The “Old Economy” strikes back


Oil prices are currently subject to spike risk. As geopolitical risk continues to build in the
Middle East and supply-side dynamics remain relatively constrained, we believe the oil price
could rise significantly in the coming weeks as the “Old Economy” strikes back.

When Brent oil went below USD 30 per barrel in early 2016, excess
inventory coupled with doubts around OPEC’s willingness and
credibility to shift oil market balances implied that we were likely to
be in a new “lower for longer” environment for oil prices. This was
also supported by an increased focus on changing consumer habits
(which are becoming more environmentally conscious) and cost
structure shifts in energy-producing technology.
Just over two years later, Brent 1st Line Futures are now at nearly
USD 80 per barrel and the “goldilocks” ride of 2017 is giving
way to a build-up of geopolitical risk premium in energy markets.
After several years of underperformance, the “Old Economy” of
heightened oil prices may be making a comeback as oil looks
subject to the risk of a significant price spike in the coming weeks.
Middle East’s safety mechanism weakened as US moves
away from post-WWII World Order
Despite President Trump’s own volatility around key decisions in
recent months, which has led to the occasional U-turn, the US
president has effectively put an end to the Iran nuclear deal on 8 May.
This Iran deal, the Joint Comprehensive Plan of Action, was agreed
in 2015 between Iran and China, France, Russia, the UK, the US,
and Germany.
It has become increasingly clear since Donald Trump was sworn
in as the 45th president of the US that the new administration is
charting a path of unilateralism. As a result, the post-WWII World
Order, built on unconditional alliances, is fracturing.
The Middle East is perhaps the strongest example to date of the
emergence of a new World Order. Despite the US pulling out of the
Iran deal and warning about sanctions on any entity dealing with
Iran after the wind-down period, the EU, the UK, China and Russia
have decided to uphold the deal.
This division on the nuclear deal, coupled with the very controversial
decision by the US to move its embassy in Israel to Jerusalem on
14 May, marks a tangible move away from its traditional allies by
generating an unconditional move towards region specific players.
Saudi Arabia and Israel have now been joined by the US to openly
confront the expanding influence of Iran in the region.
Increasingly, it seems, traditional alliances are being replaced with
narrower issue-based relationships, which could be destabilising
for the region, in our view. Historians are sure to compare this
current path towards US isolation from its present day western
allies to the days pre-dating WWII.
Despite numerous historical episodes of blow-ups in the world’s
most sensitive geography, there have been safety mechanisms
engineered by western allies under US leadership that have kicked
in to stabilise the situation. The 2015 Iran deal is among the most
important developments in this regard.
However, as we stand in 2018, this new World Order marks a
significant weakening of those safety mechanisms, which had
helped immensely in avoiding a full-blown conflict (involving
numerous world players guided by narrow self-interests)
breaking out in the region in recent years.
The optimistic view is that President Trump is just rocking the boat
and will come back to the table to do another deal after winning
some concessions. This tactic helps Trump with his voter base,
which appears inclined to follow rhetoric more closely than actuality.
His handling of the North Korea situation is an interesting template
here, where the narrative shifted from name-calling and threats of
nuclear strikes to productive diplomacy in a matter of weeks.
However, we are less sanguine about the chances of such a reversal
happening in Iran’s case. There are two key differences: first, North
Korea was heavily isolated (even China abandoned them), which is
not the case with Iran; secondly, there was a viable deal in place
and Iran’s compliance had been verified by independent authorities,
leading all other parties to support the deal.
On balance, we think Trump’s decision on the Iran deal has
weakened the safety net in the region. Furthermore, in Saudi Arabia,
the world’s largest oil producer, the ambitious reform programme
has damaged key power structures in the Kingdom, leaving it more
exposed to serious domestic blow-back.
“Old Economy” strikes back as supply-side
dynamics remain tight
The rising fragility in the Middle East comes at a time when
aggressive actions taken by OPEC and Russia initiated in
December 2016, have helped hoover up excess inventories in
the market. Those excess inventories had led Brent oil to trade
briefly below USD 30 in 2016, down from a post-2008/9 crisis
peak of USD 126 in 2012.
The interplay in oil markets has changed dramatically over the last
decade with the rising importance of the US (led by shale) as a key
producer in the market (Figure 1). According to the US Department
of Energy, US crude oil production increased from 5 million bbl/day
at the start of 2006 to 10.6 million bbl/day in April 2018. This has
geopolitical implications in a sense that the US is now significantly
less reliant on the world for its fossil fuel supplies and may explain
(beyond Trump’s populism) the reduced incentives for the US in
maintaining ongoing stability in the region.
