Clearly, oil prices have fallen further than nearly everyone anticipated. When our GIC met in December, Brent was trading at $66. We thought that due to continued US economic growth and moderate rebounds in Europe and Japan, coupled with re-stimulation of China's economy by its government's fiscal and regulatory efforts, global oil demand would be supported and lift prices mildly by March. Now that Brent has fallen to the $50 level, what are our thoughts?
Firstly, we believe that with one pacifying statement from the Saudis about cutting their production mildly, oil prices could easily jump by a large amount after their recent plunge. One reason why oil prices have not found a bottom is that many global investment banks have been forced to exit the commodities trading business. When prices were low in the past, they could fill up a few oil tankers to store oil and wait for prices to rebound. With oil production still exceeding consumption, the excess barrels are struggling to find buyers, and if sentiment is negative, even a small amount of trading can greatly impact illiquid-traded prices. Indeed, it is the seemingly uncontrollable speed of the downturn of oil prices that has spooked global investors in Western markets the most. On the positive side, Brent futures are in heavy “contango” meaning that prices are nearly $10 higher for February 2016 delivery. This jibes with consensus that there will be a rebound in prices.
As for geopolitics, which are intricately linked with current market conditions, we estimate that Iran will likely take a softer attitude, although only behind the scenes, in the upcoming nuclear discussions. This will reduce any support the US might have for lowering oil prices to squeeze them into compromise. One major point regarding such, however, is that if Iranian sanctions are loosened, then its increased exports could depress long-term prices, but the effect would likely be muted for the next few quarters. Both of these results are actually contrary to the Gulf countries' interests, so the geopolitical rationale for lower oil prices may be flawed to some degree and may, thus, be reconsidered.
We also expect the Ukrainian situation to stabilize soon. Many European leaders are pushing for a reduction in sanctions on Russia, as such (on both sides) are a key factor in Europe's recently sluggish growth. This too will reduce any support the US might have for lowering oil prices to squeeze Russia into compromise. It is quite possible that Russia could make a token unilateral cut in production, which would assuage the Saudis and oil market investors.
Lastly, the Saudi Ministry of Finance recently requested all government entities to restrain their budgets, so the fiscal effects of low oil prices is clear despite the large fiscal reserves held by the country. It is crucial to maintain fiscal spending in order to ensure domestic tranquility, so once capital expenditure cuts are crystallized by global producers (especially in shale, oil sands, deep water-offshore and other high-cost sources), then the Saudis will likely declare victory and start cutting production. As many capital expenditure cuts have already been announced, but not fully implemented, we are fairly close to this conclusion.
Meanwhile, it is extremely likely that many Saudis are greatly concerned about oil prices and its use as a geopolitical weapon. If the Saudis had cut production only 1% at the last OPEC meeting, they would likely have retained the vast portion of their fiscal revenues, whereas they are likely only receiving half of such now, so the strategy might be questioned. Much of this applies to other Gulf countries, as well, and credit rating agencies are likely to take note of such quite soon.
So, we do expect oil prices to rebound and for the time being, we will stick with our call for Brent to rebound to $72 by end-June 2015, although $65 is a more plausible goal. Our view on economic growth in G-3+ China has not changed, in fact, it has likely improved to some degree, as all of these countries are net beneficiaries of lower oil prices.
Moreover, lower energy prices will likely spur more consumption of oil products globally. Clearly, however, emerging markets that rely on commodity exports or on ample global investment flows are in more danger, especially Russia. Many of these are large importers of G-3 products, so their slowdown will counteract a decent portion of the G-3's windfall.
The main risks to our view are that emerging market contagion broadens deeply, Russian companies default on debts, some major financial institutions suffer a crisis in major countries due to unwise investments, Greece courts disaster in its upcoming elections or that conditions in China turn out to be much weaker than expected.