Should we be shorting oil?

The recovery in oil prices, since their dramatic collapse over 2014 and 2015, has been one of the major drivers of the global economy. Since their low point in January 2016, oil prices have more than doubled, with about half of the increase coming over the last year.

Over recent weeks, the surge in oil prices has stabilised, with the Brent crude price trading around US$70/bbl as the market paused to assess the next phase of price moves in the commodity. In this week’s Brief, we assess the recent drivers of the price of oil and offer our views on the next phase in the oil price cycle.

We begin with a review of the surge in prices over 2017. Over the last year, both supply and demand factors are behind the strength in oil prices.

On the supply side, we have seen a continuation of OPEC production agreements (that have restricted supply from the cartel), a rapid decline in Venezuelan supply and a pause in the growth of US oil rigs limiting the growth in oil production. On the demand side, colder-than-usual northern hemisphere winters have conspired to drive the demand for oil at a rapid clip, while the weaker US dollar has also supported oil prices.

But perhaps most importantly, the upswing in oil prices has coincided with the recovery in global manufacturing activity, industrial production, global trade, and a broader rally in industrial commodity prices. In many ways, the upswing in the oil price represents a reversal in direction of many of the factors that caused the oil price to collapse including, on the supply side, US shale production and OPEC production expansion and, on the demand side, the weakness in global economic growth.

Now that oil prices have paused at around US$70/bbl, where to from here? We expect oil prices to fall back from their current high levels, towards a value of Brent of US$56/bbl by 2018Q3.

Why won’t current oil prices be sustained? Both major commodity research groups, the International Energy Agency (IEA) and the Energy Information Agency, forecast the oil balance to move into a supply surplus in 2018; mainly due to strong growth in US crude oil output. The IEA expects US crude oil production to average more than 10mbpd in 2018; the highest on record and overtaking Saudi Arabia and rivalling Russia to become the largest oil producer in the world.

Furthermore, on the supply-side, it is unlikely that Venezuelan oil production will continue its rapid decline. While it is not likely that Venezuelan production will recover rapidly, simply halting the decline in production will ease one chief headwind to global oil supply.

On the demand-side, while we expect robust global economic growth in 2018, we see global growth plateauing at just under 4%. The stabilisation in global economic growth will ease pressure on growth in oil demand.

If we do see greater-than-expected oil demand growth (and higher prices), this increases the risk of bringing on more supply and exacerbating the supply overhang that is currently emerging. Therefore, a steady increase in the growth rate of oil supply as the growth rate in demand peaks, will ease pressure on oil prices over 2018.

Central banks typically ignore fluctuations over a normal cycle of oil prices. However, very large shifts in the commodity’s price can prove to be a destabilising force on inflation expectations, as emerged during 2014/15.

The most recent collapse in oil prices and the sudden decline in inflation expectations forced the hands of some central banks, such as the European Central Bank and the Bank of Japan; both of which were driven to ongoing rounds of quantitative easing in order to arrest a slide into deflation. However, a correction of oil prices from around US$70/bbl to US$55/bbl is mild compared to the correction of 2014/15. Our view is that a modest correction in oil prices would not deter central banks around the world from gradually tightening monetary policy over 2018 and 2019.

 

 Table 1: Financial market movements, 24 January – 1 February 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,822.0

-0.5%

US

2.79%

14.3 bps

US Dollar Index (DXY)

88.67

-0.6%

Nikkei 225

23,486.1

-1.9%

Japan

0.10%

1.6 bps

USD-JPY

109.40

0.2%

FTSE 100

7,490.4

-2.0%

UK

1.53%

12.4 bps

GBP-USD

1.426

0.2%

DAX

13,003.9

-3.1%

Germany

0.72%

13.3 bps

EUR-USD

1.251

0.8%

S&P/ASX 200

6,090.1

0.6%

Australia

2.81%

-2.0 bps

AUD-USD

0.804

-0.3%

 

For Economic update by region, click here.

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