Oil prices this year will be influenced primarily by the health of the global economy, which is why prices have closely tracked equity and bond markets in recent months.
U.S. shale production growth, the policy of OPEC and its allies, U.S. sanctions on Iran, and the threat of sanctions on Venezuela may all have an impact on the price of a barrel.
But that impact will be secondary and it is more likely to be crude prices that determine what happens with U.S. shale, OPEC+ policy and U.S. sanctions.
Predict what will happen to the global economy and the movement of oil prices in 2019 should become clear.
Business sentiment is buckling under pressure from the deteriorating relationship between the United States and China, as well as tightening financial conditions in the form of higher borrowing costs and falling equity prices.
The global economic expansion has been losing momentum since the middle of last year, and there are signs the slowdown has worsened in recent months, with risks skewed to the downside.
So oil consumption, especially middle distillates such as diesel, which are closely linked to freight transportation and industrial activity, is likely to grow more slowly in 2019.
Lower crude prices and the introduction of new pollution regulations on shipping fuels will offset some of the implied slowdown, but consumption growth is still set to slacken.
The extent of the slowdown depends on whether global growth starts to accelerate again, settles into an extended soft patch, or falls into an outright recession.
The difference between each of these three scenarios amounts to several hundred thousand barrels per day (bpd) of consumption growth, dwarfing all other influences on oil prices in 2019.
Much will depend on whether the United States and China can successfully de-escalate their economic conflict and whether financial conditions (including equity prices, yield curves and credit availability) ease.
U.S. SHALE OUTPUT
U.S. production of crude, lease condensates and gas liquids surged by more than 2 million bpd in 2018, the largest one-year increase reported in any single country in the history of the oil industry.
The frenzied shale boom coupled with signs of slowing consumption growth and unexpectedly generous U.S. sanctions waivers on Iran’s oil exports to push the market towards a large surplus in the fourth quarter.
The result has been a sharp drop in prices which has already prompted OPEC, and especially its principal member Saudi Arabia, to cut production sharply.
Lower prices are also expected to moderate the growth in U.S. shale production this year and next, albeit after a delay, as the industry completes the large number of new wells started during the 2018 boom.
The U.S. Energy Information Administration forecasts growth in petroleum liquids supply will slow from 2.22 million bpd in 2018 to 1.73 million bpd in 2019 and 1.24 million bpd in 2020.
But the speed and depth of any slowdown in U.S. shale production is uncertain and likely to depend critically on what happens to prices and thus the economy.
The Organization of the Petroleum Exporting Countries and its allies have announced plans to cut their combined production by 1.2 million bpd to prevent the oil market from becoming oversupplied.
The group’s early and aggressive production cuts appear to have removed much of the near-term surplus in the oil market and boosted sentiment.
Hedge funds and other money managers have stopped selling futures and options linked to Brent crude and European gasoil and become small buyers of both since the start of the year.
Spot Brent prices have found a floor above $60 per barrel, up from $50 in late December, and the structure of futures prices has swung from contango to level and even a small backwardation in the front-month.
Higher spot prices and firmer calendar spreads have caused some OPEC policymakers to conclude the market rebalancing process is over.
But if the global economy falls into an extended soft patch or even a recession, OPEC and its allies will probably have to make further cuts to prevent a surplus re-emerging.
Likewise, if U.S. shale production does not slow as quickly as anticipated, OPEC+ will come under pressure to cut output further.
On the other hand, if the economy grows strongly, and/or shale production slows sharply, the resulting market tightening will encourage OPEC+ to unwind some of its output restraints.
Like the shale producers, OPEC’s production policy will ultimately be contingent on the health of the global economy and the rate of oil consumption growth in 2019.
The United States has pledged progressively to tighten sanctions on Iran’s oil exports after the White House decided to pull out of the nuclear agreement reached in 2015.
The first phase of sanctions has proved less aggressive than expected after the United States granted generous waivers to some of Iran’s largest customers in Asia.
The White House seems to have responded to concerns about the lack of spare capacity in the oil market to replace exports lost from Iran and the resulting upward pressure on oil prices.
U.S. policymakers have proved sensitive to the impact of higher oil prices on fuel costs for motorists and the state of the economy.
But the initial waivers were granted for only six months so they will have to be extended, narrowed or terminated by May.
Oil market analysts have speculated about whether the next round of waivers will be tougher or if they will be terminated completely. In practice, the last round provides a route-map for U.S. decision-making.
White House decisions will be conditional on the availability of spare capacity and prices, which in turn makes them dependent on the state of the oil market and the economy.
If the global economy remains sluggish, OPEC is still restricting output, and oil prices remain relatively low, the White House may take the opportunity to narrow the waivers or remove them altogether.
If the global economy is accelerating, OPEC is unwinding its production cuts, and oil prices are rising again, the White House is likely to be less aggressive.
The same considerations apply to possible U.S. sanctions on Venezuela’s oil exports, which are likely to be contingent on the anticipated impact on prices and the availability of replacement capacity.
In Venezuela’s case, there is an additional complication because there are few alternatives to the country’s heavy and diesel-rich crudes. Venezuela’s heavy crude cannot be replaced by light U.S. shale production.
If the United States decides to impose primary and/or secondary sanctions on Venezuela’s exports, alternative supplies will have to come from Saudi Arabia, the United Arab Emirates, Kuwait and Iraq.
Spare capacity in these countries may not be enough to cover for tough sanctions on both Iran and Venezuela at the same time while leaving enough to absorb further shocks.
Like everything else, the severity of sanctions on Iran and Venezuela depends on the state of the oil market and the economic outlook.