This rise of shale and subsequent excess inventories that
incentivised the cooperation between OPEC and Russia, and the
later interest by Saudi Arabia in securing value when it came to the
Saudi Aramco IPO, have been the major drivers behind our long
standing bullish call on oil.1
The inventory clean-up operation led by OPEC and Russia, which
has been quite successful (see Figures 2 and 3), means the current
Middle East issues are coming at a time when market balances
are quite tight. We are seeing a continued increase in demand
(the backwardation in the Brent and WTI curves are a strong
indicator of a tight market). In addition, the sharp fall in Venezuelan
production, which is unlikely to recover any time soon, has added
further pressure from the supply side.
As such, in our view, the current backdrop has increased the risk
of a sharp spike in oil prices in coming weeks.
In terms of barrel counting, what happens to Iranian oil, where
production bottomed in 2013 and has since risen by more than
1 million barrels/day, will be key. Currently, the bulk of Iranian
supply is sent to China and India (Figure 4). How stringently the US
applies the renewed sanctions would determine whether Iranian
supply is re-routed or if it is completely pulled out of the market.
In terms of stabilising factors in the oil market, many investors
expect that the rise in oil prices may be contained thanks
to the incentive US producers have to increase production.
However, some structural issues are holding back the
adjustment in US supply.
The fact that the oil futures curve is in backwardation affects US
shale producers, as they have to sell their production forward to
finance their investment. Moreover, on top of the downward slope in
the forward curve, there is also a discount of about USD 12 currently
on the price producers in the Permian Basin receive for their
production (Midland oil prices) compared to the benchmark (WTI)
(Figure 5). This means the price at which these producers sell their
oil has not increased to the same extent as WTI, making an increase
in production less attractive than the level of WTI would suggest.
The widening spread between the Midland oil price and WTI
is due to capacity constraints in the pipeline network. Any
increase in production has major difficulties reaching consumers
(refiners and export hubs) or storage tanks. As a result, this oil
became considered as excess supply, leading to a lower price and
to a widening discount relative to WTI. This is very similar to the
situation Canadian producers went through between 2011 and
2013.2 In our view, the spread is likely to remain in place until
new ways of transporting oil are established, such as shipping oil
by train or barges, but these take time and are more costly than
using pipelines.
Oil price spike – global investment implications
The rise in oil prices witnessed since the volatility shock
of early-February has been different in character from both a macro
and markets perspective. Our correlation analysis has picked up this
switch, with the correlation of Brent oil versus other asset classes
shifting significantly in recent weeks. For instance, 24-month rolling
correlations between Brent oil and emerging market (EM) currencies
is now close to zero compared to a 40% average since 2011.
Similarly, we observe a switch in correlation versus US equities,
EM equities and the US Dollar Index (DXY) (Figure 6).
As such, the rise in oil seen since its 2017 lows was more
of a “goldilocks” increase, in our view. We believe geopolitical
conditions will now be shaping oil as a risk factor, rather than
a stronger global economy.
We think energy equities, given their relatively low valuations, stand
to benefit from this environment. Meanwhile, the ongoing rise in oil
further adds to inflationary pressures (Figure 7), which should keep
upside pressure on US Treasury yields, although we think the loss in
growth momentum may cap the upside of 10-year Treasuries at 3.1%.
We think the de-linking between oil and EM we are seeing currently
could continue over the short-term as emerging markets see a rise
of idiosyncratic risks against a stronger US dollar environment.
However, we believe the underperformance of Russia versus
other emerging markets is likely to be reversed as the country’s
macro conditions continue to improve. Furthermore, given Russia’s
measured response to very stringent US sanctions, we believe the
risk of further sanctions is receding.
From a broader perspective, increased volatility in the Middle
East following President Trump’s decision is likely to weigh on risk
sentiment. Markets may start to focus on the more immediate
implications of the break-down of the safety mechanisms in the
world’s most geopolitically fragile region.
That said, the stance of EU and other western countries (which
now agree with China and Russia) will also be key to watch when
it comes to the negative impact coming from the US’s unilateral
foreign policy decisions affecting the Middle East. We continue to
think that risky assets will be supported by ongoing business cycle
dynamics, but volatility is likely to remain elevated.