And now for an oil crash

Via the IEA Friday night:

While geopolitical tensions in the Middle East Gulf remain high, with US sanctions recently extended to more Iranian officials and a Chinese oil importer, as well as another tanker seizure, oil prices (Brent) have eased back from the most recent high of $67/bbl. Shipping operations are at normal levels, albeit with higher insurance costs. The messages from various parties that vessels will be protected to the greatest extent possible, and the IEA’s recent statement that it is closely monitoring the oil security position in the Strait of Hormuz will have provided some reassurance.

There have been concerns about the health of the global economy expressed in recent editions of this Report and shown by reduced expectations for oil demand growth. Now, the situation is becoming even more uncertain: the US-China trade dispute remains unresolved and in September new tariffs are due to be imposed. Tension between the two has increased further this week, reflected in heavy falls for stock and commodity markets. Oil prices have been caught up in the retreat, falling to below $57/bbl earlier this week. In this Report, we took into account the International Monetary Fund’s recent downgrading of the economic outlook: they reduced by 0.1 percentage points for both 2019 and 2020 their forecast for global GDP growth to 3.2% and 3.5%, respectively.

Oil demand growth estimates have already been cut back sharply: in 1H19, we saw an increase of only 0.6 mb/d, with China the sole source of significant growth at 0.5 mb/d. Two other major markets, India and the United States, both saw demand rise by only 0.1 mb/d. For the OECD as a whole, demand has fallen for three successive quarters. In this Report, growth estimates for 2019 and 2020 have been revised down by 0.1 mb/d to 1.1 mb/d and 1.3 mb/d, respectively. There have been minor upward revisions to baseline data for 2018 and 2019 but our total number for 2019 demand is unchanged at 100.4 mb/d, incorporating a modest upgrade to our estimate for 1Q19 offset by a decrease for 3Q19. The outlook is fragile with a greater likelihood of a downward revision than an upward one.

In the meantime, the short term market balance has been tightened slightly by the reduction in supply from OPEC countries. Production fell in July by 0.2 mb/d, and it was backed up by additional cuts of 0.1 mb/d by the ten non-OPEC countries included in the OPEC+ agreement. In a clear sign of its determination to support market re-balancing, Saudi Arabia’s production was 0.7 mb/d lower than the level allowed by the output agreement. If the July level of OPEC crude oil production at 29.7 mb/d is maintained through 2019, the implied stock draw in 2H19 is 0.7 mb/d, helped also by a slower rate of non-OPEC production growth. However, this is a temporary phenomenon because our outlook for very strong non-OPEC production growth next year is unaltered at 2.2 mb/d. Under our current assumptions, in 2020, the oil market will be well supplied.

You’ve got to love that understatement of the IEA. Here’s my market balance chart:

As things stand, that’s enough glut to trigger major price downside into year end, which is the seasonal low season for oil demand. OPEC will certainly jawbone if not act.

Now, let me show you another chart:

This is WTI versus US and EM junk bonds. They move in unison because when oil falls (or rises) it is signalling the global marginal oil producer, US shale, to borrow less or more to drill less or more wells.

But what this marginal stress in the junk bond market also does is upset wider markets. All junk spreads begin to blow out and, before long, that upsets equity markets too. I haven’t added the S&P500 to the chart because it gets a bit hard to read but its major corrections in the past few years have also tracked oil and junk bond stress.

In short, owing to the centrality of shale oil production to the US industrial revival, the oil price has inverted its traditional relationship to the US economy of lower being better for consumption and higher being worse. Today, when oil falls heavily so does the equity market and that hammers the consumer.

Looking ahead, as the trade war drags Chinese growth lower, Brexit and Italexit hammer Europe into Q4, and an oil glut gets simultaneously worse not better, oil is the key channel of contagion from a souring global economy back into US debt, equity and the US consumer.

Watch oil. If it crashes into Q4 to shut off US shale then global recession 2020 is a go.

David Llewellyn-Smith
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