Historically speaking, commodity prices tend to outperform other asset classes in the later innings of the business cycle. As the current cycle inches ever closer to the longest on record, the oil trade has not disappointed. However, with BRENT oil prices near $80 a barrel at the time of this writing, it has us asking ourselves: what oil price is too high for the US and the global economy to handle?
But first, how did we get here and is the recent price strength sustainable? A strong, mostly synchronized global growth backdrop has certainly helped facilitate strong oil demand.
However, the main driver of prices this year has been on the supply side of the balance sheet. At the November 2017 meeting, OPEC agreed to continue its production cap agreement through 2018 in partnership with a few non-OPEC members, including Russia. On top of these self-imposed production limitations, economic and political hardship in Venezuela has pushed production to its lowest level in decades with losses around 400kbpd YoY, and further declines expected in the coming months. Outside of the OPEC agreement and Venezuelan woes, US-Iranian tensions heated up just as the White House promised, and the re-implementation of Iranian sanctions likely means that the better part of 1mbpd of Iranian oil supply will be lost by early 2019.
On the positive side of supply is the world’s newest swing producer: the United States. The US shale industry is booming with production growth up 1.35mbpd versus last May. If this pace were to continue, then the US could ultimately see production growth near 2mbpd by the end of 2018 – well above most analysts’ expectations coming into the year. But with OPEC on the sidelines for now and the US now filling the role of the world’s marginal producer, growing pains are becoming evident. The lack of adequate infrastructure in the high growth Permian region has trapped barrels inland. We have seen the basis crash between US WTI and Midland, TX as the market tries to dissuade Permian production growth, which is having trouble being exported due to takeaway capacity constraints and labor shortages – and additional pipelines are not expected until 2019.
With a strong global demand backdrop and the US unable to fully make up for the global production shortfalls thus far, oil fundamentals will remain constructive as long as OPEC and Russia do not completely back away from their production strategy. This higher price environment is incentivizing investment in US infrastructure and higher-cost offshore oil to come online, but until then, the key question we are asking ourselves is will a high oil price tax on the consumer start to put the overall economic growth picture at risk?
For growth and earnings, we have found that the rate of change of energy prices can be just as important as the outright level of oil. When we look at the relationship between BRENT oil price velocity (YoY) and the subsequent 1 year S&P 500 returns, we can see that an ~80% rise or greater, in the BRENT price has historically triggered S&P500 level contractions 1 year forward. Currently, we have risen ~60% YoY as of late-May 2018, so historically speaking, $80 Brent prices alone should not raise questions about an energy tax on growth. However, if supply side constraints persist and we get to $90-100/bbl BRENT oil prices during the 2018 summer, which would represent an 80% or so increase, it might start to raise concerns.
But is this historical relationship still relevant? It is worth mentioning that over the three decades of history in the above chart, there have been structural changes in the way that the energy markets interact with US growth, such as fleet efficiency, demand sensitivity, and investment spending. So all is surely not exactly equal today, but generally speaking, this threshold has been a precursor of economic weakness over the last three decades.
Looking ahead, we know that OPEC wants higher prices to fund social welfare programs and special interests (including its Aramco IPO coming in 2019), but in order to avoid a demand destruction event where the supply constraints push prices too high, it might be in OPEC’s best interest to release barrels if prices rally too far once Iran sanctions are implemented. This could help alleviate any growth constraints that could lead to a contraction in oil demand on a longer-term basis.
The next OPEC meeting is June 22nd. The major question may not be whether or not they release supply but when and by how much. Here are the top three items to consider which we expect OPEC will be considering as well: