$7 Crude? Deutsche Bank Downgrades Oil 'Lower For A Lot Longer'

Oil prices around USD 30/bbl mean that an increasingly significant volume of future oil projects no longer make sense. Although Deutsche Bank does not expect US crude inventories to reach capacity, rising US inventories and high US crude imports may heighten downside pressures to push prices closer to marginal cash costs of USD 7-17/bbl for US tight oil.

With few plausible scenarios for a strong price recovery in the short term, Deutsche lowers their Q1-2016 price forecasts to USD 33/bbl for WTI and Brent.

We see downside risks stemming from a lower demand growth outlook this year in the event that US product demand remains extremely weak, and from the possibility that equity market declines feed through into lower consumer confidence and spending. Upside risks may arise from either a weak or unsustained rise in Iranian exports, which may then lead to OPEC production in 2017 below our assumption of 32.4 mmb/d (excluding Indonesia).

One might be tempted to claim that prices have detached from fundamentals given the rapidity of the decline since December. Although we could choose to attribute some part of price movement to outside factors such as market psychology, an undeniable rise in risk aversion since the start of the year, and associated equity market weakness, this would do little to advance the state of knowledge regarding oil fundamentals. Therefore we prefer to (i) identify a possible fundamental basis for the further decline in oil prices, which could sustain prices at a low level, and (ii) assess the likely impact of prices remaining around USD 30/bbl on the forward balance.

With regard to the first point, the disappointment in Chinese economic growth for Q4-15 should not be a key driver as the most recent data on apparent consumption remains strong as of November 2015, with average year-on-year demand growth of +400 kb/d for the three months ending in November, Figure 2.

 

 

The further strengthening of the trade-weighted US dollar (TW$) may be a more substantial influence as since mid-December we have seen a further 1.4% appreciation, along with a continuation of the newly negative correlation of crude-oil daily returns with the TW$. However the dollar-oil correlation is still not nearly as strong as that observed over the 2006-2013 period and appears to be reverting to a more neutral level, such as that observed over the 1991-2002 period, Figure 3.

 

Perhaps the most negative piece of fundamental data originates from the United States where despite a more normal weather from the start of January, Figure 4, total product demand is down versus 2015 by -230 kb/d in the most recent week of data, Figure 5.

 

 

We note that more substantial demand worries may yet surface over the balance of the year as slowing economic growth outside of the US may infect the domestic outlook, particularly if equity markets do not recover materially and translate into weaker confidence and, in turn, consumer spending.

Finally Deustche Bank shows two long-term charts that hopefully make for interesting reading when considering just how "lower" for "longer" oil could be...

Firstly a long-term real adjusted chart we publish every year in our annual longterm study that shows that the average price (in today’s money) since 1861 is $47/bbl. So current levels are low but not exceptionally low relative to longterm history. Nevertheless in this year’s long-term study if prices stay at similar levels it will be the first time our long-term mean reversion exercise will show positive return expectations for Oil since we first started it over a decade ago.

 

 

Although we don’t claim to be experts on Oil markets our long held belief is that commodities that are factors of production are unlikely to outstrip inflation over the long-term as if they do there will be alternatives found. Clearly this can take years if not decades to resolve so even if we’re correct commodity cycles can still last a long time before they eventually mean revert. Overall the graph doesn’t suggest that current levels are as extreme as many would suggest even if long term value has returned. The $140 prices a few years back look especially bubble like in a long-term prospective.

 

The second chart looks at US recessions since the early 1970s and the price of Oil.

 

 

The Oil price was broadly fixed for much of the post-war Bretton Woods period but has floated since its collapse (average real price since then $57.7). As can be seen ahead of the five recessions seen over this period, all have been preceded by a significant spike higher in the price of Oil. While there are many potential drivers of a recession it is food for thought when you look at the current situation.

As we say on a regular basis we are firmly in the secular stagnation camp but have some sympathy that the consumer is getting a big benefit at the moment from the sharp fall in Oil. If only there wasn’t huge amount of leverage in the financial system exposed to commodities that could potentially be systemic.