Roman soothsayers would look for omens in the flight of eagles or the entrails of sacrificed animals, before advising whether to fight a battle. The inversion of the bond yield curve on Wednesday, often a harbinger of recession, is clearly not a good omen for the oil market. But should the oil exporters step up their campaign to protect prices, or retreat?
The yield-curve inversion, where short-term bond yields exceed long-term ones, has predicted US recessions since 1956, but the recessions themselves have followed between three and eleven months later. Some analysts downplay this warning because of special circumstances – worldwide central bank rate cuts, a secular fall in inflation and population growth – but there are always special circumstances.
The indicator does not come out of nowhere. Consumer spending, employment and wages look strong, but manufacturing and trade are dire. The on-off US-China trade war continues to cast a shadow, sucking in Germany and Japan too, as does the possibility of a disorderly Brexit in October. Of the two emerging economy motors of global oil demand, both China and India have seen slumps in new car sales.
The International Energy Agency has further reduced its oil demand estimates for this year and next and noted that only China saw any significant expansion in the first half of this year. It sees 1.3 million barrels per day (bpd) of growth next year, but that will be overwhelmed by 2.2 million bpd of non-Opec supply growth. For once, this is not completely dependent on US shale, with Norway’s giant Johan Sverdrup field set to start up this November, Brazil reaching record high production, and Guyana achieving its maiden oil output early next year.
After climbing to a high of $74.57 per barrel on April 24, Brent crude prices have consistently slipped back under these clouds, despite the geopolitical concerns around Iran, to hit $59 on Friday.
For today’s oil market, a recession, or even significant economic slowdown, would be different from recent memory. The 2008 financial crisis followed a record high in oil prices, driven largely by Chinese demand. The slumps of 2001, 1990-91, 1981-82 and 1973-75 came after price spikes (albeit very mild in 2001), caused by Middle Eastern political upheaval and/or Opec production restrictions. In nearly all these cases, Opec subsequently cut production to boost prices in the face of weak demand.
This time, the price slump, and the production cuts, have already come – prices fell in late 2014 because of the glut of US shale oil, and Opec, plus Russia and other non-Opec allies, restricted output from the start of 2017, when the world economy was expanding strongly. This gives them less room to cut further if demand falters.
This puts them in a tricky position. Riyadh has shifted its exports from the much-watched US towards the more opaque China, and approached other Opec members to consider action against falling prices.
Khalid Al Falih, Saudi minister for energy, industry and minerals, wisely told the Ceraweek conference in 2017 that, “history has demonstrated that intervention in response to structural shifts is largely ineffective”, but that he would support “Opec intervening to alleviate … short-term aberrations such as financial crises, economic recessions”.
The exporters’ organisation will not be saved by Iran and Venezuela this time – for the simple reason that their output cannot drop much further before exports dry up entirely. Libya remains volatile but output has oscillated in a range of 300,000 bpd for the past year.
Saudi Arabian production was about 9.65 million bpd in July, below its agreed limit of 10.31 million bpd. Yet because of overproduction in Iraq and Nigeria, overall Opec output, excluding the three exempted members, was barely below target. Iraqi output in particular is likely to keep rising, as new export infrastructure comes into play. If this situation continues, Opec’s own figures show that output will be 600,000 bpd more than demand for its crude next year.
Members might hope that US shale is set for a sharp decline as financing dries up. Yet the growing dominance of supermajor firms such as ExxonMobil and Chevron, the robustness of output after the 2014 price crash, and the opening of new pipelines that improve wellhead prices for Permian basin producers, all argue against this.
The signs for the gas market are even more ominous. Liquefied natural gas (LNG) prices had reached $10.2 per million British thermal units (MMBtu) in December 2017, as China was boosting gas use to clean up its dirty skies. Now, spot LNG is selling in Asia for around $4.70-4.90 MMBtu, despite a Japanese heatwave. New export plants in the US states of Texas and Georgia will worsen the glut.
In LNG, there is no effective Opec organisation to put a floor under prices. Gas exporters should eventually benefit from low prices, in terms of a larger market, as they make further inroads against coal. However, an economic slowdown could send prices even lower for now, as demand from power and industry slumps and over-committed buyers try to sell on their cargoes.
Even without an outright US or global recession, a slowdown would be bad enough. Opec cannot practically cut much more, without burdening Saudi Arabia beyond its wishes. Unless discipline breaks down, the organisation will not boost output into a slump either, which would replicate its mistake after the famous 1997 Jakarta meeting. However unfavourable the economic omens, the oil producers do not have much choice except to hold their ground.
Robin M. Mills is CEO of Qamar Energy, and author of The Myth of the Oil Crisis