Outlook July 2018: Striking oil troubles
“My formula for success is rise early, work late, and strike oil.”
– John Paul Getty, American oil magnate and art collector.
- The oil price has risen in short order from $50 to $78 and Russia and Saudi Arabia are the big winners. India, China and the US are the losers and American voters are getting angrier at the high price of fuel.
- Oil forecasts vary widely, with predicted demand peaks ranging from 2023 to 2070. The uncertainty is also a hotbed of volatility in interest rates, equity markets and exchange rates.
- Higher interest rates stir up anxiety in the market, but are not necessarily bad for the equity market. Historically, equities tend to initially perform well when interest rates begin to rise, because rising rates are a sign of a good economy.
- The US economy is continuing to strengthen, but signs of a slowdown in China are causing some concern that the emerging markets will not be able to maintain the high growth previously demonstrated.
- Nevertheless, we have chosen to moderate the level of risk in our allocation somewhat and prefer global equities over emerging markets.
The louder rhetoric in the trade policy area right now is exacerbating nervousness in equity markets worldwide. The risk of an expanded trade war has put a wet blanket on optimism. Higher profits have resulted in lower market caps, equities as an asset class are more attractive now than they were a few months ago. Volatility is rising in the market and the American 10-year government bond rate has tested the 3 percent level. We have had falling interest rates for many years and now that we are seeing the first tentative steps towards leaving the low-rate environment, it is naturally causing some turbulence.
Long-term bond rates are highly significant and the market is trying to interpret the signals from the Federal Reserve. Changes in the American 10-year government bond rate have immediate impact on the US real economy. The costs of borrowing rise for both businesses and consumers. The long rate is also considered a key indicator.
As expected, the Federal Reserve raised its benchmark interest rate in June by 25 points to a range between 1.75 and 2.0 percent, the seventh increase since 2015. In line with the communicated rate path, a further two increases are expected during the year. There are many indications that the Fed will continue to hike rates relatively quickly due to rising inflation, which should mean that long rates will also keep going up.
Are higher interest rates bad for equities? Higher interest rates make fixed income investments more interesting as an alternative to equities if, for example, interest income is higher than dividend yield. Higher interest rates also have negative impact on stock valuations because the discount rate rises and thus results in lower present values for future profits.
Historically, equities tend to initially perform well when interest rates begin to rise, because rising rates are a sign of a good economy.
Many of the economic indicators show that there is still good demand in the economy and that growth is holding on. But for many markets, it seems that the PMI (purchasing managers’ indices) have reached their peak, although they are still recording high levels and thus indicate continued growth. The problem is more that the market is always one step ahead and although the slowdown may be of a temporary nature the nervousness is enough to create passivity and volatility in the market. We are seeing an increasingly strong US economy, but also signs of a slowdown in China that are generating some concern that the emerging markets will not be able to maintain the high growth previously demonstrated.
Oil peak in 2023 – or 2070
The oil producers’ cartel OPEC’s production agreement has been in effect since November 2016 and has achieved the desired impact. The oil price has risen from $50 per barrel to $78. Why, then, should investors be interested in the oil market? In an increasingly connected and integrated world, the oil price plays a key role. Oil supply and demand are of major importance geopolitically, but also through their impact on interest rates, equity markets, exchange rates and risk appetite.
Making oil forecasts is not exactly a doddle. When one reads various analyses, the size of the discrepancies in long-term oil forecasts is striking. Some experts argue that total demand for oil will peak by 2023, while others believe it will peak around 2070. The lack of consensus generates problems and serious uncertainty with regard to estimates and execution of long-term oil projects.
At the latest oil meeting in Vienna on 22 June, OPEC decided to increase production by about one million barrels a day, starting in July. Due to the limited capacity of several OPEC countries, the actual production increase is expected to be about 600,000 barrels a day. The production increase also applies to allied oil producers (OPEC+), including Russia. The news propped up the oil price.
Making oil forecasts is not exactly a doddle.
Iran and Venezuela have previously opposed the move, which is perhaps understandable, considering that they would have difficulties increasing production. Russia, which is not a member of OPEC but participated in the meeting, had already expressed its support for the proposal. Ahead of the meeting, there were many voices raised in an attempt to influence the oil cartel and promote increased production.
Perhaps unsurprisingly, these views were expressed mainly by the major oil consumers like India, the US and China. President Donald Trump exerted direct pressure on Saudi Arabia and made it clear ahead of the OPEC meeting that significant production increases were expected. The US gasoline price is relatively high and the president surely wants to keep it from going above 3 dollars a gallon, which is about the level at which pain at the pump becomes unsustainable for his base and where most people think fuel has become too expensive.
The main winners who can benefit from the production increase are Saudi Arabia and Russia, which have spare capacity. But there are also strong reasons for keeping the oil price at a high level. According to calculations by the IMF, Saudi Arabia needs an oil price of $70 per barrel to achieve budgetary breakeven, which may explain why they prefer a high oil price over volume. The breakeven level for other OPEC member countries is considerably lower, at $60 per barrel on average.
According to the latest report from OPEC, global demand for oil amounts to 98.85 mb/d (millions of barrels per day, according to the forecast for 2018), an increase by 1.7 percent or 1.65 mb/d since 2017. According to preliminary data for May, the global supply of oil increased by 1.74 mb/d on an annual basis to 97.86 mb/d. OPEC’s share of global oil production is about 33 percent. OPEC and allied oil producers (OPEC+: Russia, Oman, Mexico, etc.) control about 55 percent of global supply.
American shale oil producers are expected to further increase production, but are being held back by factors including problems with the infrastructure. Oil pipelines from the vast Permian Basin have, at least temporarily, reached their capacity ceiling. At the least, this will moderate and limit growth in the short term.
Normally, the US dollar is negatively correlated with the oil price, but there are periods when this correlation is relatively weak. This year, the dollar and the oil price have moved in tandem. The dollar has appreciated by 3 percent so far this year and the Brent oil price has risen by 16 percent during the same period.
To sum up the whole, we can split the factors between two scale pans. The factors that support a rising oil price include strong global demand, limited overcapacity, capacity disruptions in the Permian Basin and a stronger Saudi Arabia that is setting the agenda. In the negative pan, we see strong growth of American shale oil, high American gasoline prices and a strong dollar.