Abheek Barua*

Abheek BaruaWe write this report in the middle of a full blow crisis that has, predictably, affected asset markets particularly currencies. Our consistent view over many years has been that a crisis draws out the worst fears in traders and investors, fears that dissipate as time goes by. Part of this is driven by the fact that the worst-case scenario that panic stricken-markets seldom pan out in their entirety (we concede there are notable exceptions like the Lehman collapse of 2008) and some moderation sets in. We also know that currencies ‘’overshoot’’ their equilibrium values only to return to these levels later. In this report we look at some of the possible harnesses on an upward spiral in oil prices from current levels but on the currency front, here’s our thing: staying long on the USD in the near term makes sense but we have our doubts as to whether its strength will endure in the longer term.

Oil prices have increased by 15% this year – rising to levels not seen since 2014 when a global glut had led the oil market into a tailspin. The current rise is oil prices has been primarily driven by OPEC efforts since the start of 2017 to curb oil supply. Further, growing global demand, output disruptions in Venezuela and rising geopolitical tensions (Syria, Saudi Arabia and Iran) have all pushed oil prices higher. Recently, the reinstatement of sanctions on Iran by the US (announced on Tuesday) has added to this oil price rally. Brent crude rose to $77/bbl. and WTI crossed 70$/bbl.

So is this oil rally here to stay? Base Case: We think it’s unlikely that the current oil rally will sustain as market fundamentals continue to remain unchanged. Oil prices are likely to moderate and reverse closer to $70/bbl. levels over the coming months.

Here’s why:

I. Re-imposition of sanctions by the US on Iran – unlikely to have a major sustainable impact

  • What is the deal all about? The US government decided to unilaterally exit the nuclear deal with Iran (signed in the form of a Joint Comprehensive Plan of Action – JCPOA in July 2015 along with China, France, Germany, Russia, UK and EU) and re-impose oil-related sanctions in 180 days on Iran. That said, US President Donald Trump signalled that he expects to achieve a new deal with Iran that will lift these sanctions over the coming months. While weare certainly not predicting that things will go back to where they were, the xtreme scenario where Iran is completely isolated and a large fraction of its oil supplies go off global markets (a case which a nervous market is probably pricing in at this stage) may not prevail
  • Uncertainty regarding the stance Europe and China will take: Iran is the fourth largest producer of oil in the world and its oil exports are close to 2.5mn bpd with the majority of it going to Asia and with Europe importing close to 0.6 mn bpd. During the last round of sanctions, Iran’s oil supplies had fallen by 1mn b/d. But this time around, oil market experts expect supplies to fall by 0.3 mn bpd if the sanctions are imposed only by the US and other countries don’t fall in line. For now, it seems that most countries will be reluctant to side with the US with France, Germany and UK stating on Tuesday that they wanted to stick with the JCPOA. China, the biggest importer of oil from Iran (0.6 mn bpd in 2018) might also be reluctant to impose these sanctions and could continue to buy oil from Iran. Therefore, in such a case the impact of these sanctions might be limited and not as severe as the last time these sanctions were imposed.
  • Increase in output by Saudi Arabia could bridge the supply demand deficit: The impact of the US sanctions on oil supplies is likely to be spread out over the course of the next 6 months and might get offset by increased production by certain OPEC members (Saudi Arabia etc.) and the US. Saudi Arabia said on Wednesday that it would work with other producers to lessen the impact of any shortage in oil supplies. Also the US signalled that it was not in favour of an increase in oil prices and was in conversations with various parties that would be willing to increase their oil supplies in order to offset the supply from Iran.

II. What about other factors?

We believe that the rise in oil prices over the past few months has also been led by certain temporary factors that could reverse going ahead.

1. Over compliance among OPEC members could get normalized: The production cuts by OPEC and Non-OPEC members have deepened in recent months – increasing the compliance rate from 104% in April 2017 to 163% in March 2018- in part due to falling production in Venezuela and Mexico. Venezuela, the world’s biggest holder of oil reserves, has seen a 40% decline in its oil output since 2015 amid political turmoil and an economic slowdown. We believe that going ahead, the fall in production cuts by Venezuela could bottom out (post Presidential elections on 20th May) and overall OPEC over compliance in production cuts could normalise. Venezuela has seen a reduction in output of 579,000 bpd overshooting its target production cut of only 95,000 bpd. In regards to overall production cuts by the OPEC, experts believe that as OPEC stocks fall to their five-year average by the end of this year, OPEC countries may actually start to ramp up production in 2019 limiting the upside pressures on oil prices.

2. US production to increase: The recent rise in oil prices has led to an increase in US drilling activities resulting in an increase in US oil production. The increase in US oil supply could be a major offsetting factor that is likely to keep the rally in oil prices contained. The IEA in its monthly report increased US production estimate for 2018 to 10.72 mn bpd. Also, over the medium term, US could account for 3.7 mb/d of the new supply of oil (6.4 mb/d) by 2023 (IEA estimates). This implies that more than half of the world’s new oil production is likely to come from the US over the next five years. While there are issues related to refining and distribution of new shale supply, we believe with new investments in the sector, the supply side constraints could be sorted in the coming months.

3. Impact of geopolitical tensions (Syria, Saudi Iran tensions etc.) could moderate: While it is difficult to predict the magnitude and duration of volatile movements in oil prices due to geopolitical tensions, historically we have seen that these factors do not last long. For example, during the US-Iraq tensions in 2003, oil prices had risen by 7% and then moderated by 12% by the end of the war. In another recent episode, during the 2013 Middle East tensions oil prices did not move substantially as increased US oil production cushioned supply disruptions.

Please find attached a story in charts on oil.

*Mr. Abheek Barua, Chief Economist, HDFC Bank. Mr. Barua tweets at @AbheekHDFCBank.

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