You’d be forgiven if you’re confused as to the outlook for crude, which is caught in the crosshairs of U.S. foreign policy, U.S. trade policy and U.S. fiscal policy.
The Trump administration is seeking to apply what, in a letter to European officials, Mike Pompeo and Steve Mnuchin described as “unprecedented financial pressure” on Iran in the wake of the President’s decision to pull the U.S. out of the nuclear deal.
That letter suggested waivers on secondary sanctions are not in the cards and the news came amid reports that South Korea and Japan are set to stop taking Iranian crude.
The problem with that, if you’re Trump, is that lost Iranian barrels could lead to higher oil prices, which in turn means higher prices at the pump for Americans. The risk is that higher gas prices eventually offset the gains from the tax cuts, effectively removing another feather from the GOP’s cap ahead of the midterms in November.
Last week, BofAML was out with a quick take on how high prices at the pump would have to rise to completely negate the effect of the tax cuts for everyday Americans.
That worry began to manifest itself on Trump’s Twitter feed in April and behind-the-scenes pressure from Washington ultimately compelled the Saudis to marshal support within OPEC (in conjunction with Russia) for a production hike in the back half of the year. When that wasn’t enough to bring down prices, Trump took to Twitter again to suggest that he had talked to King Salman on the phone and convinced Riyadh to lift production by 2 million b/d, a contention that was subsequently walked back and a suggestion that prompted a series of responses from Tehran that ranged from irritated, to incredulous to sarcastic.
Finally, in what certainly feels like a Hail Mary, Trump is reportedly considering tapping the Strategic Petroleum Reserve in order to drive down gas prices ahead of the November midterms.
Meanwhile, Trump’s combative trade posturing is leading some traders to ponder the prospect of across-the-board demand destruction in the commodities complex. This is part and parcel of the “are trade wars inflationary or deflationary?” question/debate.
Last Wednesday, the Bloomberg commodities index dove the most since 2014 on the heels of the USTR’s decision to publish a list in conjunction with prospective tariffs on an additional $200 billion in Chines goods.
Well, against that backdrop, Goldman is out with a new piece on crude called “A muddied outlook” that seeks to make some sense of an otherwise non-sensical situation.
Here’s the bank summing up the push-and-pull:
Oil prices have sold off sharply over the past week, with Brent now trading at its lowest level since early April. The sell-off was triggered by bearish demand and supply news: the escalating US-China trade war, the end of the Libya disruption and the potential for a more gradual decline in Iran exports than previously feared. Friday also came news that the US administration was actively considering an SPR release. These supply shifts, alongside the ongoing surge in Saudi production, create the risk that the oil market moves into surplus in 3Q18, consistent with the sharp decline in Brent front-month timespreads near contango. Such a shift into surplus would stand in sharp contrast to the larger than seasonal June stock decline and we believe such volatility in global oil fundamentals may become the new normal, after four years of large and persistent inventory shifts.
In case it isn’t clear enough, Goldman notes that the “new fundamental volatility” regime in crude is “driven by U.S. political decisions.”
But the bank reminds you that last Wednesday’s bloodbath in oil wasn’t all about trade.
“The move lower also reflected supply factors, with higher core-OPEC production, lower disruptions and the potential for an US SPR release or a gradual decline in Iran exports all pointing to a bearish shift in 3Q18 global oil balances”, Goldman writes, adding that “lower oil prices were accompanied by sharply weaker Brent timespreads despite tariffs unlikely to have much of an impact on demand initially.”
They go on to apply the same logic to the oil market that applies pretty much across assets: it’s not so much the mechanical impact of a given dollar amount in tariffs that matters, as much as it is the second-order effects.
The concerns are that the demand hit becomes larger through four channels: (1) reduced trade’s outsized impact on freight oil demand, (2) a larger growth hit if financial markets start to unravel, (3) reduced investment given rising economic uncertainty, (4) trade tensions becoming multilateral rather than bilateral.
As far as supply disruptions go, remember that one of the prevailing concerns here is that even if Saudi Arabia and Russia can offset the impact from lost Iranian barrels, that effort would leave them constrained (from a spare capacity perspective) to respond to future supply shocks. With no light at the end of the tunnel for Venezuela, that’s a risky scenario.
Still, Goldman notes that near-term, the supply picture is bearish. Here are a couple of visuals that depict an expected rebound in Libyan output and show the recent ramp up in production from Russia, the Saudis and Riyadh’s regional allies:
Goldman’s piece is lengthy, but the bottom line is this:
Venezuela production remains in steady decline of 60 kb/d mom. We therefore still see risks to our expectation that production from Libya, Iraq, Venezuela and Nigeria would only decline by 95 kb/d from 2Q18 to 4Q18 as skewed to the downside.
This volatility in production may soon be exacerbated by the large supply shifts driven by US political decisions. With the ramp-up in Saudi, Kuwait, UAE, Qatar and Russia production already ongoing, key to near-term oil balances will be the path of Iran exports.
Going forward, the bank expects Brent to trade in a $70-80/bbl range and, again, the overarching narrative here is that volatility is the new normal.
