Last weekend OPEC and Russia met and agreed not to increase production quotas to counter export barrels to be lost when new US sanctions on Iran come into effect in November. The decision defies a demand from President Trump to “get oil prices down,” albeit Saudi Arabia has always indicated US$80/bbl oil is a preferred level.
The Saudis did suggest they would pump more oil if customer demand required, but while it has taken some time, Brent crude’s recent move above US$80/bbl would imply a sense of “mission accomplished”.
But just as US$80/bbl might be a sweet spot for OPEC, a move higher still in prices begins to imply demand destruction. Yet Iran is not the only issue facing oil markets at present.
As NAB’s analysts note, the reimposition if US sanctions on Iran imply as much as -1.2m barrels per day of exports being removed from the market, based on pre-2016 levels when sanctions were last in place.
There is also the matter of Venezuela, which, thanks to crumbling infrastructure, attacks on foreign-owned oil companies and US sanctions on the Venezuelan government, has seen production fall to 1.5mbpd from a prior 2.5mbpd, with predictions of 1mbpd by year-end, NAB notes.
When OPEC first introduced the production quotas now in place, the general assumption was higher oil prices would incentivise increased US shale production, which would rebalance the equation and prevent too-high prices. But so rapid has the growth of US shale capacity proven, the pipeline infrastructure required to move crude to refineries is simply inadequate at this stage. The oil is there – no doubt – but it’s not going to get to market in a hurry.
Another possible outlier risk, NAB points out, is the potential for Iran to further stir up current Shia-on-Shia unrest in Iraq, which extends down to the port of Basra, through which 3.5mbpd or 75% of Iraqi crude production is moved.
Leaving that possibility aside, oil market consensus is that Brent could head back to US$100/bbl in coming months, which was the bottom of the range from 2011-14.
It was that period in which US shale production, which had begun to come to the fore thanks to new fracking technology, exploded. It was in 2014 the Fed completed “tapering” its QE program. In 2015, markets began to anticipate the first Fed rate hike post-GFC, from zero. That hike wasn’t delivered until December that year but from mid-2015 to that time, the US dollar rallied 25%.
Oil prices fell to below US$30/bbl. This served to put the US shale explosion on hold, and prompted OPEC and Russia into action. Suffice to say the Brent price is now back to US$80/bbl for the first time in four years, having last fallen through US$100/bbl in August 2014.
What if it goes back there?
NAB has modelled the impact on the US dollar.
Historically, oil, like all USD-denominated commodities, has a negative correlation with the dollar. But there are times when the historical correlation reverses for a time. As NAB notes, the US is now oil self-sufficient and a net exporter, rather than a net importer as it was before “fracking” became part of the common lexicon. Thus higher oil prices are a net positive.
A net positive, that is, for US oil producers. US fuel prices may be “cheap” on a global basis but are not government controlled. High oil prices impact on the major driver of the US economy – the US consumer – hence Trump’s demand for OPEC to “get prices down”. What would be gained on the GDP roundabout of energy sector strength would be more than lost on the swings of rising household and industry cost.
Hence NAB suggests that in the end, oil prices and the US dollar will remain negatively correlated.
NAB has looked at historical data beginning in 1988 to find eleven occasions in which the oil price rallied 27% over a three month period. On six of those occasions, the US dollar index fell by -7% or more, and two other occasions saw falls of -5.6% and -3.5%. On three occasions the dollar rallied.
Each of these three occasions coincided with rising US Treasury yields. On seven of the eight other occasions, yields fell.
US yields are currently on the rise as the Fed continues its tightening program. How far they can rise from here is largely dependent on policy moves from other major central banks still implementing QE/negative rates. The conclusion, nevertheless, is there is no guarantee what the greenback will do if oil continuers on to US$100/bbl.
NAB believes there is a high probability the US dollar will fall, at least by -5%, which implies the Aussie dollar will rise accordingly.
However if it all happens very quickly, the impact on risk sentiment with regard the Australian economy would be negative, NAB suggests, bringing pressure on the Aussie.
With Australian household debt already at historical levels and Australian industry already complaining about rising energy costs, it’s not hard to see that US$100/bbl oil, translated to prices at the pump, would not be good for the Australia economy if the Aussie does not rise to buffer the price impact, which in turn undermines the earnings of Australia’s major exporters of everything from iron ore to healthcare.