Oil outlook: OPEC-US tug-o-war
Oil enters 2018 on a far firmer footing than it began 2017. Brent crude futures have risen beyond $62 and held the bulk of their gains following the rally since June’s trough. WTI crude has risen to above $56.
Both benchmarks are trading close to two-year highs after OPEC agreed to extending curbs on output designed to help the oil market rebalance following a long period of oversupply.
There are two major competing factors that will pull crude prices in opposite directions. While OPEC cuts production, output from the US is rising sharply. The combination suggests limited upside to oil prices from current levels and significant downside risk should the OPEC-Russia pact come apart.
US crude output has climbed steadily to achieve multi-decade highs by the end of 2017. Oil output hit 9,780,000 barrels a day (b/d), above the records hit at the peak of the shale output boom in 2015, US Energy Information Administration figures show. With OPEC cuts pushing up prices, there is reason to believe that US shale oil production will continue to rise and act to weigh on the upside potential.
Caption: US oil output is surging and threatens to make 2018 a tough year for OPEC
OPEC’s data suggest non-OPEC oil supply growth of 810,000 b/d in 2017, up 150,000 b/d from its last report. Supply growth outside OPEC for 2018 is expected at 120,000 b/d to 990,000 b/d. This is largely being driven by the US, where output is set to expand by 610,000 b/d in 2017 and 1.05 million b/d in 2018. At the same time, OPEC production has fallen to its lowest in six months.
The International Energy Agency (IEA) suggests OPEC will struggle to stay in this tug-o-war contest in 2018. It estimates non-OPEC supply will rise 600,000 b/d in 2017, and 1.6 million b/d in 2018. In addition to the US, new sources of supply in Brazil and Canada are set to come on stream.
In addition to the OPEC-US tussle, there are some other factors to be borne in mind. We note that while Venezuela output is well below its limits set by OPEC, this simply allows others to fill the gap and there is little chance that this may lead to a supply shock. In the North Sea, the temporary shutdown of the Forties pipeline has affected the market but this is not expected to deliver a significant impact on the market over the course of 2018.
While we see US output heaping pressure on prices, demand is seen growing. OPEC believes oil demand will rise 1.51 million b/din 2018, versus 1.26 million b/d in 2017. However the rally in crude prices may crimp demand following two years of cheap oil. Demand is incredibly hard to predict but is a key factor in determining whether the market will rebalance in 2018 or will remain oversupplied.
Rising US output will weigh on prices even as OPEC and Russia extend cuts. Crunch time will come in June when OPEC members gather in Vienna. Speculation about whether will stand up to rising US production with more aggressive cuts will likely be the key driver of oil prices in the first half of the year. Markets may begin to fret that the cartel has the muscle or the will to push for deeper cuts and this could spark sharp falls in futures.
Gold outlook: If real yields rise
Gold’s had a pretty good year in 2017, gaining around $100 an ounce to trade around the $1,250 mark. What’s in store for 2018 depends almost entirely on one thing: real US yields. And this depends on a number of factors by can be boiled down to the interplay between inflation and interest rates.
From their highs at the end of 2016, when the Trump trade pushed up Treasury yields all down the curve, real yields as measured by the 10-year Treasury inflation-indexed security have declined, pushing up gold prices.
Caption: Gold has a very tight inverse correlation with real US interest rates.
While short-term interest rates continue to rise, pushing up the yield on the 2-year Treasury note, there has not been a commensurate rally in 10-year yields. While this poses the risk of a yield-curve inversion, there are signs that yields on longer-dated paper could rise in 2018.
The Federal Reserve should continue to hike rates in 2018 at a pace consistent with its December economic projections. Market indicators show a shallower path of tightening, but this may be overly pessimistic. In this vein, the market has been right previously to doubt the Fed’s tightening agenda as defined in the dot plot, but in 2017 the Fed has stuck to its guns and carried through on more rate hikes than the market has anticipated.
While markets were previously correct to bet against the Fed, there are a number of reasons they may be wrong to do so now.
First, the US economy is growing at a rapid rate and even the Fed may be underestimating the pace of expansion in 2018. Growth in Q2 and Q3 was more than 3% yet the Fed’s projections are anchored at 2.5% for 2018 and fall off to 2.1% for 2019. This would appear to be pessimistic given the global economic growth picture, rising US oil output and the prospect of tax reform, the last of which the Fed admits will boost growth.
This takes us on to point two. Tax reform has yet to be factored into policymakers’ assessments of where interest rates should be in the coming years. Fiscal stimulus ought to give the Fed the headroom to tighten more quickly than the market expects.
Thirdly, while inflation remains below target, there is increasingly less room for the Fed to remain accommodative as the labour market has not only tightened but is pretty much at full employment. The break down in the Phillips Curve has been discussed before and it is worth noting there does seem to be a structural issue with the pass-through of jobs growth to inflation. Therefore it would seem likely that the Fed, while still seeking to achieve its mandate on inflation, will have to balance that aim with the situation in the labour market, as well as the GDP picture.
Finally in addition to raising short term rates the Fed is pressing on with its balance sheet reduction and ought to have the effect of elevating the yield curve further out to the ten-year mark. Although real yields have declined a touch since the end of 2016, there has been a rally since September as the market began to factor in the reduction in the Fed’s balance sheet.
The combination of rising yields and persistent weak inflation should continue to pressure gold prices in 2018. However there is a significant risk to this thesis if the yield curve continues to flatten and inverts. This would not only mean much lower real yields (positive for gold), it would also be a significant indicator of a recession, which is also usually positive for gold prices.