Commodities were at the heart of investor concerns throughout last year and these concerns have become even more acute entering into 2016.
Thus far in January, oil has extended its losses, amid deteriorating investor sentiment due to the weaker CNY and renewed global growth concerns (chart 1). This despite the fact that its oversupply started to decline in the latter half of 2015, on the back of falling US shale output and resilient demand. Market drivers appear, however, to have shifted from US production to the Middle East. A drop in the oil price below USD 30/bbl (the lowest level since mid-2004) could have consequences for producers and markets that cannot be ignored, leading us to review the case. While we continue to foresee an eventual oil price equilibrium at higher levels (around USD 55/bbl), set by the marginal cost of the US shale industry, we must acknowledge that strong headwinds are blowing in the short term, in turn likely to fuel persistent volatility during the quarter to come.
Chart: Fall in crude oil prices
While we (and the market as a whole) had no strong expectations regarding last December’s OPEC meeting, the lack of guidance on a production quota did underline the discord between country members, sending oil prices into free fall. Communication suggesting that some members were ready to talk to other global producers in order to achieve “fair prices” supported oil in the days leading into the meeting, but Saudi Arabia’s focus on market share gains precluded any production cut. With most other members currently producing at full capacity, the Kingdom holds the key to the pace of OPEC supply. And, with US shale output just starting to subside (see below), it is not in its interest to balance the market on its own. True, Gulf Sovereign Wealth Funds (SWF) experienced severe losses in 2015 (Chart 2) and the Saudi Arabian 2016 budget emphasizes a commitment to fiscal consolidation, with a drop in the fiscal breakeven price from USD 106/bbl to USD 96/bbl. But there is no hurry to support prices: we compute that Saudi Arabia could maintain its current budget expenses for 4 years with prices around USD 55/bbl – or 3 years around USD 35/bbl.
Chart: Saudi Arabia selling reserves
Another negative outcome of the OPEC meeting was the absence of an agreement about how to accommodate higher Iranian production (the decision was deferred to the next meeting in June 2016). Much has been said about the return of Iran production, but the visibility on its actual capacity remains limited (estimates range from 300 Kbbl/day to 1 Mbbl/day by the end of 2016), meaning that related uncertainties will continue throughout this year. In addition, given recent geopolitical escalation, we see little likelihood of Saudi Arabia limiting its own production so as to facilitate the return of its long-dated rival into the oil market. All told, we would be very surprised to see the OPEC taking action to support prices.
Operational stress on storage capacity
Almost two years of over-supply, combined with warm weather in both the US and Europe, has driven inventories to historically high levels, with further build-up likely during the winter (Chart 3). Historic precedents of commodity shock suggest a maximum duration of two years, ultimately cleared via a price collapse to production costs once the oversupply breaches logistical and storage capacity. As such, a first step would be the reopening of floating storage arbitrage. The second step would be to experience oil prices near cash costs, eventually forcing production to align with demand, as occurred in 1986 and 1998. Uncertainties as to available storage capacities and the actual level of cash costs (estimates vary between USD 5/bbl and USD 30/bbl, or even USD 40/bbl for some Canadian oil sands producers) complicate the equation. Given uncertainties regarding the market balancing mechanism, particularly with OPEC action highly unlikely, a scenario in which global balance is achieved through a price fall to cash costs cannot be totally ruled out.
Chart: US crude inventories bn bbl
Renewed global growth concerns
The start of 2016 saw a further deterioration in risk sentiment, due to the weaker CNY and Chinese equity market sell-off. Commodity markets were not spared. We view this market reaction as overdone, since China remains well supported by fiscal and monetary policies as well as the on-going credit cycle. It is premature to bet on a hard landing. Globally, we continue to expect slow but stable economic growth – the cycle is not yet coming to an end. Indeed, we expect current dynamics in the US to hold up, with a weak manufacturing sector, strong tertiary activities and robust employment. As for the Eurozone, the latest data (PMI and sentiment indicators) confirm that the recovery is well on track.
Medium term outlook: oil price to drift up to a higher equilibrium
Medium-term, we maintain our scenario of a gradual reduction in the supply glut (see chart 4) and an equilibrium price set by the swing producer, i.e. by the marginal production cost of the US shale industry (Chart 5). The longer the oil price remains low, the larger are likely to be the cuts in this sector’s capital expenditures and, in turn, US production particularly since the shale industry investment cycle is rather short relative to that of conventional peers. In addition, more than 50% of the high yield energy sector is already in distressed territory and the default rate can only increase as hedging strategies and potential credit lines come to an end. That said, an important point should be borne in mind as regards the US shale industry: it has the ability to adapt very quickly and has cut its costs over the past months (recent studies point to a 20% year-on-year decrease in some cases), enabling most companies to continue to produce even at current oil price levels. Acknowledging such cost deflation, oil price equilibrium might be now closer to USD 55/bbl.
On the demand side, we expect resiliency in 2016 given our scenario of stable global growth and the lagged consumption boost from low oil prices (an effect that is, however, likely to vanish as the year proceeds). For now, US vehicle miles travelled, a leading indicator of US demand, remain at 10-year record levels.
Chart: World supply and demand for crude
Investor positioning across the energy complex continues to send mixed messages, and we think that positive price momentum should originate from a significant decline in US shale oil output, potentially triggered by production shut-down announcements. While the trend is clearly already underway, all-time high inventories make for a definite headwind, particularly giving the pending negative seasonality, suggesting that our scenario might take longer to materialise. Last but not least, one should not underestimate the spill over effects from US dollar strength. The final phase of the USD/commodity shock should be felt during the first three or four months of this year. As such, oil prices could have a little more downside in the near term, but we see this as part of a broad bottoming process. Oil should then be able to drift higher over the remainder of 2016. Let us not forget that, in both above-mentioned historical precedents (1986 and 1998), prices doubled over the 12 months following the trough.
Global market implications
- Commodities: We reiterate our bearish view on the commodity complex. Regarding Energy, we remain cautious given short-term risks and uncertainties surrounding the timing of the eventual rebound. The risk/reward of a direct exposure seems unattractive today when taking into account the strong contango currently witnessed on the forward curves.
- Risk exposure: For now, market participants seem more inclined to price in the disruptions in the oil industry than the boost in consumption that ought to follow from the collapse in oil prices. Oil prices stabilisation is a prerequisite for greater risk-taking in portfolios.
- Even with an oil rebound to our target, the US high yield energy sector should remain under pressure, due to accelerating defaults.
- An eventual oil price rebound puts upside risk on yields, given that inflation expectations are currently dampened by low commodity prices. We thus recently upgraded TIPS in our asset allocation.
- Emerging currencies and assets will stay volatile so long as oil prices have not bottomed: selectivity remains key.
Sophie Chardon is a member of the Asset Allocation Team for Private Banking at Lombard Odier