Abheek Barua*

After almost two months of turmoil, oil prices recorded a sharp reversal in the last three trading sessions. As Russia and Saudi Arabia deliberated on an increase in oil output of 1mn/bpd to offset the supply reductions from Iran and Venezuela, Brent crude fell to $75.34/bbl., down almost 6% from the peak of $80/bbl. reached earlier in May. This reversal is in line with our baseline view that the rally in oil prices was a deviation from the market supply demand fundamentals and a moderation is oil prices was in the offing (see our report “Tackling Headwinds: The Oil Rise” for a detailed analysis).

OPEC and Russia could finalise and announce the rise in production limits in its meeting on June 22 in Vienna. It is likely that OPEC and Non-OPEC members will try to bring back production cuts to a 100% compliance level of the agreed production ceiling from currently being over 150%. Anticipation of the increase in supply by OPEC and Non-OPEC members is likely to have a moderating effect on oil prices over the coming weeks.

However, the period of low (say sub-$70 to the barrel for Brent) oil prices seems to be over – for at least 2018. We have seen upside risks to oil prices rise substantially over the last few months. In our view, a significant fraction of the risks appear to be ‘’priced in” and indeed some of these might abate over time. However, the existence of these risks mean that oil prices are likely to remain volatile, witnessing periods of spikes should any of these risks escalate. That said, we continue to stick to our call of oil prices averaging at $70-72/bbl. this year.

Over the coming months, the trajectory of oil prices can be influenced by a number of risks that are building up. What you need to watch out for:

1. The Venezuela factor: 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- primarily 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. Venezuela has seen a reduction in output of 579,000 bpd overshooting its target production cut of only 95,000 bpd. Further, since the election win of President Nicolas Maduro, the risk of US imposing sanctions on Venezuela’s oil industry have risen and if imposed could lead to further supply disruptions.

2. Libya supply disruptions: Recently, a Libyan oil company has significantly reduced its output (close to 12,000 bpd) due to weather disruptions. Although this disruption is viewed as temporary, the stagnation in Libya’s oil supply at 1mpd over the last year, raises questions over the stability and growth in Libya’s oil output. This lack of increase in oil supply from Libya has less to do with the production cuts imposed for OPEC members and more to do with the unstable political situation in the country. Any escalation in political uncertainty in Libya could attenuate the already high over-compliance levels by OPEC members and put pressure on oil prices.

3. Iran sanctions: The impact of US sanctions on Iran has still not gone into effect. In the event that other countries fall in line with the US and impose sanctions on Iran, supply from Iran could fall by as much as 1m/bpd.

4. US oil production could be constrained: US oil production has seen tepid production increases in the last two weeks, most likely due to pipeline constraints in the Permian region, the . Although US oil exports hit a record high of 2.6mn bpd in the middle of May, there is concern that the US port infrastructure has insufficient capacity to support the increasing supply. While issues related to refining and distribution of new shale supply could get resolved in the medium term with new investments in the sector, over the short term supply from the US could be constrained.

5. Saudi Arabia clearly in favour of higher oil prices: The success of Saudi Arabia’s fiscal deficit target is dependent on oil prices. A recent IMF report shows that oil prices need to be close to $88/bbl. to balance the countries’ national budget. More importantly, the success of ARAMCO IPO also depends on higher oil prices and thus might push Saudi Arabia to keep oil prices elevated.

6. The US position – working the political math: For the US, traditionally higher oil prices adversely affect growth. However, with US becoming a major exporter of oil, higher oil prices up to a certain level can actually be beneficial with consumer loss being offset by rising capital investments by US oil companies. That said higher prices at the pump hurt the consumer and the government needs to weigh the interests of the oil companies (and the benefits of their investment) against rising consumer dissatisfaction. With the mid-term elections for the houses of Congress due towards the end of this year, President Trump seems against a sharp ramp up in oil prices for fear of alienating his middle and working class voter base. If we read between the lines or Mr. Trumps tweets in this case, the US establishment appears to be comfortable with a price in the ballpark of $70 a barrel.

The upshot: Oil has played havoc with our currency market with the USD/INR pair plummeting all the way to 68 levels since April 2018. With the recent moderation in oil price the USD/INR pair has quite predictably seen some relief. That said, emerging market risks are rising and the sentiment seems to be turning away from them. As this risk unfolds and the USD index (DXY) hardens, the INR is feeling the heat. Thus the opposing forces of softer oil and EM aversion could keep the pair in the 67.25 to 68 range over the coming weeks.

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

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