|23 September, 2019

Oil: Supply-side shocks, dented demand-driven factors, and a wild card

Monte Safieddine is a market analyst at IG Dubai. He has spent nearly a decade in the FX industry and has held roles within financial firms that have included risk, analysis, statistics, and trading. Safieddine holds a Masters in Economics from Wayne State University where he completed multiple PhD-level fields and taught undergraduate students. He provides commentary on financial markets, including FX, cryptocurrencies and commodities, and publishes IG’s Daily Market Report and Weekly Market Report.

Website: https://www.ig.com/ae

As it stands, US oil producers suffer from higher costs of oil extraction but enjoy geopolitical stability, while Middle Eastern producers have some of the lowest production costs but suffer a lack thereof

The tussle continues between supply side concerns that are pushing the energy commodity's price higher as geopolitical tensions rise, demand-side worries reducing appetite with global recessionary fears mounting and liquidity woes worsening, and a wild card in the wings in the context of any potential strategic and geopolitical shifts.

As if there weren’t enough battles within both the supply and demand-side aspects of oil, last weekend’s geopolitical shock forced oil prices out of its relatively range-bound channel and lead to increased talk of a ‘geopolitical risk premium’ being applied to its price that had previously been ignored. 

That was quickly embraced by oil producers desperately in need of higher oil prices, and although we won’t know the extent to which US producers have hedged their future production until third quarter reports are released (or that of Mexico which although delayed was expected to hedge next year’s production around this time), a significantly higher oil price would be a lifeline given the recent rise in bankruptcies that have been plaguing US oil, and entice plenty into initiating shorts be it to secure a higher price on existing production infrastructure, or in bringing idled higher-cost rigs back online.

Previous supply side worries had risen following US sanctions on Iran in an attempt to take its oil exports off the market, anticipating its replacement would originate from increased oil production from not just other OPEC+ members, but from rising US production that – bankruptcies aside – remains not far off its recent record highs.  However, that number pales into insignificance when compared with Saudi crude oil exports, which in turn is lower when combined with the remaining oil output of oil-exporting countries in the vicinity all at risk should conflict ensue.

As it stands, US oil producers suffer from higher costs of oil extraction but enjoy geopolitical stability, while Middle Eastern producers have some of the lowest production costs but suffer a lack thereof. Furthermore, while costs of extraction are low for the region, government obligations are high and rising, especially when considering a rise in military spending in light of recent events and domestic economies that are struggling.  US private oil producers on the other hand, need not concern themselves with US budgets or government obligations.

Shifting to demand-side factors, they’ve been a drag on oil prices and the reasons are plenty. Chief amongst them are global recessionary fears with the manufacturing sector suffering contractions, and with the auto sector in both China and India suffering and factoring into reduced global oil demand growth forecasts.   The Chinese yuan’s weakness denting overall commodity demand, global (and US short-term) dollar liquidity shortage sapping the strength out of the financial markets and crippling companies’ debt servicing continuity, and a shift in demographic preferences when owning a vehicle have all been cited as contributing factors.

And that’s just the short-term.  Demographic shifts, alternative energy, larger electric car lineups on the horizon as stronger emissions controls come into effect, and talk of phasing out internal combustion engines (outside the US) over the next decade while not coupled with any regulation thus far has caused fears to resurface amongst oil majors that while the pool of oil they have yet to extract from the ground isn’t worthless, as time progresses it may be fundamentally worth less.  One doesn’t have to venture that far back in time to remember the 2014-16 oil market that witnessed a plunge in oil prices as Saudi Arabia sought to capture greater market share and put pressure on US shale, with oil prices failing to recover to those highs since.  And while the strategy has changed since then as OPEC+ agreed to limit output, the underlying fear hasn’t and could resurface with ease if oil prices continue to remain relatively subdued. 

And then there’s the wild card.  As with the US-China trade war whose underlying has been strategic as ‘America first’ attempts to keep China second, thus far we’ve been seeing strategic decisions with heavy implications on the financial markets, and it has been a significant cause denting oil demand growth globally.  It has yet to affect the supply side.  With oil, while it’s in the interest of some in the US to keep oil (and hence gasoline) prices low ahead of next year’s elections, the greater economic harm should any conflict occur in the Middle East would be (aside from the direct countries involved) the East Asian region, who are net oil importers and heavily reliant on the flow of oil out of the Strait of Hormuz. 

Putting it all together, and any future conflict would come at the expense of Middle Eastern oil producers and their clients in East Asia – such as China – forced to scramble for higher-priced alternatives at a time of scarcity, while significantly benefitting oil producers unaffected by the conflict who would be able to increase their production and lock in higher oil prices via the futures market.  Oil demand is for now inelastic to changes in price, and while oil supply is getting more elastic, another significant strategic shock won’t prevent a surge in the energy commodity’s price.

* Any opinions expressed in this article are the author’s own

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© Opinion 2019

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