Shift in Market Sentiment Supported by Market Fundamentals (at least for now…)
May 19, 2016
The first four months of 2016 have seen both a decided shift in market sentiment and now increasingly the sense of supportive fundamentals, not the least of which involve a rash of supply disruptions—some planned, some unexpected, both large and small. Somewhat surprisingly, markets have been quick to shrug off the January doldrums and pessimism associated with the devaluation of China’s currency and concerns over projections of anemic global growth, even as the International Monetary Fund (IMF), World Bank, and others continue to adjust estimates of global gross domestic product (GDP) downward. And while global oil stocks—the enormous inventory overhang—continue to grow, albeit more slowly, we are finally seeing “signs” that the long awaited market rebalancing may now be months rather than years away.
Markets are forward looking. Back in 2014, we argued (correctly as it turns out) that, absent any major disruption, oil prices were in for a long slog that would carry well over into 2016. At the same time, others predicted that low prices would be a short-lived phenomenon and that increased demand would undergird a positive bounce.
Now halfway through the second quarter of 2016, however, the prospect of rebalance is no longer years away—and actually could occur within the next several months. The lack of agreement in Doha last month could actually accelerate rather than delay that prospect, especially to the extent that prices stay below $55/barrel and new investor money does not stampede back to the oil patch. Billions of dollars of new investment in expensive, but large-volume, projects have been scrapped, and indications of a U.S. unconventional rollover are about to be confirmed, just as third-quarter seasonal demand looks poised to increase. Last week, the U.S. Energy Information Administration (EIA) reported that U.S. oil production had fallen from a high of 9.7 million barrels per day (mmb/d) in the summer of 2015 to 8.8 mmb/d in April 2016, the lowest level since September 2014. By the next Organization of Petroleum Exporting Countries (OPEC) meeting in June, we should have a materially better fix on global demand, as well as a better indicator of supply declines due to persistent low prices. Interestingly, having achieved something close to pre-sanctions levels of output, Iran might now pivot to support a “freeze.”
At $45/barrel, some producers are back hedging future production, while other market players look to a flatter forward curve as an opportunity to pull volumes out of inventory to improve cash flow. At the same time, even with the massive overhang of global stocks, real and potential disruptions from places like Iraq, Venezuela, Libya, Brazil, Nigeria, and more recently the devastating fires around Fort McMurray—in aggregate, removing over 3 mmb/d of supply from the market—are most certainly feeding supportive sentiment, though duration of the outages remains in question.
Ironically, any material price increase above current levels seems likely to bring on additional supply—either from wells or storage, thereby capping any precipitous upswing and putting future prices into an undulating pattern—at least until demand growth and depletion signal that the markets are really turning (and history would suggest that’s the time for an OPEC cut, not now). Massive global inventories will still need to be worked off, but given persistent geopolitical risk, it’s unclear what the new level of acceptable stocks might look like longer term. Rapid change tends to move markets more than sameness, and high(er) but stable inventories could be the new normal.
And as markets are forward looking, so too should policy be. Two years of depletion and normal demand growth will require additional supplies the equivalent of Saudi Arabia’s output. Earlier this month, the G7’s communique reemphasized the need for continued investment in oil and gas to ensure continued and reliable future supplies, even as the member countries expressed concerns about the impacts of fossil fuel emissions on climate change. EIA’s recently released International Energy Outlook projects that over the next 25 years, as a result of GDP and population growth, demand for oil and gas will continue to grow. Failure to invest in energy and infrastructure today will leave the world with a global gap to fill, the result of which will invariably be higher prices.
Oil and gas are depletable resources and time frames count. Proponents of the “leave it in the ground” movement may think that by limiting production of oil and gas in the United States they are simply accelerating the transformation to a low-carbon future. But in the near term, there simply are no readily available, reliable, or affordable replacements for oil and gas at scale. And breaking the system only further erodes nations’ abilities to mitigate and adapt. A recent presentation at CSIS, suggested that with higher-priced gas and renewable mandates, coal could be a winner in many markets outside of the United States. If true, the environmental benefits derived from electrification of the transport sector could be offset by the resurgence of coal for power generation.
In January’s State of the Union address, President Obama pointed to lower energy prices, increased domestic production, and reduced reliance on imported oil as net positives for a nation long concerned with energy vulnerabilities. By the time his administration leaves office, U.S. production will undoubtedly be lower, imports will have risen, and prices will be higher. Energy and climate rank low on the list of issues voters appear to be concerned with in the run-up to the November elections. But they undoubtedly will be at or near the top of the stack in the new president’s inbox.
Frank Verrastro is senior vice president and holds the James R. Schlesinger Chair for Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Guy Caruso is a senior adviser with the CSIS Energy and National Security Program. Kevin Book and Lawrence Goldstein are senior associates with the CSIS Energy and National Security Program.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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