OPEC, the 12-member group of oil producing countries, will meet in Vienna this Thursday, 25th of May. The market consensus is that they will agree to extend the production cuts implemented in January of this year. Members agreed to collectively cut production with the intention of rebalancing supply and demand by reducing output by 1.8 million barrels per day, thereby supporting the recovery in the price of oil. This was to be achieved over a six-month period from January to June.
Despite a higher-than-expected compliance of members with the agreed cuts, the price of oil is still slightly below the price at the inception of the cuts. OPEC stated they would be comfortable with prices between US$60 to US$70 per barrel and with the current price around US$50 per barrel, they are still some way off their target.
Headwinds to higher prices
The two major headwinds noted for a more sustained recovery in oil prices are non-OPEC producers and sluggish demand.
Non-OPEC producers, like the US and Russia, are playing an increasingly influential role in global energy markets. US shale oil producers (who bore the brunt of the kamikaze-like pricing strategy by OPEC from 2014 to 2016), have proven more resilient than many expected. Oil rig counts have recovered strongly from a low of 316 rigs to 742 at the more recent count.
These rigs are also more efficient and cost-effective than their predecessors, making US producers more competitive, allowing them to add to the global oil supply in ever increasing measure. January 2016 saw the US lifting their embargo on oil exports, further indicating that the US has thrown its hat into the international energy ring, and has come to play.
Much of the coverage in the oil space has focused on the supply side, with many overlooking the weakening demand side. The weakening demand can mostly be attributed to growing debt saturation, demographics and technological advances.
Famed hedge fund manager Ray Dalio, recently commented that we are at the end of a debt super cycle that started in the early 1980s. This is further evident in a saturated consumer, but many corporates are also carrying crippling debt loads that constrain capital expenditure. This is adding weight to deflationary pressures in the global economy. Furthermore, China has emerged as a swing importer of oil, having recently overtaken the US as the number one consumer of crude oil. Some observers have concerns over China as they struggle with credit problems and misallocation of capital during their blistering growth period. Their credit markets are also concerning many as their yield curve flattens and starts to invert.
The demographic problems are becoming a real issue not only for pension funds and governments, but the likes of the energy sector are also being impacted. As people age, their habits change; they drive less and also consume less. (Sometimes this is not by choice as can be seen with the pension problems currently unfolding in the US.)
Technology is also having a growing impact. From electric cars and alternative energy sources, more efficient energy storage and transfers, along with more efficient production methods and the ability to work remotely, reducing the need for travel.
A bullish case for crude oil can still be made over the long term. More than half a barrel of oil finds its way into a range of consumer items such as lipsticks to rugby boots, and as the middle class grows in Asian countries, like India and China, demand seems well-supported going forward.
The growing geopolitical importance of oil
Over recent years, oil has been at the heart of new economic alliances which has inevitably lead to geopolitical tensions pitting the old imperial powers of the West against the coming-of-age East. China, Russia and India have emerged as important participants in the oil story. Russia (as a swing producer) and China (as swing importer) as well as notable growth in consumption coming from India.
We have seen the formation of the BRICS group of countries that has lead to greater economic and political cooperation among its members, and an expansion of many trade deals through China’s economic initiatives of which the One Belt One Road (OBOR) is garnering much attention of late. It’s projected there will be 5000 cargo trains in operation between Europe and China by 2020. This threatens to marginalise America as the OBOR and related plans tied in Europe, Asia and some African countries. This also indirectly threatens the US Dollar as world reserve currency, as countries opt to trade more directly without added costs, leaving the US fighting to remain relevant.
The bets are currently bullish
Shorter term positioning in oil has become increasingly bullish and the price has rallied sharply in the lead-up to the OPEC meeting. It may be a classic case of “buy the rumour and sell the fact” in the weeks ahead, as it seems unlikely that the supply and demand dynamics weighing on markets can be fixed that easily. Should OPEC spring a surprise on the markets, we could certainly see prices react higher. However, it may be short lived, as non-OPEC producers could step in to fill the gap.
Historically, there has been a relatively high correlation between the performance of US stock indices such as the S&P 500 and crude oil. Oil has been lagging and equities that are currently trading near their highs, may suggest that either crude oil will play catch up or that we may be due for a correction in equities.