WTI continues its journey towards a possible $35/bbl by Q4 of this year on rising US shale-oil production and a slight slowdown in the Chinese economy with big implications for global economic growth. And $25/bbl or lower crude in 2018 seems perfectly possible on these same dynamics.

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By John Richardson

THE US shale oil industry was never going to roll over and die. It was clear as early as late 2014 that debt would be written off to make wells that were on paper uneconomic economic. This would leave producers only having to cover variable costs.

And it has also been clear for several years now that shale production costs would continue to fall. Why should innovation come to a sudden end? Rex Tillerson, when he was CEO of ExxonMobil, made this point in 2015.

Equally evident, ever since the oldest Babyboomer started turning 55 or older, is that the shale oil and gas industries are one of the few genuine bright spots in the US economy. Ten thousand Americans have been retiring every day since 2011. This is rapidly turning what was once the demographic dividend of a youthful local population into the demographic deficit of an ageing population. Pumping ever-greater volumes of oil and gas is therefore a great way of creating new jobs that help to offset some of this demographic deficit.

The US has, as a result, been producing more oil than it in imports since 2013.  Production estimates continue to be revised upwards – for example, the EIA now expects the US to produce 9.2m bbls/day in 2017 compared with its earlier forecast of 8.7m bbls/day. Here is an even more significant number: Next year, the EIA is predicting US output could hit up to 10m bbls/day, which would be above the previous all-time peak production of 9.6m bbls/day in 1970.

Right now, therefore, rising US shale oil production is helping to exert major downward pressure on oil prices, with that pressure being felt for the first time since 1975 in export markets. In 1975, the US banned oil exports for energy security reasons. Last year, though, the ban was lifted. The Wall Street Journal estimates that US exports will average around 1m/bls a month in 2017.

The China Factor

It wasn’t supposed to be like this. In late May, OPEC extended their pledge to cut production by 1.8m bbls/day an extra nine months until the end of Q1 next year. But the exact opposite of what was intended has happened as since the end of May. Up until early trading this morning, both Brent and WTI prices were down by almost 13%.

It seems sensible to assume, therefore, that the longer that this downturn in oil prices continues the more likely it is that OPEC will eventually say enough is enough and return to its market share strategy of pumping more, rather than less, crude. The Saudis in particular have production costs low enough to put at least a temporary dent in the US shale oil industry. By pumping more oil, Saudi Arabia can regain customers and boost revenues. OPEC abandoning its cutbacks would be a recognition that the days of the cartel being able to raise prices by cutting output are coming to an end.

OPEC, and everyone else, needs to consider the China factor. China is the world’s most important source of incremental demand growth for oil. This growth will continue to fall during the rest of this year and into 2018 as the Chinese government maintains its slowdown in lending growth. The reason is that China’s president Xi Jinping and his fellow reformers are back in control of the economy. They will continue to demonstrate a “surprising attitude for pain” as they tackle China’s bad debts crisis, and, in parallel, reduce air pollution.

The May lending data further confirms this direction of travel:

  • China’s total social financing, which is a measure of all the new lending in the economy from private and state-owned banks, fell to Yuan1.06 trillion in May from Yuan1.39 trillion in April.
  • New loans to households were, however, higher than expected. This suggests that these loans will be the next target of the government’s latest round of its “whack-a-mole” game.
  • But in a sign that Beijing has already very successfully whacked a few moles, Reuters estimates that combined trust loans, entrusted loans and undiscounted banker’s acceptances, which are common forms of shadow banking activity, fell to just Yuan28.9 billion in May from Yuan177 billion in April. These are some of the highly speculative, and so risky, forms of shadow lending that the government wants to bring under control in order to reduce financial risks.
  • Crucially, also, interest rates continue to rise. The same Reuters story, which I linked to above, reports that government data show a 4.2% rise industrial firms’ financing costs year-on-year in April.

I need to again stress that the Chinese economy isn’t going to collapse. It will instead just moderately slow down over the rest of this year. China is in a strong position to allow this to happen because official GDP growth hit 6.9% in Q1. Growth can thus be allowed to fall quite significantly in Q2-Q4 and Beijing will still be easily able to hit its target for full-year 2017 growth of 6.5%.

But, as I said, a moderate cooling-off of the Chinese economy will exert more downward pressure on oil prices – and on other commodities prices such as iron ore.

$35/bbl now more likely for Q4

What will become more and more apparent over the rest of this year and into 2018 is that the return to inflation in Western economies was largely driven by China’s 2016 credit bubble.

This also explains the improvement in purchasing managers’ indexes (PMI) in Europe and the US. Purchasing managers were forced to buy ahead of their immediate raw material needs because of rising oil and other commodity prices that was the result of the 2016 China credit bubble.

Now, though, Western PMIs will start to weaken. Purchasing managers will switch from restocking to destocking because of falling oil and other raw material costs. Leading the way was the official US PMI for May which was at 5.25 – the lowest since last September. The survey’s output index has steadily trended down from a peak in January to an eight-month low in May.

Two weeks ago, I forecast that oil prices would be back at $35/bbl by Q4 – certainly WTI, which is of course is trading at a discount to Brent. I expected Brent could easily fall below $40/bbl by the fourth quarter. Recent events have made my forecasts more likely to come true.

What happens next? Where might this stop? Oil prices may continue to decline into 2018, possibly to below $25/bbl – barring major geopolitical disruptions to supply.

What would this mean for petrochemicals and polymers markets in Asia? That will be the subject of my post on Wednesday when I focus on polyethylene.

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