The Exceptional Factors Driving Oil Markets

Brent crude moved over $70/barrel in the first half of April, despite a weak global economy. In its latest World Economic Outlook, the IMF reduced both its estimate of global growth in 2018 and its forecast for 2019, which fell from 3.7% to 3.3%. If realised, this would be the weakest expansion of global GDP since the 2009 financial crisis.

Although the IMF sees something of a recovery in 2020, the OECD's composite leading indicator has been below its long-term average of 100 since July 2018 and remains on a downward trend, reaching 99.10 in February, again the lowest level since 2009.

There has been some loosening of monetary and fiscal policy in the US, China and Europe, and Chinese-US trade talks appear to be inching towards some kind of resolution, but the world economy continues to skirt recession. The IMF warns that the prospects for recovery remain fragile, but financial markets appear to be taking a 'glass-half-full' attitude.

Higher oil prices and weak economic growth are not conditions that will stimulate oil demand. What growth there is will be captured mainly by US producers, raising the cost in terms of market share to OPEC and Russia of their current production curbs, complicating their decision on whether to extend current policy beyond the end of June.

Supply tightening

Higher oil prices are justified in the short-term because of the sharp fall in OPEC crude output, which according to S&P Global Platts' monthly survey, dropped 570,000 b/d from February to 30.23 million b/d in March, the lowest level in more than four years. Further declines may well be on the cards as a result of General Khalifa Haftar's offensive against the Libyan capital Tripoli, which has raised fears that Libya's crude production will again face disruption.

OPEC and its non-OPEC partners agreed in December to reduce oil supply by a total 1.2 million b/d in first-half 2019 from October 2018 levels. By over-complying with its own share of the cuts, Saudi Arabia is indeed leading by example.

Saudi production in March was 440,000 b/d lower than required under the deal, a position which flies in the face of Trump administration concerns that higher pump prices in the US will undermine US President Donald Trump's re-election chances in November 2020.

Meanwhile, the huge fall in Venezuelan output by 360,000 b/d to just 740,000 b/d in March appears to herald a new level of crisis in the country's oil industry as it struggles to maintain adequate power supplies and deal with shortages of the diluents necessary to keep its heavy oil operations functioning.

US sanctions against the country are taking their toll and closure of the country's heavy oil upgraders further limits naphtha availability as they play a key role in recycling the diluents necessary for lifting oil from the Orinoco Belt. The drop in exports may be exaggerated - Lloyds list has reported suspect shipping movements off Trinidad and Tobago - but the complexity of Venezuela's heavy oil supply chain makes it particularly vulnerable to sanctions.

Venezuela remains an unpredictable oil market flashpoint, particularly if the country's growing humanitarian crisis increases the pressure for outside, particularly US, intervention.

Developments in Libya also increase upside price risks. Although Libyan crude output rose by 190,000 b/d in March to an average 1.06 million b/d as the El Sharara field came back on stream, Haftar's advance on Tripoli creates an untenable situation in which most oil production is under the control of the eastern-based Libyan National Army, or militias, while financial payments continue to flow through the National Oil Company (NOC) based in under-siege Tripoli.

With Libyan crude production reported by NOC to have reached 1.2 million b/d by end-March, there is now little further supply upside amid growing downside risk.

Sanctions decision

These threats to oil supply heighten the risk of a further rise in oil prices, if the US tightens sanctions on Iran. Washington is poised to decide on the extension of waivers by May 2 for key importers of Iranian crude - China, India, Japan, South Korea and Turkey. A failure to extend China's sanctions waiver could impact progress in the two countries' trade talks.

A more accommodative stance by Saudi Arabia would support Washington's toughening of sanctions against both Iran and Venezuela by reducing the upward pressure on oil prices. So far, Riyadh is not playing ball, but events in Venezuela and potentially Libya create the conditions for some loosening of its current level of over-compliance.

However, the real fissure in OPEC's position may be with its partner Russia, which has been sending mixed signals over its willingness to extend its production cuts beyond June. Russian crude production fell to 11.3 million b/d in March, according to the country's energy ministry, down from February, but was still 116,000 b/d higher than its promised reduction of 228,000 b/d from October 2018 levels under its agreement with OPEC.

Russian energy ministry and industry sources suggest the country's oil companies are champing at the bit to raise output, but the cost to Russia of the OPEC+ deal so far is much smaller than the gain. Russia is enjoying higher oil prices on near record output, while Saudi Arabia and US sanctions deliver the majority of supply curbs. Saudi Arabia, Iran and Venezuela are certainly losing market share to US producers, but Russia much less so.

The ultimate decision on whether to extend Russia's cooperation with OPEC lies with Russian President Vladimir Putin, whose calculations are complex.

He has assiduously been asserting Russia's influence in the Middle East, a strategy in which cooperation with OPEC plays a major role. He has expressed concern that the US may be able to use regime change in Venezuela to its own advantage. He has had to contend with an extension of US sanctions against Russia under Trump, but almost certainly has more to fear from a Democrat victory in the US presidential election in 2020, so he may also have an eye on US pump prices. Tougher US sanctions against Russia could prove a direct threat not just to long-term oil production, but Russia's growing LNG ambitions, which remain dependent on foreign technology imports.

There are too many moving parts to make firm predictions, but while acting tough with the US' foreign adversaries is good electioneering for Trump, it works less well if it results in tougher economic conditions at home. Trump's focus is likely to turn increasingly to the domestic economy as the presidential election nears, which suggests keeping US-China trade talks on track and oil prices under control, but not low enough to reverse US production gains.

So - no tightening of sanctions on Iran. Saudi Arabia and Russia will watch events in Venezuela and Libya closely before deciding on their options in June.