Crude oil prices fell close to 4% during the week that began 19/06/17 (see Exhibit 1 below) negatively impacting valuations of oil-linked assets such as some Emerging Markets (EM) currencies and, with some delay, the US high yield market.
Exhibit 1: Crude oil prices are falling again – changes in the price of crude oil (Brent, in USD) for the period between 26/04/14 and 26/06/17
But the effect on broader risky assets has been fairly muted. The moves in market prices suggest to us that the correction in prices has been driven by concerns over ample supply rather than insufficient demand.
Expectations of an extension of OPEC production cuts supported prices until mid-May. However, prices subsequently fell rapidly after OPEC announced on 25/05/17 an extension of production cuts by a further nine months. The bar is therefore quite high for further cuts to curtail supply by the cartel, at least in the near term.
In contrast, in the US, crude production rose to a fresh year-to-date (YTD) high in mid- June and inventories remain historically very high. Production is up 7% YTD, while West Texas Intermediate (WTI) prices are down close to 20% (from ~USD 55 to USD 43/bl) as shown in Exhibit 2 below.
A key concern is that shale production costs are low enough to support plenty of production even with prices below USD 50/bl. Research from Barclays, for example, shows that 80% of the cost base is below USD 60/bl, but at USD 43/bl only 35% of exiting oil fields would breakeven. The glut in supply therefore now appears to be largely incorporated into current valuations.
Exhibit 2: US crude production reached a YTD high, while WTI prices slipped further
Source: Bloomberg and BNP Paribas Asset Management, as of 26/06/2017
Two other pieces of news during the week that began 26/06/2017 added to the supply pressures:
(i) Libya pumped the most oil since 2013 during the week that began 26/06/2017 and
(ii) Saudi Arabia’s newly-crowned price, Mohammed Bin Salam, could be more hostile to Iran, making it more difficult for OPEC to achieve production cuts in the future.
On the other hand, the outlook for demand remains robust, with both developed markets (DM) and EM demand supported by synchronised global growth.
The bottom line for us is that supply remains strong, but prices have adjusted materially and further shale investment and efficiency gains are unlikely in the near term. Demand prospects remain robust so the market could potentially encounter a small deficit in supply during the second half of the year.
In our view, prices should therefore drift higher in the next few months, but the upside will likely be capped by expectations of a response from shale supply.
Written on 29/06/2017