market sentiment – will switch quickly if signs of rebalancing emerge.

The problem at that point would shift to demand, where new doubts are suddenly appearing. Lacklustre consumption growth bears some responsibility for the steep price falls in January. Warm winter weather in the northern hemisphere hasn’t helped. But even if normal conditions resume, the 1.2m b/d of global demand growth expected for 2016 is disappointing, suggesting that the consumer reaction to price weakness already happened last year, when demand rose by 1.8m b/d.

Averaged over two years, demand growth of 1.5m b/d looks less worrying. But the forecasts for 2016 came in before the latest macroeconomic headwinds started to shake equity markets. Two demand-side threats to oil’s recovery this year are now visible. 

China’s transition is the biggest of these. Its stock farms are now thought to be full – until new capacity is built – which on its own implies between 100,000 and 300,000 b/d of lost imports compared with last year. Worse are the data showing the impact of slowing industrial activity. Despite some strength in gasoline and jet-fuel consumption, total oil-products demand is expected to rise by just 3% this year, or 300,000 b/d, says the IEA. That’s all modelled into the agency’s global forecast. But the recent equity and currency losses – the latter making oil imports more expensive – have not been factored in. If the deceleration of Chinese oil demand in Q4 2015, when year-on-year growth came in at 200,000 b/d compared with around 0.8m b/d in the preceding quarters, persists through this year Chinese consumption will be even softer than expected. Even the IEA’s Q4 numbers may be too high. Platts, a pricing agency, estimates that Chinese oil demand grew by just 1.5% in November compared with a year earlier. 

The second threat comes from oil producers themselves. After last year’s recovery, crude demand is flatlining again in advanced economies; so, alongside China, the second pillar of global oil-consumption growth is emerging economies. But the combination of slumping GDP and spending power, alongside some energy-subsidy cuts, should hurt demand in this segment.

December’s cuts to subsidies in Saudi Arabia, among those in other Gulf Arab states, means consumption in the region will only grow by 1% this year, according to the IEA. But the subsidies will continue to be cut over the next five years too, points out Apicorp, a bank. So deeper adjustments from profligate consumers may be in store. Seth Kleinman, global head of energy strategy at Citi, argues that the impact of emerging market (EM) GDP weakness on demand continues to be underestimated. As it downgraded global growth forecasts for 2016, from 3.6% to 3.4%, the IMF noted that the outlook for EMs is “in many cases challenging”. GDP in Latin America will contract in 2016 and Russia will remain in recession; and growth will slow in sub-Saharan Africa. Further tightening by the US Federal Reserve this year, strengthening the dollar, will make oil more expensive for any net-oil importer too. As Ed Morse, Citi’s head of commodities research, noted recently, “new global forces appear to be driving down demand for commodities, promising to prolong the time it will take for commodities to come back into balance”.

For oil, this means that as supplies start to contract this year a price reaction may depend on consumers. If projections of 1.2m b/d demand growth hold, the market should see some sort of balance as the upstream starts to wither. Marginal producers are losing money on every barrel they sell, so the bottom is close. But if weakening macroeconomic conditions prevail in the coming months, further dimming global growth prospects, oil’s recovery will be slower and more fragile than hoped.

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