Oil may be close to bottom, but don’t expect sharp rebound

Historically, such a sharp decline in oil prices has been accompanied by a recession and a collapse in energy demand. Yet the story of oil’s latest decline cannot be more different from those of the past. Far from a recession, global demand for oil has been rising incessantly in recent years, primarily because of soaring demand from China, India and other emerging markets. 

What has upended the balance this time? And what, indeed, is the outlook for oil? Getting this right may be critical, as it is likely to have a profound effect on global growth and asset prices. 

Our base case is for oil averaging around US$45-$55 a barrel over the next 12-18 months. This is likely to lead to an unprecedented transfer of wealth (amounting to trillions of dollars, according to some estimates) from the world’s oil producers to consumers. 

Since the world’s biggest economies are all net consumers of oil (the United States, Europe, China, Japan and most of Asia), such an outcome should be positive for global growth. However, we may have to ride through quite a bit of volatility on the way. 

The game changer this time – and the source of ongoing volatility – is the so-called shale revolution in the US, where oil producers have employed a new horizontal drilling technology to extract vast reserves under rock formations deep below the Earth’s crust. 

This method has been so successful that US output, after two decades of decline, soared from around 5 million barrels per day (mbpd) in 2008 to above 9mbpd in 2015, turning the US into the world’s largest oil producer.

However, it was the competitors’ response to this US supply shock that dealt the final blow to oil prices – instead of accommodating the new-stream of supplies, Saudi Arabia and Russia, the world’s two other leading producers, decided to maintain their output and preserve their market share.

Where do we go from here? The medium-to-long-term picture for oil is easier to construct. Most estimates point to excess global supply of about 1.0-1.5mbpd as of the end of 2015. Annual demand growth tends to average about 1 mbpd in non-recession years. Indeed, recent data suggest demand from the developing world shows no signs of slowing. This means the global demand-supply gap could close over the next 12-18 months. 

This outlook is likely to be supported by supply cutbacks by producers, largely in the US and Canada, which are no longer viable at these prices and are not able to access funding. We are already seeing such pressures among some of the smaller US shale-oil producers. As a result of these shutdowns, US output has fallen since peaking last June. 

However, this does not create an unambiguously bullish story for oil, as record US inventory levels still need to be burned through.

The near-term outlook for prices is murkier, as oil may be driven by a host of factors. These include market sentiment, valuation, investor positioning, the US dollar, technical indicators, storage capacity and geopolitics.

Recent speculation that oil could fall to $20 or lower come from the charts. Oil bounced back from $20 a barrel in 2001; before that, it rebounded from around $10 in 1998. While these levels seem far-fetched today, we could get there under a worst-case scenario of a world running out of storage capacity or in the event of a global recession. However, marginal producers would become unviable at these levels, eventually driving prices higher. 

Our base-case scenario is for oil staying below $60-$65 a barrel over the medium term. Thus, in the next 12-18 months, a range of $45-$55 seems appropriate. 

Given the cloudy near-term outlook, we would prefer longer-term strategies that benefit from modestly higher oil prices. This could include exposure to the energy sector through equities or US high-yield bonds and oil-dependent currencies such as the Canadian dollar. Be sure to gird yourself against near-term volatility, though.

 

Manpreet Gill is head of fixed income, currencies and commodities strategy at Standard Chartered Bank’s wealth-management unit.