Sooner-than-expected equilibrium and greater uncertainty
In Q2 2016, the situation on the global oil market unfolded in line with our expectations. Oil prices continued on an upward trend started around mid-January 2016. On the back of stronger demand (fuelled by low prices) and unforeseen events, which amplified the factors with a bearing on supply, the average price of Brent crude in Q2 was up 35% on Q1 2016, at USD 45.6/bbl.
Last quarter the low-price environment, prevailing since early 2015, finally led to an over 500 thousand barrels/day y/y decline in global output of crude. In the previous three quarters, output was on the rise year on year, with only the pace of growth waning.
The alignment of supply to low prices was not uniform across all oil-producing countries. The five Gulf OPEC countries (the G-5) were strongly motivated to boost production of cheap oil. These countries hold easily accessible reserves (Saudi Arabia, the United Arab Emirates, and Kuwait) and production potential (Iran and Iraq). The G-5’s oil production costs (from producing fields) are below USD 5 per barrel, and since they lost control over supply growth (and prices), their only means for improving revenue is to increase output. Russia has also upped production, though on a much smaller scale.
Shale oil production in the US has proven to be highly resilient to the price decline. The short investment cycle suggested that this is where we should expect to see output reductions first. However, thanks to mobilisation of reserves and cost cuts, the US shale oil production resisted year-on-year decline until Q1 2016, with the decline accelerating in the following quarter.
Production in countries other than the G-5, Russia and the US started to go down as early as Q4 2015. With no spare production reserves, these countries were left with no instruments to protect their revenues against the dramatic fall in prices and had to abandon numerous production projects. The final nail to their collective coffin was the gradual depletion of their production base. Q2 2016 is the third consecutive quarter when output in these countries fell.
Q2 2016 saw unexpected events, which led to a temporary decline in crude oil supply: a strike in Kuwait, a forest fire close to Canada’s producing oil sands, and supply disruptions in North Africa (blockade of a Libyan port, attacks on Nigeria’s oil infrastructure).
Taking into account the surge in demand in the US, China, India and Asian countries driven by low fuel prices, Goldman Sachs estimated that in Q2 2016 the oil market probably reached equilibrium, which came one or two quarters earlier than anticipated in our scenario.
Will this change the outlook for oil prices? It is hard to tell at the moment with Brexit on the horizon and the lingering uncertainty as to its long-term impact. Based on various scenarios, we may expect that if Brexit unfolds as a peaceful transition, it will stifle GDP growth in the United Kingdom and across the EU, with the UK being more affected than the EU. Furthermore, it is emphasised that a decline in GDP growth will not have a significant impact on European demand for crude oil and liquid fuels because the EU’s energy and climate policy has done much in the way of reducing dependency of demand for oil on GDP (in 2009–2015 European GDP grew by over 8% while crude oil consumption dropped by 10%).
Scenarios assuming a turbulent Brexit even consider the possibility of a global recession caused by ensuing turmoil on financial markets. The threat of Grexit provided a foretaste of what could happen, though only on the example of a small economy with weak financial links. But let me add at this point that the UK economy is not exactly flourishing either. Its aggregate public sector and current account deficit currently stands at over 8% of the country’s GDP. Given the elevated macroeconomic risk (lower ratings), we may expect a strong outflow of capital from the British pound, primarily towards the US Dollar.