As usual, trying to get the oil forecast right this year has proven to be just about as difficult as predicting who might win the English Premier League. The resilience of the price is surprising and has certainly come as a welcome relief to an otherwise beleaguered Russian economy. The sigh of relief from some oil-dependent Central Asian states has also been quite audible in recent months. So, here we are again, asking the question: “how sustainable is the oil price rally and how justified are those sighs of relief?”
The first point to make is that this year’s oil rally, which has seen Brent rise 30% since the start of the year, and 70% from the end-January low, is not because of the optimism generated by Russia’s brokered talks about a possible oil production freeze. The purpose of that action was to create short-term support in late January and prevent the price of crude from slipping to the mid-$20s per barrel, which it surely would have done without that intervention. To that extent it was a successful tactical intervention. But given that Saudi Arabia was openly dismissive of the idea and Iran made clear it would not participate, the whole episode quickly became background noise.
What actually sustained the price rally and is keeping the price of Brent comfortably in the mid-$40s area is a combination of key events:
The main driver of the rally has been the steady cut in US production, mostly from the shale projects. According to International Energy Agency (IEA) data US production has fallen by 400,000 barrels per day (b/d) since the start of the year. That is a real event which addresses the most important reason for the oil price weakness in 2014, ie. over 1.5mn barrels of excess supply every day.
The second reason is because Iran’s ability to add significant volumes of additional oil to the export market was exaggerated. In January Tehran officials were promising up to 1.0mn b/d by mid-year while the reality has been a not-insignificant 400,000 b/d, but well short of the total which scared traders back in January.
Consumption continues to grow and may expand even more. Last year the IEA predicted oil consumption growth at 1.2mn b/d, the long-run average growth, but eventually had to revise that to 1.8mn b/d as consumers across Asia burned more oil. The low oil price in the first quarter has certainly allowed that optimism to extrapolate to a second year. Rising consumption, especially set against either a stable or declining market, will also erode the excess supply and that may happen by early 2017 given current trends.
There are also a couple of other oil price positives, such as the weaker US dollar. Historically there is a good inverse correlation between oil and the dollar value. The continuing disruption in Libya, which has cut out over 1mn b/d from export markets, and the risk of escalation in the Middle East are also amongst the reasons which supported the oil rally.
Investors in Russia have benefitted from the rally in oil such that dollar-denominated assets are amongst the best performing in the world so far in 2016. The RDX Equity Index gained 25% over the first four months of the year and the yield on Russia’s benchmark Eurobond (2023) has dropped from 4.6% in late December to 3.8% in early May. In April Russian fertilizer producer PhosAgro raised $250mn via a London secondary placing. That was the first issue on a foreign bourse by a Russian entity since March 2014.
The Russian economy has also benefitted from both higher oil revenues and the 14% gain in the ruble-dollar exchange rate. The net impact on the budget is positive as dollarized tax revenues have risen faster than the ruble exchange rate. The ruble exchange rate and the oil price are also seen as important benchmarks for the country’s economic well-being by businesses and many consumers and an important factor for the trend in confidence.
Politically the gain in oil is also important for the Kremlin. In late January, with oil in danger of heading to the mid $20s per barrel, the issue of whether financial sector sanctions would be eased or rolled-over this year was starting to look critical. Today the situation is somewhat more comfortable as the budget and the capital account are under less pressure with oil in the mid $40s. When President Vladimir Putin acknowledged that sanctions are unlikely to be eased anytime soon during his recent live phone-in, he was able to do so with a resigned shrug. If oil was trading at $20, then the shrug would have been more of a panic twitch; albeit the topic would more likely have bene avoided entirely.
None of this is to suggest that the oil price rally has in anyway solved Russia’s basic economic problem or even brought an end to the recession. The data for the first quarter showed that while the pace of decline is easing the trend across most sectors is still downwards. Macro-Advisory’s base case scenario for the economy in 2016 is for a contraction of 0.6%, with a recession covering the first half and modest growth across the second half. But while none of this offers any reason to celebrate, the country’s fiscal and budget position would be a whole lot worse with lower oil.
Despite the rally since late January, predicting where oil goes from here is no easier. But there are at least a number of important events to watch:
If US oil production continues to slide, then this will be the most important driver for a higher oil price because it will continue to erode the excess supply. It is, however, very possible that the oil price recovery will halt the slide and may even bring some shut-off production back on line. It suggests that there is limited upside for the oil price from here without having a supply effect.
Traders will also watch Iran’s production to see if the country has hit a quick-fix celling (positive for the price) or can continue to build output (bad for the price).
The demand side is also important, as while the US cuts and Iran increase balance each other out, the growth in demand is also eroding the net excess supply situation. Any evidence of increasing demand, as happened last summer, would be price positive, albeit just with US supply, a much higher price could start to have the opposite effect.
The trend in the US dollar, ie. US Federal Reserve actions, will continue to have a price impacting role as will any threat of supply disruption from, eg. labour disputes in Venezuela or an expansion of conflicts in the Middle East or North Africa.
Traders will also watch closely what Saudi Arabia’s Oil Minister says at the June 2 Opec meeting in Vienna. The Kingdom remains resolutely stubborn in its defence of market share, which means no chance of a production cut, but if oil is still in the mid $40s or better, it may take advantage of that to add some of its spare capacity. It is not in the Kingdom’s interest to allow the oil price rise too high, too soon, as that would bring back the twin evils of rising US and Iranian production.
For investors and businesses in Russia, and Central Asia, these are the critical events and trends which will determine whether the recovery in economic and political optimism is no more than a dead-cat bounce or more sustainable. Forget sighing – hold your breath and hope is a more appropriate strategy.
Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer