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Oil price: reverting to fundamentals?

06 September 2019

5 minute read

By Henk Potts, Senior Investment Strategist

The sharp fall in the oil price of late reflects weaker growth prospects and rising output. However, will rising risks of supply shocks and a restatement of fundamentals help the oil price recover?

Oil is considered the lubricant of the global economy; as such investors watch the price of crude very closely. Oil is a key cost to businesses. Prices at the pumps influence consumer spending, an elevated oil price can cause a build up in inflationary pressures – putting pressure on interest rates. A high oil price can be thought of as a tax on global growth.

Oil and the global economy

The positive news for the global economy is that the oil price has weakened. Brent recently fell into bear market territory, falling more than 20% from its peak in April.

The negative news is that the reason why crude prices have fallen is partly due to the reduced confidence in the growth outlook. Trade wars, China’s weakening growth profile, anaemic expansion in Europe and Brexit risks have encouraged economists to cut their global growth expectations. We forecast that the global economy will continue to grow this year, at a 3.2% clip. However, that would be a marked slowdown from the 3.9% achieved in 2018. As global growth forecasts fall, so do expectations of demand growth.

Oil price chart

Output pressure

Along with concerns around the economic outlook, there is downward pressure on oil prices from rising output from non-Organization of the Petroleum Exporting Countries (OPEC). Technological advancements, in areas such as shale extraction, have transformed the production capability of the US, which has gone from being an importer of oil to a net exporter.

The International Energy Agency estimates that the US will produce a record 13m barrels per day (mbpd) of oil next year, overtaking Saudi Arabia as the world’s largest producer. Along with the US, other non-OPEC members, such as Brazil, Canada and Norway, have been ramping up production levels.

Potential supply shocks

Iran’s seizure of several oil-tankers in the strategic shipping lane of the Strait of Hormuz (one-third of the world’s seaborne petroleum is transported through the channel) has raised tensions. If escalated, the tensions could lead to considerable disruption. US sanctions on Iranian oil have taken around 2.7mbpd off the global market for some time. Disorder in the producing regions of Venezuela and Libya has further reduced supply.

In efforts to promote higher prices, OPEC+ (a 21 country alliance of oil producing nations) has agreed to extend production cuts of 1.2mbpd until March 2020. Compliance levels have been unusually high, with members cutting by more than the prescribed amount.

Outlook for investors

In the short term the price of oil is likely to be driven by news headlines, but fundamentals suggest a market in balance over the next 18 months. As such, we forecast that Brent will average $69 per barrel for this year and next. Investors should look to implement solutions that allow them to participate in the upside of Brent, while providing protection against moderate intermittent drops in the price.

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Market Perspectives September 2019

Find out our latest key investment themes. Expectations of more dovish central bank policy could do nothing to prevent a sharp, negative, swing in senitiment in August as recession fears returned to markets. Furthermore, US-China trade tensions seem unlikely to be resolved soon.

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