The oil market has come under strain over the last few weeks, with selling pressure intensifying in May amid a spike in volatility. Earlier this month crude prices dropped to the bottom of their six-month range, erasing virtually all the gains recorded since OPEC’s Vienna deal, before stabilising around $50. What is the broader macro message from this price action? Why now? And what comes next?
The soft tone in bellwether commodities since mid-March is evidence of the reflation trade running out of steam. Industrial metal prices have stayed on the back foot, the dollar has weakened, sovereign yields have declined and the advance in global inflation expectations has stalled. Elevated survey readings have lowered the bar for disappointment and, with hard data coming in more mixed of late, economic surprise indices have turned lower. Prolonged uncertainty over the specifics of US fiscal policy has also weighed on sentiment. Earnings growth was strong in Q1, yet the S&P 500 has failed to break higher and market breadth is relatively narrow.
In addition, weaker Chinese manufacturing PMIs and signs of hawkish monetary fine-tuning by the PBoC have sown renewed concerns over the durability of the global industrial cycle, weighing somewhat on EM currencies since mid-April. At the same time, the yen has rebounded in 2017 and expectations of a progressively less accommodative ECB have buoyed the euro, pulling the Dollar index (DXY) down from multi-year highs. Oil continues to track well the relative performance between these ‘two dollars’ (ie versus DMs and EMs), which is now consistent with reflation momentum taking a breather.
Crude and the trade-weighted dollar (USD) have weakened in tandem in 2017, giving back the lion’s share of their strong gains post Trump’s election. Oil has been catching up with this year’s pronounced underperformance of US energy stocks, which tend to lead moves in crude prices; and USD has failed to benefit from the recent jump in market expectations for a June Fed hike, in contrast with the run-up to March’s FOMC meeting.
Investors have also gradually shifted their focus away from global macro ‘push’ factors to idiosyncratic oil supply-side fundamentals. Just like financial markets ran ahead of themselves with the Trump trade, hopes that OPEC’s November deal would result in a swift oil market rebalancing were taken too far. Q1 earnings showed US shale production is in full swing while the reduction in US crude stockpiles has been slower than expected, underscoring the IEA’s warning that “much work remains” to drain excess global inventories. This has cast doubt on the effectiveness of OPEC action, even though recent remarks by senior Saudi and Russian officials point to an extension of the output cuts at the cartel’s May 25 meeting – what remains to be seen is the specifics of the deal. If anything, the recent price weakness has increased the probability of an agreement.
So, what now for oil? Both from a global macro and a fundamental standpoint, the latest bout of pressure was somewhat overdone. The Trump trade has lost its shine, but reflationary dynamics are keeping the global synchronised recovery intact, driven by three locomotives: US, China and the euro area. The Fed rightly continues to see the US economy working through the current soft patch on its way to stronger growth that will ultimately push wages and prices higher. Growth in the euro area is gaining momentum, broadening out to manufacturing and construction. The Chinese economy is set to slow for the rest of the year following an exceptionally strong first quarter, but that should still leave real growth well above the 6-6 ½ % medium-term average, imparting continued impetus to the rest of the world over the coming quarters.
What is more, all three major oil agencies (IEA, EIA and OPEC) expect the oil market to go into deficit sometime in H2 2017, as long as OPEC’s output cuts are maintained. After all, the response by US shale producers will gradually soften with the oil price down from $55 to $45-50, so drilling activity should cool somewhat. As such, we are likely to see a steady, albeit slow, reduction in global inventories over the coming quarters as seasonal factors (global refinery maintenance) abate. Also, speculative positioning has now become more balanced, with net longs seeing a meaningful retracement from February’s extremes.
That said, things do not look so rosy for OPEC beyond the near term. With breakeven rates well below $40, US shale producers have ramped up their hedging this year but their reaction function remains asymmetric, ie they respond more strongly to rising than to falling prices. Likewise, the easy gains from the OPEC deal have probably been reaped. The surprise factor has fizzled out, pushing OPEC to adopt ‘whatever it takes’ rhetoric; and sustained high compliance should buoy prices as demand picks up going into Q3, triggering an increase in non-OPEC output. In this regard, while Russia’s cooperation remains in place for now, we expect it to weaken once next year’s presidential election is out of the way and the temptation grows to ramp up output. In all, come 2018 OPEC members will be hard pressed to choose between maintaining a price floor and protecting market share, unless global demand is surprisingly brisk. OPEC’s action should best be viewed as a defensive supply ‘taper’ in the hope of better demand.
By Konstantinos Venetis, Senior Economist, TS Lombard
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