Uncertainty Ahead

It’s hard to predict the energy market in a year filled with political and economic surprises.

Energy demand is a function of economic health. Economic health is driven by the workings of society. Society, in turn, is shaped by culture and politics. Alas, 2016 is scrambling these relationships, leading one to conclude that quite possibly everything we thought we knew to be true about them may not be true after all.

      That possibility dawned on me as I sat with my wife around a campfire on a cold evening in the bush of Zimbabwe. Sitting with us were a retired couple from Germany, a young couple from Australia, and a middle-aged couple from southern England (the husband originally from Ireland and his wife from the “original” Zimbabwe – Rhodesia, the former whites-only-ruled southern African country).  

      After debating the question posed by the German couple as to which of us spoke “correct” English, the conversation turned to how strange a year 2016 was becoming. It was an easy transition given that less than two weeks earlier the “Leave” faction had won the U.K.’s Brexit vote by a surprisingly large, four-percentage point margin. 

      The result shocked the world and especially those prognosticators who had confidently predicted that “Remain” would prevail by a comfortable margin. That view dominated the media’s reporting until the first votes were counted. The upset sent world financial markets into breathtaking declines as the prospect of Britain’s leaving the 28-member E.U. created huge uncertainty over the future of one of the world’s most important economic and political blocks, not to mention the U.K. itself.

      The Australian couple lamented missing the ongoing election back home arising from the fractious relationship between their government’s leader and the country’s legislative body over key national policy directives, especially energy and climate. The conversation then pivoted to the upcoming U.S. election and prospects for either a Hillary Clinton or Donald Trump presidency. 

Whither Oil Prices?

While energy policy hasn’t been a hot-button issue, election outcomes always influence future oil supply and demand trends. As a result, we must ponder whether 2016 will end with the oil market strongly in recovery mode or could the uncertainty of new policy initiatives take a toll on global demand as Middle Eastern oil exporters continue to ramp up output? Will oil prices struggle to stay in the $40s per barrel range or will they climb to $70 and beyond? Could oil prices even revisit February’s $26 low? Where oil prices sit at the end of 2016 will be determined by the health of world economies along with the wellbeing of the industry.

      Following nearly 18 months of falling oil prices due to surging global output, primarily from U.S. shale formations, and weaker than anticipated demand, the spot price for West Texas Intermediate (WTI) oil bottomed at $26.11 a barrel on February 11, 2016, down 76 percent from its cyclical peak. Immediately after, it climbed steadily higher until nosing above $50 a barrel on June 21. The next day it fell back to $49 before rising once again above $50 the following day. 

      The June 23 price, however, failed to surpass the earlier high, which signaled oil prices were likely headed lower. Weakness in oil buyer sentiment took its toll, reflecting the view that the Federal Reserve would soon boost short-term interest rates and thereby strengthen the U.S. dollar vis-à-vis other currencies. A strong dollar dampens global commodity demand, especially for oil, which is traded exclusively in dollars. Since the June high, WTI has fallen roughly 10 percent to the mid-$40s. 

      The spring price rally was helped by a weaker U.S. dollar and optimistic expectations about how quickly the global oil market would return to balance. The U.S. shale oil revolution that produced five years of rapid output growth was largely responsible for the surge in global oil inventories that weighed down prices. A continued weak economic recovery from the 2008 financial crisis limited global demand growth. 

      The imbalance was further tilted into oversupply by the fallout from the rift within OPEC itself over its role, or really the role of its leading oil-exporting member, Saudi Arabia, in supporting global oil prices. With Saudi Arabia rejecting its historical role of fine-tuning OPEC’s output, the supply glut exploded.

      Saudi Arabia had undergone a leadership change in early 2015 following the death of King Abdullah. His brother, King Salman, assumed the throne only to overthrow the traditional line of succession by elevating his nephew and son, essentially passing the leadership torch to the next generation of royal princes. Deputy Crown Prince Mohammed bin Salman, the king’s son and now third in line to the throne, was charged with revamping the country’s economy, including its oil policy. 

      Influenced by the view expounded by Saudi Arabia’s 1980s oil minister that “The Stone Age didn’t end when they ran out of stones,” the new leadership moved to shift the country’s economy away from its total dependence on crude oil and toward one based on manufacturing and finance. That plan is driven by fear that the country’s low-cost oil reserves might have little value if high oil prices continue to bring forth additional high-cost supplies at the same time that they suppress oil demand. The prospect that the “Oil Age” could end before Saudi Arabia runs out of oil scares the royal family, whose very existence has been dependent on Black Gold.

Confounding Expectations

Low oil prices traditionally stimulate economic growth. This time, low oil prices failed to lift economies. Why? Because the ravishing of the oil industry by falling prices stopped energy investment and destroyed employment while decimating the economies of oil-exporting countries. Surprisingly, weak oil prices also undercut general capital spending, and the fear of an oil price rebound kept consumer spending in check.

      Now, as oil prices climb, fear of economic chaos from 2016 political developments is further trimming the more robust demand outlook anticipated earlier this year. Recent terrorist attacks and Turkey’s failed coup attempt are further clouding the outlook. Oil demand growth is now expected to be slightly higher in 2016 than originally projected but still well below 2015. Demand in 2017 is being lowered. 

      If the U.K. falls into recession due to the fallout from its Brexit decision and the E.U.’s economic resilience weakens in the vote’s aftermath, global oil demand will fall further next year. The E.U. is also struggling with the economic problems in Greece, Italy and Spain. Because no one can confidently predict the outcome of the Brexit negotiations or their impact on the U.K. and E.U. economies, fear of an adverse outcome will restrain consumer spending and capital investment and hurt energy demand. 

      The upcoming presidential election in the U.S. has people concerned. The two candidates have the highest negative ratings among voters of any candidates in recent history. Visions of the future, as spelled out by the candidates, have voters worried about how vigorous the U.S. economy may be. An exploding government debt burden, increased taxes and government fees, weak labor productivity and adverse demographic trends have kept U.S. economic growth in the two percent per year range, down from the long-term three percent norm. Will capitalism or state socialism drive future growth?

      Both Europe and the U.S. are struggling with widening income inequality within their societies. That issue was cited for motivating the Brexit vote and in the U.S. for the popularity of Donald Trump and Bernie Sanders. Low-income citizens have suffered economically through lost employment, years of no wage growth, and uncontrolled immigration that threatens their future.  

      At the same time, the easy money policies of national banks globally are producing a surge in government debt, often resulting in negative yields such as in Japan and Europe. Today, an estimated $12 trillion of government debt now carries negative yields, and even corporate debt in certain countries is being priced with negative returns. There is rising concern that negative yields will come to North American markets too.

      Negative returns erode the savings of citizens, an important income source for retired Americans. The situation is generating grave concerns, leading to a high number of survey respondents saying their children’s futures will be worse. 

What Next?

A growing sense of frustration is shaping people’s attitudes and negatively impacting their spending, the lifeblood of economic activity. Energy forecasters are troubled by today’s political and social upheavals, and forecasting future oil demand has become more challenging as a result of the muddied political outlook. Be wary of people telling you they know how energy markets will function in the future because no one really knows what will happen during the remainder of 2016. – MarEx