The Market Corner - the month in review by Filippo Lecchini
Time to check in, for the first time in 2019 and see what’s going on in the energy market after the wild ride in quarter 4 2018.
Prices are up over 25% in 2019, with WTI around $58. One may say that the same is true for US equities, for example, a more “risk on” kind of sentiment has returned, but different markets are influenced by different drivers. We previously discussed long term dynamics and changes in demand and supply, but in the short term, it’s important to be aware there is a whole lot of decision making focused on controlling price dynamics. January marked the beginning of a new six-month production freeze for OPEC and other non-associated producers--noticeably Russia. Memories of the 2016 lows (and how long it took getting through the production glut) are still haunting the cartel, which has a lot vested in ensuring a similar scenario doesn’t reoccur. This time, however, to make things more complicated, some non-OPEC countries are actually increasing their production. Particularly, the resurgent US shales business is going full-speed ahead with two overarching goals: gaining as much independence as possible from imports and increasing global market share. Then there are the rather complicated situations of Venezuela and Iran, whose output is restricted from the global markets because of sanctions. Not quite a voluntary decision to decrease output but practically fairly equivalent to a production cut.
That’s enough for the production side; let’s move onto the demand side, which appears to be on a downward trend. The current anticipated number of barrels per day for 2019 has been recently revised down, creating another factor behind OPEC adjustments.
The result of this quick snapshot is a rather complicated picture. OPEC and Russia made their priorities clear—with their economies heavily dependent on oil export, they need to avoid another oil glut and consequent bottom prices. Venezuela and Iran, for different reasons, don’t have much of a choice. The US situation appears to be the more complex and interesting case to think about. Like other countries, American producers were hurt by recent unexpectedly low prices. However, the American producers were likely to hurt more than others, as production in the US is not a government business (like it is in Saudi Arabia and other countries). There are big players in the US but also smaller producers who have bank loans collateralized by their output. If oil prices crash, the value of the collateral craters, which can cause lenders to consider renegotiating increasingly riskier loans. The lender may also become unwilling to offer new credit, which could push some players out of the market. Holding production then would seem to be desirable for the US as well. But this must be balanced with the opportunity to gain market share and become a bigger player globally while other countries may be choosing to pull back. As of now, it appears the latter motive is prevailing; especially considering the US producers know what OPEC is doing and can capitalize on OPEC bearing the cost of sustaining prices. Hard to say though whether strategic behavior is the only explanation. This may simply be the result of market dynamics: as long as it is profitable, agents will participate in the market. These agents are likely well aware of (although tend to discount) their exposure to shocks. Other global players are government monopolies, who are more inclined to planning and price controls, which can explain some of the differences in the priorities. It’s also worth remembering that unpredictable events could change the map in a heartbeat. For example, a new Iran deal could significantly increase supply, punishing the more leveraged producers. Conversely, a new conflict in the Middle East could reward those who have increased their market share.
We discussed recently the three big themes for the markets: with the FED on hold for a while and the US budget out of the way until fall (although most likely the debt ceiling will have to be raised in the spring), international trade and tariffs are now the biggest catalysts. Also, a proxy for how the wider relationship between the US and China develops. Plenty of optimism has been going around lately and the rumor is that there will be an agreement signed sometimes in April. Nothing is official though, as President Xi Jinping is determined to avoid announcements until there is a done deal, particularly after observing how the second summit between Kin Jong Un and President Trump ended in February.
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