OIL

WHY CHEAP ISN’T CHEER­FUL

Finweek English Edition - - FRONT PAGE - By Jana Marais

it has been a volatile year for oil in­vestors, with prices for Brent crude swing­ing from a 12-year low of $27.88 a bar­rel in mid-Jan­uary to a high of $41.58 last month. De­spite the re­bound – at the time of writ­ing, Brent crude was trad­ing at $37.58 a bar­rel – it is still a far cry from 2008’s peak of $145 a bar­rel, or 2014’s high of $112.04.

The slump, largely driven by a sup­ply glut, has had a sig­nif­i­cant im­pact on busi­ness, con­sumers and economies around the world. Glob­ally, more than 250 000 jobs have been cut in the oil and gas in­dus­try due to the slump, and com­pa­nies have cut spend­ing by more than $100bn, ac­cord­ing to a 2015 re­port by in­dus­try con­sul­tant Graves & Co. Tens of thou­sands of jobs re­main at risk, ex­perts say.

The slump has also hurt oil-ex­port­ing coun­tries. Nige­ria, for ex­am­ple, asked for $3.5bn in emer­gency loans from the World Bank and the African Devel­op­ment Bank in Jan­uary in an at­tempt to plug a $15bn bud­get deficit left by the drop in oil prices. The In­ter­na­tional Mone­tary Fund (IMF) has es­ti­mated that the drop in the oil price low­ered state rev­enues of Arab oil­ex­port­ing states to the tune of $340bn in 2015, with fur­ther de­clines ex­pected.

Yet low oil prices are tra­di­tion­ally a boon for the global econ­omy, with the pain for oil ex­porters off­set by the eco­nomic ben­e­fits of lower in­fla­tion in im­port­ing na­tions. Low oil prices tra­di­tion­ally also ben­e­fit eq­uity mar­kets, as lower fuel prices mean con­sumers have more cash to spend, while com­pa­nies’ in­put costs are lower, thereby boost­ing prof­its. Over the past six months, how­ever, eq­uity mar­kets have of­ten moved in tan­dem with oil, with global mar­kets de­clin­ing in line with a drop in oil prices.

There is con­cern over the im­pact of the oil price slump on the global fi­nan­cial sys­tem.

Oil and the econ­omy

Ben Ber­nanke, econ­o­mist at the Brook­ings In­sti­tu­tion and a for­mer chair­man of the US Fed­eral Re­serve, said in a re­cent blog post

in­ves­ti­gat­ing the link be­tween stocks and oil prices that this pos­i­tive cor­re­la­tion be­tween oil prices and eq­uity mar­kets may arise “be­cause both are re­spond­ing to un­der­ly­ing shifts in global de­mand”.

Ac­cord­ing to one of his cal­cu­la­tions, be­tween 40% and 45% of the de­cline in oil prices since June 2014 can be at­trib­uted to un­ex­pect­edly weak de­mand. Other fac­tors at play can be ex­plained by over­all un­cer­tainty and risk aver­sion in the global econ­omy, Ber­nanke said.

Maurice Ob­st­feld, chief econ­o­mist at the IMF, and two col­leagues wrote in a re­cent blog post that, while oil prices have been per­sis­tently low for more than 18 months, the widely an­tic­i­pated “shot in the arm” for the global econ­omy has yet to ma­te­ri­alise. The IMF is ex­pected to down­grade its growth outlook for the global econ­omy, cur­rently es­ti­mated at 3.4% for 2016, when it releases its World Eco­nomic Outlook this month.

Ob­st­feld and his col­leagues ar­gue that the world may be need­ing higher oil prices, and the re­sul­tant higher in­fla­tion, to spur growth. Low and even neg­a­tive in­ter­est rates in many ad­vanced economies have eroded the ben­e­fits typ­i­cally brought by low oil prices.

