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Although oil demand is growing rapidly in India, the pace of expansion has moderated in other emerging markets including China and Brazil. As demand from emerging markets is vital in the global context, might the risks to the oil price be on the downside in 2017?
An apparently striking turnaround in oil market dynamics – with a shift towards a reflationary environment in the US, strong demand from select emerging markets and OPEC committing to its first production cuts since 2008 – has helped keep the oil price back above US$50. Forecasts from the International Energy Agency (IEA) suggest that if OPEC members maintain their commitments to pare back production, the market is likely to move from surplus to deficit in 2017.
Figure 1: Oil market dynamics: The balance of supply and demand
Source: International Energy Agency, as at 13 December 2016
Nevertheless, a number of factors might curtail the upward price trend, including a rapid expansion of supply. While OPEC members grapple with capacity reduction, other producers worldwide are bringing facilities on-stream. Rig counts are increasing again, with a sharp step up in the US.
Figure 2: Oil supply dynamics: rig capacity is building again
Source: Baker Hughes, Worldwide Rig Count, as at January 2017
“President Trump is committed to reducing the reliance on external energy supplies and ‘making American energy great again’,” says Lei Wang, Senior Research Analyst at Aviva Investors. “Output is expected to increase significantly. There is additional capacity that can be brought on-stream, particularly by shale oil producers in the Permian basin. Shale producers are using new technologies that are faster to deploy and can bring capacity online in just six months. In my view, reality will start to bite in the second half of the year. The ramp up in production will show obvious results in inventory.”
Elsewhere, there are other long-planned projects coming on stream in Australia, Brazil, Canada and Kazakhstan, while productivity could also step up in Colombia. ”This increase [in output] could be supplemented by higher production from Libya and Nigeria, both of which are exempt from OPEC production cuts,” as the IEA points out.1
Meanwhile, the outlook for demand growth is not clear. Energy efficiency is increasing, and a gradual shift in the fuel mix (away from coal and oil, towards gas and renewables) is expected to lead to slower growth in the future.
Emerging markets have been the engine of growth in the past decade, drawing on oil and related products for transport and the production of petrochemicals and plastics, while OECD demand has declined. China is currently the world’s largest oil importer, but demand is expected to grow less rapidly in the future as it focuses on cleaner fuels and rebalancing its economy2. India has replaced it as the world’s fastest growing energy market3, following a similar trajectory to China as it industrialised just over a decade ago; calls for transport fuels and naphtha and ethane for petrochemical projects are driving demand. Other markets like Brazil are using tax incentives to tilt consumers towards petroleum alternatives, such as ethanol produced from sugar cane.
Figure 3: Emerging markets: driving oil demand
Consumption of petroleum and other liquid hydrocarbons
Source: US Energy Information Administration, 2016 estimate, as at 7 February 2017
China’s role as a key oil buyer
Wang believes demand from China is the key swing factor that will determine the oil price trajectory in the near term. China has been taking advantage of lower oil prices to build its Strategic Petroleum Reserve - an oil supply buffer for use in emergencies - in both 2015 and 20164. Although the scale of purchases is difficult to determine, state buying was estimated to be broadly equivalent to the total global increase in crude demand last year. The country has also begun a crackdown on privately owned ‘teapot’ refiners in an effort to increase the government’s tax take. That has the potential to reduce their profitability, cut throughput and reduce overall demand.
Combined demand to fill strategic reserves and from China’s ‘teapot’ refiners is thought to be larger than OPEC’s planned production cuts (approximately 1.2 million barrels per day). Slower strategic inventory building and a reduction of perhaps 30 per cent to 50 per cent of demand from China’s private refineries would remove important pillars of price support.
Meanwhile, early indications suggest US President Donald Trump may seek to impose tariffs on imports from Mexico and potentially Saudi Arabia to promote the US energy complex. Although the president could impose temporary tariffs of up to 15% for 150 days on specific goods, establishing permanent tariffs would require congressional action. “If non-US producers face higher tariffs getting their product into the US, they may seek to sell elsewhere and end up selling at discount,” says Wang. “Tariffs could also have a negative impact on refiners if they force up the cost of feedstock in the US, or lead to retaliatory action against petroleum-based exports from it.”
Other important variables include the relative weakness of local currencies against US dollar, which has intensified since the US election. Putting countries with established pegs to the US dollar aside, emerging market currencies are trading well below longer term averages, diminishing their purchasing power.5
These complex scenarios create an environment where there is a huge divergence in expectations, partly due to the way in which the economics of production change in response to price. Projections from the US Energy Information Agency include a ‘high oil price’ scenario, built on estimated GDP growth of 2.6 per cent annually, with Brent crude reaching over $150 a barrel by 2020, then lifting over $200 by 2040. Conversely, a conservative ‘low oil price’ scenario suggests prices might drift around $40 dollars for another two decades, shown below.
Figure 4: Oil price outlook
Assumptions: High oil price: GDP growth averages 2.6% p.a., Reference case: GDP growth averages 2.2% p.a., Low oil price: GDP growth average 1.6% p.a.
Source: EIA, Annual Energy Outlook 2017
There are certain vulnerabilities investors need to be aware of in the more cautious scenario. “Oil prices in the low-to-mid $50 range are enough to stop many exploration and production companies bleeding cash”, says Wang, “but it is still not enough to break even for most others. We expect oil prices to be in the $50-$55 range for the first few months of 2017, and then to potentially head lower.”
Although direct price exposure varies across production chains, a downward shift in the oil price would be reflected in equities. At the moment, forward earnings expectations are positive and sector valuations have improved significantly in the past year. The MSCI ACWI Energy Index, which covers both developed and developing markets, has appreciated by almost one third in that period.6
In fixed income, energy makes up a significant part of both the investment grade and high yield debt indices. Stronger issuers have taken advantage of the low cost of debt to maintain or increase payouts to shareholders or undertake acquisitions, while weaker credits have issued secured debt to maintain liquidity. Here, the market’s perception of risk has also fallen away; in high yield, US energy defaults are expected to end the year at around 3.3 per cent, down from over 18 per cent in late 20167, and the spread on US high yield debt has narrowed back towards the high yield benchmark.8
Figure 5: US energy high yield spread narrows
Nevertheless, there are reasons for caution in a cyclical, capital intensive industry where some operators have elevated leverage and are burning cash. Even in the context of better-than-expected data from around the world, further weakness in the oil price cannot be ruled out. Greater protectionism, another supply shock, non-compliance by members of OPEC with planned capacity reductions and a dip in emerging-market demand are all possible outcomes in 2017.
1 International Energy Agency. Key Oil Trends 2016
2 Bloomberg. Solving the Puzzle of China Oil Demand, as at 12 December 2016
3 The Oxford Institute for Energy Studies. India’s Oil Demand: On the verge of ‘Take-Off’?, as at March 2016
4 JPMorgan. China SPR, as at 2 September 2016
5 Deviation from 10y average real effective exchange rate. Bloomberg, Aviva Investors, as at 31 December 2016
6 MSCI ACWI Energy Index, as at 31 January 2017
7 Trailing 12-month default rate, Fitch Ratings, as at 15 December 2016
8 Thomson Reuters Datastream, as at 6 February 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 14th February 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
Lei Wang, Senior Research Analyst at Aviva Investors, contributed to this insight