The Fuse

Goldman Sachs Outlines Key Factors Driving Oil Market Volatility Through 2018

by Nick Cunningham | July 20, 2018

The oil market is no stranger to volatility, with sudden outages or restoration of disrupted supply frequently causing violent fluctuations in prices. The current scope of risks are global in nature and both above and below ground. Reasons for optimism, such as Libyan output trickling back online, are insufficient to offset the risks from other producers such as Venezuela and Iran, and even the United States is contributing to market uncertainty through President Trump’s interactions with OPEC and volumes coming online from the Strategic Petroleum Reserve (SPR). The net result is heightened volatility risk through the end of the year.

Higher production and an SPR release

OPEC President Suhail al-Mazrouei has been reiterating OPEC’s message, stating on July 11 that the group does not want price volatility, and that major producers within OPEC are working on a long-term plan to boost spare capacity. “Fluctuation is not good and we do not like to see lots of fluctuation in the prices,” Al-Mazrouei told Reuters. “OPEC and non-OPEC are working on this long-term plan for market stability,” he said.

Despite al-Mazrouei’s stated goal of maintaining stability, there’s little sign of relief on the horizon.

Saudi Arabia increased production to just shy of 10.5 million barrels per day (Mbd) in June, an increase of nearly 0.5 Mbd from a month earlier. Saudi officials had previously hinted at plans on ratcheting up production further this month, perhaps to as much as 10.8 Mbd. However, on July 19, Saudi Arabia’s representative to OPEC said that output would be essentially flat in July at about 10.5 Mbd.

Saudi energy minister Khalid al-Falih said more recently that OPEC+ would no longer track country-specific production quotas, and would instead adhere to a collective target.

The supply increase adds uncertainty to the market because the precise production level from the OPEC+ coalition is no longer spelled out. OPEC+ promised a return to 100 percent compliance with the production cuts, which would roughly translate into a little less than 1 Mbd of additional supply, but the group did not clarify which countries would be allowed to increase production, or by how much. Additionally, Saudi energy minister Khalid al-Falih said more recently that OPEC+ would no longer track country-specific production quotas, and would instead adhere to a collective target. In addition, Saudi and Russian officials have said that they would be willing to go further if required by market conditions.

The production limits from the OPEC+ group that began in 2017 provided some predictably to the market because the group was explicit about their intentions. But the confusion around the latest decision from OPEC+ in June, and multiple clarifications since, point to discord from within the group, creating uncertainty for traders.

Moreover, increasing production necessarily cuts into Saudi Arabia’s spare capacity, and although it will result in more supply added onto the market, periods of low spare capacity have historically coincided with higher price volatility. The EIA projects that OPEC spare capacity will decline steadily over the next year and a half, falling to just 1.19 Mbd in the fourth quarter of 2019, down from 1.82 Mbd in the second quarter of this year.

Another factor adding uncertainty to the oil market is the reports that the Trump administration is weighing a release from the SPR, with options ranging from a relatively small 5-million-barrel test sale to a more significant release of 30 million barrels, perhaps in coordination with other IEA member countries. A one-time release of oil from the SPR would not have the same fundamental impact on the oil market as a sustained production increase, but the psychological effect is significant nonetheless. The uncertainty over the timing and magnitude of a release, if it occurs at all, is creating confusion.

Trade and economic headwinds

Another variable is the prospect of an economic slowdown. The International Monetary Fund warned in its latest World Economic Outlook that while global GDP growth remains robust at 3.9 percent, the risks to that outlook are “mounting.” The Fund said that the U.S.-China trade war presented the “greatest near-term threat to global growth.”

But it isn’t the only one. The Federal Reserve has been steadily increasing interest rates, which has helped strengthen the U.S. dollar. A stronger greenback has put a strain on currencies around the world, with particularly violent fluctuations seen in Argentina, Brazil and Turkey. Even China’s yuan, which is tightly controlled, has depreciated under dollar pressure. Cracks in the Chinese economy are starting to form from the growing trade war, which, needless to say, have global ramifications.

Already the Trump administration has implemented $34 billion worth of tariffs on Chinese goods, but a much larger set of tariffs estimated to affect as much as $200 billion in imports from China could be forthcoming. Goldman Sachs said that the messaging from the U.S. government suggests there are “diminishing odds that a resolution of these trade tensions will be reached quickly.”

Specific fallout in the oil market from the trade war could remain limited. Goldman Sachs estimates that tariffs affecting $800 billion of global trade would only translate into a reduction in oil demand by a relatively paltry 100,000 barrels per day (b/d). However, that figure could rise significantly if it curtails freight oil demand used in trade; if it leads to financial contagion; if it reduces investment because of economic uncertainty; or if the trade war morphs from a bilateral spat into multilateral trade retaliation.

An economic downturn is not a foregone conclusion, but with the U.S. in a late stage of its 10-year recovery and the Chinese economy throwing up some red flags, repeating the robust oil demand growth of the last few years may prove difficult.

Iran

Recent comments from U.S. Secretary of State Mike Pompeo softened that line a bit, suggesting the U.S. government would consider some waiver applications.

The most decisive variable affecting the oil market could be the curtailment of Iranian oil exports due to U.S. sanctions. Oil prices spiked in late June after a State Department official suggested that governments around the world would have to cut their purchases of Iranian oil to “zero,” and that the U.S. government would be unlikely to provide any exemptions. That statement led to speculation that all of Iran’s 2.5 Mbd of oil exports could be affected. Recent comments from U.S. Secretary of State Mike Pompeo softened that line a bit, suggesting the U.S. government would consider some waiver applications.

The wide range of possible outcomes for Iranian oil will go a long way to determining what happens to oil prices going forward. It’s hard to overstate the significance. Roughly 3 percent of global supply hangs in the balance.

Volatility not going away

Goldman Sachs says Brent could retest $80 per barrel, but in the meantime, price volatility is making a comeback.

Counterintuitively, increased volumes from Saudi Arabia and the SPR are likely to increase rather than dampen the profound uncertainties currently impacting the oil market. The trajectory of Saudi production levels going forward is a bit unknown, and any leeway from higher Saudi output will offer greater flexibility to the U.S. government to incrementally tighten the screws on Iran. Also, oil market fundamentals remain tight, and further supply disruptions from Libya, Venezuela and Nigeria are entirely possible. Inventories are back to the five-year average and demand continues to rise. But economic risks are mounting. Goldman Sachs says Brent could retest $80 per barrel, but in the meantime, price volatility is making a comeback.

“The uncertainty on the magnitude and timing of these shifts has muddied the near-term outlook for oil fundamentals, with such supply changes large enough to potentially turn the 0.5 mb/d June deficit into a 0.3 mb/d August surplus and back into a 0.6 mb/d November deficit,” Goldman Sachs said in a note.

 

 

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