Fur­ther adding to the con­cerns over de­mand, the In­ter­na­tional En­ergy Agency (IEA) said in its March re­port on the global oil mar­ket that there has been a “sharp de­cel­er­a­tion in de­mand growth, par­tic­u­larly in the US (the world’s largest con­sumer of oil) and China”.

There is also con­cern over the im­pact of the oil price slump on the global fi­nan­cial sys­tem. Moody’s warned in Fe­bru­ary that the price slump will in­ten­sify pres­sure on banks glob­ally, with those in ma­jor net oil-ex­port­ing coun­tries most ex­posed to credit risks in the near term. Ac­cord­ing to sta­tis­tics from the Bank for In­ter­na­tional Set­tle­ments, the global oil and gas in­dus­try’s debts have in­creased from $1.1tr in 2006 to $3tr in 2014, or more than eight times the size of the South African econ­omy.

Has the oil price bot­tomed?

Eco­nomic fore­cast­ing firm Ox­ford Eco­nom­ics said in a March re­port that it ex­pects the mar­ket to re­main over-sup­plied for the fore­see­able fu­ture, un­less there are sig­nif­i­cant changes to sup­ply “of the or­der of sev­eral mil­lion bar­rels per day”. With­out sig­nif­i­cant cut­backs in Opec (Or­ga­ni­za­tion of the Petroleum Ex­port­ing Coun­tries) pro­duc­tion, there will be a limit on how far oil prices can rally, it said.

A ma­jor fac­tor in the cur­rent sup­ply glut has been Opec’s de­ci­sion in Novem­ber

Ac­cord­ing to sta­tis­tics from the Bank for In­ter­na­tional Set­tle­ments, the global oil and gas in­dus­try’s debts have in­creased from $1.1tr in 2006 to $3tr in 2014, or more than eight times the size of the South African econ­omy.

2014 to stop manag­ing out­put in or­der to bal­ance the oil mar­ket, opt­ing in­stead to try and main­tain global mar­ket share (see side­bar) and force higher-cost pro­duc­ers out of the mar­ket.

This, along with the re­turn of Iran to the ex­port mar­ket, fol­low­ing the lift­ing of sanc­tions in Jan­uary, has con­trib­uted to the sig­nif­i­cant over­sup­ply in the mar­ket, which in turn has led to the ma­jor de­cline in prices.

The shale oil rev­o­lu­tion in the US over the past decade has been seen as a game-changer for the in­dus­try, with US oil pro­duc­tion al­most dou­bling from 7.5m bar­rels a day in 2010 to a peak of 13.2m bar­rels a day in April 2015, ac­cord­ing to data from Ox­ford Eco­nom­ics.

Due to tech­no­log­i­cal ad­vances, it has be­come com­mer­cially vi­able to ex­tract more oil trapped in shale, a spe­cific rock for­ma­tion, through the process of hy­draulic frac­tur­ing (frack­ing) and hor­i­zon­tal drilling. The in­crease in US out­put has led to Congress vot­ing in favour of lift­ing the 40-year ban on US oil ex­ports last year.

The over­sup­ply is es­ti­mated at around 1.5m to 2m bar­rels a day, or 2% of global pro­duc­tion, ac­cord­ing to var­i­ous es­ti­mates.

In its monthly oil mar­ket re­port re­leased in March, the IEA said while the re­cov­ery in prices since mid-Jan­uary shouldn’t be seen as a “de­fin­i­tive sign that the worst is nec­es­sar­ily over”, there are signs that prices may have bot­tomed out.

These signs in­clude pos­si­ble ac­tion by oil pro­duc­ers to con­trol out­put; sup­ply out­ages in Iraq, Nige­ria and the UAE; signs that sup­ply from non-Opec mem­bers is fall­ing; no re­duc­tion in the IEA’s forecast of oil de­mand growth; and the re­cent weak­ness of the US dol­lar.

Pro­duc­tion freeze?

