OUTLOOK ’19: Crude oil demand to slow on tighter liquidity, higher risk of down cycle

Author: Julien Mathonniere


LONDON (ICIS)--OPEC is dead. Long live OPEC! The cartel and its leader Saudi Arabia may not have the influence they had a decade ago, but 2018 has shown, if anything, that they remained critically important to global crude prices.

OPEC producers still own an enormous part of global supply, even if Russia and the US have since caught up.

The cartel’s decision to start cutting global supply by 1.2m bbl/day from January will help the market re-balance in the first half of 2019, but it might prove insufficient afterwards.

At present, oil is stuck in a bear market and investors are concerned that record US production, now in excess of 11m bbl/day, and a skittish fuel market may drag on demand.

US oil remains the wild card in 2019, being no party to any supply agreement.

With lower oil prices, the US Administration still has a good hand in the game. President Donald Trump has backed off on his threats, but he still has the ability to punish and can decide to go harder on Iran within the next six months.

US shale drillers have proved more responsive to price swings than big oil, but their aggregate response is extremely difficult to gauge since they do not coordinate their supply decisions.

Data on rig productivity is produced with a one-two month lag, and often followed by huge revisions in the next six or 12 months.

Likewise, consumption responds to changes in price with a six-to-18-month lag. By the time demand destruction becomes visible, it is too late and prices will have risen too much.

Lower oil prices are likely to boost demand, but OPEC’s efforts will have little bearing on the global economy.

Global oil prices are influenced by less visible developments at present, among which the drain on US dollar liquidity.

The current monetary tightening, which materialised through higher policy rates by the US Federal Reserve (Fed) and hence a stronger dollar, has put emerging economies under strain.

Source: CME Group

Emerging market equities were down 25% between late January and late November 2018, with a low probability of rebounding in 2019 without a stronger fiscal stimulus from China (government spending).

Global oil demand is forecast to grow by about 1.29m bbl/day in 2019, 1.04m bbl/day of which will come from non-OPEC countries, according to OPEC.

There is strong refined product growth from countries like India, Indonesia, Singapore and Thailand.

For the past few years, those emerging economies have benefited from high liquidity and tight fiscal policies, but the trend is inverting towards looser policies and tighter monetary supply.

There is a higher risk of recession and US growth could slow to less than 2% in the second half of 2019, converging downward with those economies. The run-up in US Treasury yields and appreciation of the dollar hence poses a significant stress test to the global financial system.

US Fed chairman Jerome Powell said in November that interest rates remained “just below the broad range of estimates of the level that would be neutral for the economy”, implying a possible pause in the pace of policy rate hikes.

However, monetary tightening will persist as the Fed continues to reduce its balance sheet holdings.

If the risk of a liquidity crisis crystallised, failing any adequate policy response and given the current oil supply overhang, the market would have to rebalance through either lower oil prices or slower growth. The latter option is already happening in Europe and in China.

Despite the US-China trade truce at the G20 summit in Argentina, fundamental issues remain unsettled.

China’s biggest problem is weakening credit growth despite cautious policy support, and the country’s GDP is expected to remain weak until the second quarter of 2019, with growth forecast at around 6.1%, down from 6.5% in 2018.

Source: ICIS, ICE Europe

Global economic growth is forecast to weaken from about 3.7% in 2018 to 3.5% in 2019.

The broader analysts’ consensus seems to point to downside risk, notably on rather poor 2019 trade prospects and steady geopolitical risk, notwithstanding the tighter monetary conditions.

If China’s economy slows down, there will be less demand for commodities, including for crude oil.

This tends to reinforce the argument for a decline in the US Fed’s five-year breakeven rate, which represents investors’ view on the annual inflation rate until 2023. There is less risk of overshooting on the inflation target in 2019.

Source: ICIS, ICE Europe, CME Group

Both the Brent and WTI price curves are currently in contango, a situation where prices for future delivery are higher than prompt prices (upward-sloping forward curve) and that usually signals an oversupplied market.

The expectations are for the price structure to flip back into backwardation, if possible with a lasting phase of lower price variation.

Pictured: Oil pumps work at sunset in the desert oil fields of Sakhir, Bahrain; archive image 
Source: Hasan Jamali/AP/REX/Shutterstock

Focus article by Julien Mathonniere