Lower for (even) longer
In our January oil outlook update, our forecast for oil prices this year was adjusted down to $30~$50 from $40~$60, expecting the realignment of OPEC quota post Iran/Iraq production increases to normalize oil prices back to $80 range in 2018. OPEC inaction and weakening Chinese appetite were key factors behind the pessimism.
We are keeping our near term forecast range of $30~$50 with a $40 average, while pushing out the $80 recovery schedule to 2022 rather than 2018. The key change in our outlook is driven by new political developments in Saudi Arabia. We believe that the new Deputy Crown Prince Muhammad bin Salman has the royal family’s backing to enact fundamental economic reforms. His sweeping reform programs and hawkish foreign policy stance leaves little room for coordinated oil price control.
Key Points to Watch
We see a possible small production cut (~1MMbd) from Saudi Arabia, Kuwait and Abu Dhabi in 2H 2016. This could be a pre-emptive test to see how other producers react to cuts.
Seasonal effects could come into play in Q3 2016 in the form of strengthening prices without longer term adjustments in supply and demand. We could potentially see increased volatility as this seasonal effect phases out in Q1 2017.
Diverging paths of global central banks add another layer of uncertainty in the form of FX volatility. The US Dollar’s strength, relative to other major currencies, will be hard to predict in a hotly contested monetary environment. The swings in US Dollar could amplify the moves in oil.
Oil Demand
The sharp decline in oil prices since mid-2014 was caused not only by increased supply from tight oil producers, but also from waning demand from emerging economies. While there were no meaningful improvements in global economic outlook, we could expect opportunistic purchases from China’s Strategic Petroleum Reserves this year. The state financed program was largely responsible for oil price increase in the first half of 2015 and has further capacity to add to the reserves.
Supply
US: Total US output has been resilient since the price correction in mid-2014. Despite dwindling activities onshore, US offshore production around Gulf of Mexico has continued to increase output as the capital intensive project with long lead time came online.
Iran/Iraq: Attempts by Saudi Arabia to coordinate a meaningful OPEC wide production cut has been stalled a couple of times recently as member states refused to negotiate for reduced quota. Iran is a key dissenter as it aims to recover pre-2011 sanction production levels, which would be around 1MMbd increase from current capacity, before agreeing to any strategic price control. Due to Iran’s heavy dependence on outdated infrastructure, foreign investments are unlikely to ramp up production levels quickly. Iran might only reach the pre-sanction production level by 2020, extending our forecast for oil price normalization.
Saudi Arabia: Instead of focusing on market share, we believe that the long term goal of Saudi Arabia’s oil production is to reduce production to a comfort zone 8MMbd for sustainable management of their reserves. While our previous update assumed the Kingdom to achieve this comfort level by 2018 with a well-coordinated OPEC production cut, we now expect the production cuts to be far more gradual. The adjustment reflects the Saudi government’s concern about production elsewhere including Iran, Iraq and the US.
Saudi Arabia and OPEC members in line with the Kingdom’s strategy, namely Kuwait and Abu Dhabi, could coordinate a collective production cut of ~1MMbd later this year. This reduction will make room for increased output from Iran & Iraq and could be a pre-emptive test to see how OPEC and non-OPEC members react to production adjustments. The net reduction in US production between Q4 2014 and Q1 2016 has been underwhelming for Saudi Arabia.
Royal family matters
In accordance with the founder King Ibn Saud’s wishes, the tradition was to have the deceased monarch’s younger brother to succeed rather than his own son. However, King Salman broke this tradition by putting his own son Muhammad as the new Deputy Crown Prince. Prince Muhammad is only 30 years old but western media has been focusing on the unprecedented concentration of power around this young prince.
As defense minister, Muhammad bin Salman spearheaded the air strike campaign against Shia rebels in Yemen – the campaign was a decisive message from the prince against the regional foe Iran who backed the rebels. The air strikes also embodies the heightened nationalist and sectarian (Wahhabism) sentiment. There are speculations that the prince could also absorb more power from the tribal based fighting force and the National Guard. The Yemen campaigns also highlighted the rift between the Deputy Crown Prince and the interior minister Crown Prince Mohammed bin Nayef, who is increasingly being sidelined.
Muhammad bin Salman also controls a powerful economic co-ordination body, which gives him power over structural reforms in the Kingdom. The price called his economic plan to be “Thatcherite” in a recent interview with the Economist: He is using the recent collapse in oil price as an opportunity to push radical fiscal reforms such as cutting subsidies, balancing the budget, introducing value-added taxes and reducing public sector payroll. His plan for a possible IPO of Saudi Aramco has also gathered significant attention as Saudi Arabia tries to gradually shift away from dependency on oil to developing revenues from other industries.
Driven by the reform minded young deputy crown prince Muhammad bin Salman, we see increased likelihood of Saudi Arabia extending the strategy of ‘inaction’ before taking significant actions to bring oil prices to pre-2014 levels.
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