05-06-2017

Oil: Supply deal confidence erosion

oil

The lukewarm reaction to the supply deal extension reveals how scepticism about its effectiveness prevails. We see oil prices trading sideways around and below $50, writes Norbert Rücker, Head Macro & Commodity Research, Julius Baer.

As expected the Organisation of the Petroleum Exporting Countries (OPEC) and its allies including Russia announced to extend the production cuts by nine months. Oil prices tumbled around five per cent last Thursday, revealing that some market participants had hoped for deeper cuts. The market reaction stands in contrast to the price bounce seen in late November when the supply deal was first announced. Scepticism about the deal’s effectiveness had grown in recent weeks with global oil inventories receding much slower than anticipated. This scepticism will likely remain in focus going forward and possibly centres on the following topics:

• US oil inventories are top of mind to gauge the oil supply situation not least as the data is published weekly. The latest tightening trends comfort the bulls, but could also mirror the unusually high refinery activity and growing exports.

• US shale oil production is set to surpass the 2015 record high this summer, much earlier than initially expected. Today’s drilling frenzy will fuel significant growth towards year end.

• Quota compliance will be closely monitored. The deal cuts production but not exports. A case in point, Saudi Arabia is shifting from oil to gas use for power production which should support exports and partially offset the production cuts effect on petrodollar revenues. With the deal’s signatories set to lose market share we believe that quota compliance will be seriously tested going forward.

We stick to our neutral view and see oil prices trading sideways around USD 45 and 50 per barrel going forward. The market’s surplus will persist for longer on the back of the non-OPEC production growth and plateauing western world oil demand, where structural efficiency gains offset cyclical tailwinds. The supply deal will enter rougher waters ahead. The exit strategy is becoming increasingly discussed. Finding a scape goat to blame for lacking quota compliance seems the most viable optio

Elsewhere, climate politics was a key area of disagreement at the past weekend’s G7 summit. There is a great likelihood that the United States could withdraw from the Paris agreement. Such a move would create major headlines but its fundamental impact would be benign. We have long argued that the Paris agreement could become a paper tiger as it lacks binding measures. In the United States clean energy technologies enjoy bipartisan support. Subsidies, namely tax credits to wind and solar, had been extended late 2015 and will be phased out over the coming years. Thanks to declining costs, solar and wind have become mature markets no longer in need of governmental support. Thus, the United States withdrawing from the Paris agreement would likely cause short-term sentiment headwinds to the clean energy segment, but does not derail the longer-term structural growth story.

Source: CPI Financial

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