In­dus­try hopes that Opec mem­bers would agree to an out­put freeze when they meet on 17 April in Doha were dashed on 4 April,

when Saudi Ara­bia’s deputy crown prince

Mo­hammed bin Sal­man told Bloomberg that Saudi would only freeze its out­put if Iran and other ma­jor pro­duc­ers fol­low suit.

The news sent oil prices plum­met­ing, as Iran is un­likely to agree to a freeze. It has been steadily in­creas­ing pro­duc­tion fol­low­ing the lift­ing of years of sanc­tions in Jan­uary. Ac­cord­ing to the IEA, Iran is es­ti­mated to have in­creased pro­duc­tion by 220 000 bar­rels a day in Fe­bru­ary to 3.22m bar­rels, the highest level in four years.

How­ever, Iran’s re­turn to the mar­ket “has been less dra­matic than the Ira­ni­ans said it would be” (the coun­try is tar­get­ing an in­crease of 1m bar­rels a day by Jan­uary 2017), and it ap­pears that in­creases will be grad­ual, the IEA said in its monthly oil mar­ket re­port re­leased in March.

Outlook for prices

The slump in global oil prices has ben­e­fit­ted South Africa, a ma­jor im­porter,

even though the 65.5% de­cline in the dol­lar oil price since June 2014 has been par­tially off­set by a 38% weak­en­ing in the rand agains the dol­lar over the same pe­riod. Prices for 95 un­leaded petrol in Gaut­eng de­clined from R14.32 a litre in March 2014 to R11.74 last month, pro­vid­ing in­fla­tion­ary relief and boost­ing house­holds’ dis­pos­able in­come. (See side­bar on the outlook for the petrol price.)

But should con­sumers brace for higher prices?

Ox­ford Eco­nom­ics be­lieves that the in­crease in Ira­nian pro­duc­tion will be the main source of in­creased global sup­ply this year, and that global sup­ply is “on course to ex­ceed de­mand for a third con­sec­u­tive year”.

Sup­ply and de­mand are only likely to come back into bal­ance to­wards the end of 2017, it said, and even then there will be sig­nif­i­cant over­hang of global in­ven­to­ries that will have to be worked off.

In the US, the world’s big­gest con­sumer of oil, crude in­ven­to­ries have been at record lev­els, with the US En­ergy In­for­ma­tion Ad­min­is­tra­tion (EIA) re­port­ing on 1 April that stocks had in­creased for the sev­enth week in a row and to­talled 534.8m bar­rels, up 13% from a year ago and suf­fi­cient to meet de­mand for nearly a month, the body said.

Opec said in its lat­est monthly oil mar­ket re­port, re­leased in March, that com­mer­cial oil stocks in OECD (Or­gan­i­sa­tion for Eco­nomic Co-op­er­a­tion and Devel­op­ment) coun­tries to­talled 3.02bn bar­rels in Jan­uary, which is around 328m bar­rels higher than the five-year av­er­age, re­flect­ing for­ward cover of 65.3 days.

The South African Re­serve Bank’s lat­est oil price fore­casts for Brent crude are $37 for 2016, $45 for 2017 and $50.50 for 2018. The World Bank is ex­pect­ing Brent crude to av­er­age $37 a bar­rel this year, down from its Oc­to­ber 2015 forecast of $51. Ac­cord­ing to es­ti­mates by the EIA, Brent crude is ex­pected to av­er­age $34.28 a bar­rel this year and $40.09 in 2017. While we see cur­rent prices as low, it is trad­ing near $35, the av­er­age price of a bar­rel of oil for the last 150 years (2014 dol­lar ref­er­ence year), ac­cord­ing to the Har­vard Busi­ness Re­view.

Saudi will only freeze its out­put if Iran and other ma­jor pro­duc­ers fol­low suit.

Ben Ber­nanke Econ­o­mist at the Brook­ings In­sti­tu­tion and a for­mer chair­man of the

US Fed­eral Re­serve

Maurice Ob­st­feld Chief econ­o­mist

at the IMF

Mo­hammed bin Sal­man Deputy crown prince of

Saudi Ara­bia

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