Fifty or hundred Dollar oil: which is next?

Tom Traill - 2 May 2019

At the start of the year, the dawning realisation that the global economy was not plunging into recession sparked a relief rally in crude oil prices. The demand destruction scenario, beloved of the deflationists, has not materialised. Our obstinate attachment to premium-grade fossil fuels is unshaken. The 40 per cent increase in WTI is the more remarkable for the coincidence of a strong US Dollar. Which is next: a relapse to US$50/bl or an extended rally to the 2011-14 benchmark of US$100/bl?    

There is much debate concerning the respective contributions of demand, supply and other factors, such as net speculative positioning, to the rising oil price.  The condition of demand is inferred from the buoyancy of global industrial production and transportation volumes but comprehensive data on oil consumption arrives with a substantial lag. Oil production data is more immediate and the news of actual or potential supply disruptions is absorbed in real time. Arguably, in 2019, the oil price is moving much more in response to supply considerations.

Tensions between Iran and the US are front and centre as President Trump’s sanctions come into full effect. The Iranian economy is already in deep recession, but this could become much worse as more countries decide not to break US sanctions for fear of reprisal.  Given that Iran is a major producer (third largest in OPEC), there is a significant margin of supply that will need to be made up elsewhere. Since October 2018, Saudi Arabia, Russia and UAE have cut their oil production by an amount greater than the level Iran currently exports, leaving scope to reverse their actions. There is a balancing act for the major oil producers to play – some, like Russia, are seemingly happy for a low price as they try and take market share, others like Saudi Arabia see a rising price giving a much-needed boost to their coffers.

The US threat to countries that deal with Iran is significant, given US control of the SWIFT US Dollar transfer system. The Iranian retaliatory threat to close the Straits of Hormuz is perhaps less likely to materialise but would have a major impact were it to happen, since around 20 per cent of the world’s seaborne crude flows through the passage. Supply is also under threat in Venezuela and Nigeria.

The Trump administration appears to want the oil price to be as high as possible to boost the profitability of its tight oil sector, but not so high as to stymie consumer demand. With the first election salvos beginning to be fired President Trump will become more sensitive to the issue of high gasoline prices. Despite concerns over supply interruption the International Energy Agency still forecasts a production surplus through this year and next.

The rebound in US real economic growth in the first quarter has allayed concerns of an imminent cyclical downturn, but manufacturing survey data (figure 1) has yet to confirm an improvement. While it would require the supply destruction scenarios to coincide over the next few months, there looks to be sufficient interval of time to allow the oil price to spike higher before the cyclical moderation of demand carries the market balance decisively to the downside. A resumption of the global growth scare would likely lead to lower oil prices, aggravated by activity in oil futures.

Figure 1

Data source: Thomson Reuters Datastream

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