AuthorRoss CunninghamCost Economist View profile
Co-AuthorJumana SaleheenChief Economist View profile
In our view, higher oil prices reflect a variety of supply side and geopolitical uncertainties that have attracted speculative buyers into the market. It already seems that speculator interest is fading, and we are unsure now how much lower the price can fall. In this Spotlight we explore the effects of higher oil prices on emerging market economies and the costs of metal production. We also discuss our base case outlook for 2019 and explain why we expect lower, rather than higher, oil prices on the horizon.
$100 oil is an added burden for emerging market currencies
We have run a scenario showcasing the effect of a rise in the oil price to $100 /bbl in 2018Q4 that persists through to 2019Q4. The chart below illustrates how higher oil prices are likely to affect selected emerging market economies whose currencies have been under pressure recently. Since these economies are net oil importers, the higher oil price raises the cost of imports. If the economy has a current account deficit already, and relies on external funding, the additional pressure on the current account causes the currency to weaken further. As the currency weakens, foreign investors become wary and if they exit the currency, another round of depreciation follows.
Impact of higher oil price on metals: vary by metal and mine
Higher oil prices tend to push up on the costs of producing different metals, because they increase input costs through their impact on fuel costs (e.g. diesel and gas). This is largest for thermal coal conversion costs – the cost of transforming inputs into metal outputs – at 15% and smallest for aluminium smelting at 1%. There are also indirect effects, for example through power generation costs (e.g. electricity) where the impacts may be potentially larger. The chart below illustrates that power’s share of conversions costs is largest for aluminium smelting followed by nickel, copper, lead/zinc and smallest for thermal coal. These metal exposures to oil are indicative in that they average across regions and mines. For this illustration, we have not included transport costs – which would have more influence on bulks. And we have not explored the broader indirect linkages between high oil prices and metal costs, e.g. through currency effects.
Supply constraints fuel potential for higher prices in Q4
Above, we have presented the results of the $100 oil scenario on EMs and the costs of metals production. In creating our base case forecast, we find that the key driver of oil prices will continue to be the supply and demand fundamentals.
In the chart above, we can see that the oil market experienced a prolonged period of deficit which began in February 2006 and finally ended in January 2015. Oil prices rose above $100 in 2008, and again between 2011 and 2014. During that time, the US dollar also experienced profound weakness, reaching $1.60/€. If it had not been the marked slowdown in global economic growth caused by the GFC, oil prices might have risen much higher than the $143/bbl reached on 3 July 2008.
By January 2016, the physical market had reached an historic level of oversupply which caused the price of Brent crude oil to fall below $30/bbl for the first time since March 2003. This prompted action by OPEC and other oil-producing countries — most significantly, Russia — to reduce output. This curtailment arrangement was extremely successful, and, by May 2017, the glut of excess oil dwindled and the market began to register deficits, allowing prices to recover.
As we look ahead to the rest of 2018 and into 2019, we expect the global crude oil market to remain broadly balanced. However, price risk is to the upside in the near term given a high level of uncertainty around production levels. The chart below illustrates that, during May through September, shortfalls in output by Iran and Venezuela were largely made up by the rest of OPEC (far left of chart). However, beyond November, the potential additional shortfalls in production from these two key producers (as noted by the distance between the blue bars and the gold diamonds) are not likely to be fully recouped by additional output from the rest of OPEC.
To further make this point, Russia (which is not part of OPEC) and Saudi Arabia, have gradually increased production since May/June. However, it is unclear whether they will be able to ramp-up fast enough to fully offset any further losses from Iran or Venezuela without prices rising further. In the case of Saudi Arabia’s output, another risk has now arisen in the form of potential sanctions against the kingdom if the recent murder of Saudi journalist Jamal Khashoggi can be tied to Deputy Prime Minister Mohammad bin Salman (MbS).
By mid-2019, the threat of $100 oil fades
Our base case forecast expects the crude oil market to remain in relative balance for the rest of 2018. Beyond November, however, there is significant risk that supply could fall short of demand. If that is the case, the oil market may attract new speculative buyers, resulting in another round of higher prices and potentially hitting $100/bbl.
With Brent crude currently trading below $77/bbl, reaching $100 oil seems quite a stretch. The price has fallen since early October because speculative buyers have exited the market. This decline in investor sentiment supports our view that, beyond Q1 2019, participants in the crude oil market will focus less on the potential lack of supply and, instead, on whether demand will be as strong as we expect. Put another way, supply constraints will start to ease in Q2 2019, just at the time that global oil demand may be softening.
Thus, even if Brent crude hits $100 sometime between December and February 2019, we do not believe that price level is sustainable based on future supply/demand fundamentals. We therefore expect the price of Brent crude to average $75/bbl in Q4 2019, with additional downside risk stemming from slowing momentum in the global economy and more plentiful oil supply.