INFOCUS. The challenges for OPEC 2.0 DECEMBER 2018

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INFOCUS M A R K E T S N A PS H OT DECEMBER 2018 The challenges for OPEC 2.0 DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. The icons alongside represent our investment process.

1 INFOCUS M A R K E T S N A PS H OT DECEMBER 2018 The challenges for OPEC 2.0 DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. The icons alongside represent our investment process. Through a disciplined provision of investment policy and security selection at the global level, regional portfolio management teams have the flexiblility to construct portfolios to meet the specific requirements of our clients. HIGHLIGHTED IN THIS PUBLICATION: GLOBAL STRATEGIC ASSET ALLOCATION GLOBAL SECURITY SELECTION REGIONAL ASSET ALLOCATION REGIONAL PORTFOLIO CONSTRUCTION

2 In this edition of InFocus, GianLuigi Mandruzzato looks at the impact of the recently-announced cutback in oil production and also examines what the new grouping of 24 oil-producing nations OPEC 2.0 means for the market. Last week, oil-producing countries decided to cut production targets by 1.2mbd from next January onwards. Canada also announced lower production targets for The measures are aimed at balancing oil supply and demand, undoing the recent fall in prices. Another important element emerged from the OPEC meeting in Vienna on 7 December where OPEC and ten other oil producers agreed to ratify the Charter of Cooperation between Oil Producing Countries, thereby formalising their agreement. This establishes OPEC 2.0, a group of 24 oil producing countries that controls about % of the current world supply. 1 The conclusion is that prices will rise again. Our model forecasts the WTI oil price will be around USD per barrel (/bbl) by the end of The outlook, however, remains very uncertain. As demand growth is expected to be stable, the swing factor for prices will come from the supply side. The lesson of the last two years for OPEC 2.0 is that cohesion and readiness to adjust production are crucial for stabilsing prices. Oil supplies will fall in January At the end of a long negotiation, OPEC and ten other non- OPEC oil-producing countries, led by Russia, decided to reduce production by 1.2 million barrels per day (mbd) from January for a minimum period of six months. The OPEC countries will reduce output by 0.8mbd and non-opec countries by 0.4mbd. The benchmark for the cuts is the output level of last October. Iran, Libya and Venezuela are exempted. The next meeting between OPEC and non-opec countries will take place in April 2019, a tighter schedule than the usual semi-annual OPEC meetings. In addition to the reduction decided in Vienna, the Premier of the Canadian province of Alberta, Rachel Notley, imposed a limit on production. From January, the maximum output will be 0.325mbd below the November level. The two independent decisions aim to reduce the excess supply 1. Oil prices ( dated) Brent WTI Source: Thomson Reuters Datastream. that has recently prevailed, limiting the accumulation of inventories, and alleviating the downward pressure on prices (see Figure 1). Why are oil prices under pressure? The supply reductions are a response to recent price volatility. After rising to the highs since 2014, prices for Brent and WTI have fallen by almost 35% since early October. The price volatility reflects the Trump administration s sanctions on Iran which limited the country s oil exports from the beginning of November. After the US announced the sanctions in April, OPEC and Russia increased their oil production, reducing the risk of a serious shortage of crude. Total production by OPEC and Russia in October and November was 1.2mbd higher than in May. In the same period, the US production rose by 1mbd. However, rising demand and fear of losing at least 1mbd of Iranian supply supported prices during the summer. The trend changed after the US administration granted waivers from the sanctions to eight of Iran s most important buyers. Suddenly, the market switched from a situation of potential crude oil scarcity to large excess supply, estimated at around 0.9mbd. This sparked the price drop. 1 OPEC 2.0 will be composed of the OPEC countries and 10 other oil producing countries that signed the Declaration of Cooperation in December OPEC currently includes 15 countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Congo, Saudi Arabia, UAE, and Venezuela. Qatar has announced it will leave OPEC at the end of The non-opec signatory countries are: Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russian Federation, Sudan, and South Sudan. 2 December 2018

