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Shaky Recovery

June 2016

Crude oil supply glut is expected to continue this year and the next. However, prices will be affected by the extent to which oversupply can ease or extend, says Dharmesh Bhatia, Manager – Commodities Market, Emirates NBD Securities

Crude oil hit a low of $26.05 per barrel in February, the lowest level since May 2003, but bounced back sharply to hit a high of near $50 per barrel and is currently lingering near $50/bbl. Crude’s incessant fall has been cause of worry as it dented inflation outlook for major economies and caused economic slowdown in oil producing nations. Producers saw dwindling revenues but chose passivity to maintain market share.

Global economic uncertainty and weaker inflation outlook caused major central banks to express support for loose monetary policy to boost growth. This led to a revival in risk sentiment causing a rebound in global equities. Crude along with other commodities also rode high on central bank stimulus. Crude also benefitted from signs of slowdown in crude production. US crude production eased to the lowest level since 2014 while OPEC and there major producers floated the idea of a production freeze.

Energy-ChartGlobal market remains oversupplied
Crude’s fall to multi-year lows has been due to an oversupplied global market. Supply glut is expected to continue this year and the next. However, prices will be affected by the extent to which oversupply can ease or extend. Demand and supply is expected to rise modestly this year, however, supply outlook will remain pivotal in the near term. While US crude production is steadily falling, the pace could be affected by price. Any sustained rise in price will rekindle production interest. As per US Energy Information Administration (EIA) estimates, US crude production averaged 9.11 million barrels per day (mn bpd) in February, the lowest level since September 2014. Production is estimated at 8.67 mn bpd in 2016, down about 8% from a year ago. Decline in rig count shows weaker production interest. The number of rigs drilling for crude stood at 354 rigs, the lowest level since 2009. Rig count has fallen by 184 rigs so far this year but the pace has been price sensitive. Rig count dropped by nearly 140 rigs in first two months of January and February and by a modest 40 rigs in March. The sharp slide in crude price forced some OPEC members and Russia to garner support for production freeze at January levels. This turned out to an arduous task and a meeting between major producers took place on April 17 in Qatar. However, the meeting further reduced credibility of OPEC to take extreme measures to correct global crude market.

Chinese demand to rise at the slowest pace since 2001
Global crude demand is set to see a modest growth in 2016 led by India, China and the US. However, there are certain headwinds which could persist in the report quarter. US economic growth slowed down substantially in Q4 2015 and slower activity is seen in the near term. Chinese crude demand is expected to rise by 2.9% in 2016, the slowest growth since 2001 when it rose by 2.5%. The economic slowdown has affected demand as China’s GDP rose 6.7% in Q1 this year, the slowest since 2009. Economic indicators will continue to affect outlook for the economy and demand expectations for crude. Focus will also be on import numbers. China’s crude imports totaled 31.8 million tons in February or about 8 mn bpd, the highest daily average on the record. China is importing huge quantities of crude imports but the same is being refined and products are being exported. China was a net exporter of fuel products for the eight consecutive month in February. China is exporting a huge amount of gasoline to Asia but rising stockpiles are a cause of concern.

Fundamental Outlook
Crude oil has witnessed a handsome recovery from a near 13-year low and is trading near $50 per barrel. The question now is whether demand supply scenario or market sentiment has changed enough to warrant sustained gains or will we see the price dropping back. With mixed factors at play, crude prices may remain choppy but bearish factors will still outweigh supportive factors.

On the supply side, US crude production has fallen and this trend may continue. However, the pace will be affected by price levels. Producers may see higher price as an opportunity to lock in sell price. OPEC and other major producers have failed to reach a deal on production freeze and further chances remain slim. Iran is also keen on raising production to pre-sanction levels. Lack of a deal on production freeze also rules out the possibility of a production cut in coming months.

On demand side, optimism about US economy is countered by bleak outlook for Chinese economy. Mixed economic data from major economies especially the US will keep sentiments weak. Central bank action has been able to stabilize equity markets but confidence in global economy remains low. The US dollar has corrected on Fed’s cautious tone on future rate hikes, however, the gap between monetary policy of Fed and other central banks will continue to support the US currency.

Risk factor to above call is sharper fall in US production and renewed talks between major producers for production freeze of production cut. A sharp rise in US gasoline demand during summer driving season could also push price higher. Another risk factor is sharp depreciation of US dollar if Fed’s rate hike stance remains unclear and outlook improves for other major economies. On domestic front, rupee movement will also affect domestic crude price. Depreciation of Indian currency could support domestic price.

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