Worsening demand-supply dynamic to keep oil prices lower, for longer


A worsening demand-supply dynamic is likely to delay a much-needed rebalancing in global energy prices, with broad implications that ripple beyond the oil industry, Morgan Stanley said in a report.

It said that while a year ago the steep fall in crude prices seemed to track a historical parallel to 1986 based on the outlook for a relatively quick rebound, that was no longer the case now.

Oil prices have tumbled nearly 80 percent from highs of around $120 a barrel in June 2014, rattling global markets and rippling far beyond the usual sectors tied to the industry.

“Weaker-than-expected demand, higher-than-expected supply, rising inventories and increased hedging incentives all work to delay rebalancing, and slow the rise in prices immediately thereafter,” says Andrew Sheets, Morgan Stanley’s chief cross-asset strategist.

The new outlook holds broad implications for the global economy and markets, interest rates, currencies, and oil-sensitive sectors and regions, as well as how policy makers,  businesses, and investors react and adjust to what likely will be a deferred recovery for oil.

The report said that during prior downturns, including 1986, oil prices quickly found a floor and stabilized, setting the stage for a rebound. “This time around, global demand appears weaker, amid slowing growth in China and other emerging markets, while the oil majors have delayed projects and cut capital expenditure. Yet, OPEC has maintained its output, with additional supply expected to flow out of Iran. In addition, the ramp-up in US oil production over the past decade doesn’t come with an easy off-switch. In other words, growth in demand continues to lag behind unexpectedly resilient supply,” it said.

The strength of the dollar against other major currencies was another factor at play. “Because oil, like other commodities, is traded internationally in dollars, a stronger US currency can act as a de facto drag on demand. In fact, Brent crude oil prices have traded nearly in (inverse) lock step with the trade-weighted dollar, which has been gaining against other major currencies, such as the euro, pound, and China’s yuan, among others,” the report added.

It said for oil prices to recover, three things need to happen. “First, an over-supplied market needs to rebalance primarily through increased demand because production can remain stubbornly high in these environments. Then, high oil inventories will need to be worked off. Finally, producer hedging will need to run its course,” said Adam Longson, lead energy commodity strategist. After that, oil prices must also stabilize at a level high enough to maintain a supply and demand balance.

In the meantime, “volatility should remain elevated, with the trade-weighted US dollar, headlines and macro concerns continuing to drive oil prices,” he added.

Persistently low oil prices are likely to exacerbate short-term disinflationary trends in many regions, the report pointed out, adding that some major central banks have already reacted, with the European Central Bank planning to expand its quantitative-easing stimulus program, and the Bank of Japan unexpectedly taking key rates into negative territory for the first time at the end of January. These moves also have likely raised the bar for the Federal Reserve’s rate-tightening plans this year.

The oil industry is bearing the brunt of this downturn. At current levels around $30 a barrel, many producers face flat to negative margins. “Several million barrels-per-day of oil production is cash loss-making, and practically no upstream projects offer sufficiently attractive returns to warrant investing,” said Martijn Rats, head of the European energy equity research team.

The major oil companies are likely to try to maintain their dividends to keep investors engaged, something that has worked well in previous downturns, the report said.

In the past, free cash flow, a key barometer of corporate financial health and strength, generally held steady and was enough to cover such dividend expenses. Not this time around, said Rats. “With oil prices in-line with the current forward curve, we no longer forecast any of the majors to cover their dividends fully with organic free cash flow,” he warned.

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