3 The positioning of the market has exacerbated the price decline. Net long speculative positions were at an historical high at the beginning of February The initial price fall caused losses on the most recent trades and triggered the liquidation of large long positions. However, market positioning is now in line with the recent historical average (see Figure 2). 2. Long positions on oil and WTI prices US shale oil active rigs and output Number of rigs Million barrels per day Net long position (000s) WTI net long positions WTI price (13-week change, rhs) Source: Thomson Reuters Datastream and EFGAM calculations. According to some commentators, the slowing in economic growth (illustrated by the reduction of 2019 GDP forecasts by the IMF and OECD) will mean less demand for oil an will therefore weigh on oil prices. Oil oversupply is temporary The market doubts that the production cuts announced last week will balance the oil market. Prices remain low and the futures market does not anticipate significant changes until the end of 2019 (see Figure 5 on Page 4). In contrast, we believe that the reduction of supply of over 1.5mbd from OPEC and non-opec countries and from Canada will end the oversupply as early as the first quarter of Clearly, changes in oil demand also matter. The International Energy Agency (IEA) expects demand to rise by 1.4mbd in 2019, exceeding mbd. According to the IEA s World Energy Outlook published in October, global oil consumption will approach 110mbd in This estimate could be even higher if prices remain low. To meet the increased demand and avoid price spikes, the IEA estimates that, in the next seven years, the production of American shale oil will have to grow by 16mbd on top of the current 7.8mbd (see Figure 3) % US shale oil active rigs US shale oil output (mbd, rhs) Source: US Energy Information Administration, Thomson Reuters Datastream and EFGAM calculations. Investment in the American oil sector will therefore have to grow significantly. Since the industry comprises profitmaximising companies, the expected price of oil will have to cover costs and offer a profit margin. According to the latest Energy Survey of the Federal Reserve Bank of Kansas City, US shale oil companies are profitable if the price is at least USD55/bbl, a bit higher than current market prices (see Figure 4). Given the future amount of investment needed to match higher oil demand, the lack of specialised personnel and the increase in financing costs, it is conceivable that the breakeven price for shale oil firms will rise further. In the absence of higher oil prices, the lack of investment could cause a relative scarcity of oil in the medium term. 4. US shale producers breakeven price is rising Profitable oil price WTI oil price, quarterly average Source: Kansas City Fed Energy Survey September 2018, Thomson Reuters Datastream and EFGAM calculations. Last December

4 A more balanced market will support prices. Our econometric model forecasts that the price of WTI oil will rise to about USD/bbl at the end of 2019 (see Figure 5). Although below the levels reached at the end of last summer, the forecast is more than % higher than both the spot price and the price of the futures contract expiring in December Oil production shares, 2018 year-to-date averages Latin America 4.7% Asia 6.7% Other 10.7% OPEC 41.6% 5. WTI price model and market forecasts Canada 5.5% US 11.4% Non OPEC 19.5% Source: US Energy Information Administration, IEA, Datastream, and EFGAM calculations WTI price Base case forecasts to Q4 2019: WTI futures prices as at Upper Central Lower Source: Datastream, Refinitiv, and EFGAM calculations. The birth of OPEC 2.0 will support prices Higher oil prices depend on the rebalancing of supply and demand. The announcement of the forthcoming ratification of the Charter of Cooperation between Oil Producing Countries increases the likelihood of a balanced market even beyond The signing of the Charter will institutionalise the cooperation already in place since December 2016 between OPEC and non-opec countries, thus giving life to OPEC 2.0. Historically, OPEC has guaranteed between % and 45% of world oil supply. The expected growth of American production, however, puts at risk its hegemonic position in the oil market. By joining forces with the non-opec countries, which provided almost 20% of global supply in 2018, OPEC 2.0 will control about % of total oil supply (see Figure 6). Even if rising American output erodes OPEC 2.0 s market share, it will not fall below %, and will thus preserve the cartel s decisive role in influencing oil prices. It is important to note that co-operation with Russia and other oil-producing countries has increased the OPEC countries compliance with agreed production targets. This is a change from the tradition of OPEC countries exceeding the quotas set by the cartel. The challenge for OPEC 2.0 will be to remain cohesive and ready to react to market conditions as it has done in the last two years. If successful, its credibility will increase and will help in stabilise crude oil prices at higher and more sustainable levels. This will foster an adequate flow of investment and reduce the risk of oil scarcity despite the robust demand growth expected in the coming years. Conclusions Despite the co-ordinated reduction in oil supply since January 2019 announced by OPEC and non-opec countries and the similar move by Canada, oil prices remain low. Markets are worried that the announced cuts are insufficient to remove the excess supply of oil currently in the market. The downward revision of global growth risks reducing oil demand. There are also doubts about whether the announced production cuts will be fully implemented. However, OPEC 2.0 will ensure greater compliance with the production quotas decided by the cartel. The credibility of OPEC 2.0 will benefit from this. Because it controls about % of global oil supply, this will reduce the risk of persistent supply-demand imbalances. In a context of market rebalancing, the price of WTI oil should rise towards USDbp at the end of 2019 and then stabilise at more sustainable levels. 4 December 2018

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INFOCUS. Where might long US yields settle? APRIL 2018

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