Oil producers: we start again from Iran
The oil sector is undoubtedly the one that presents the greatest complexity of reading as it is influenced by multiple poorly predictable macro and geopolitical variables. One of these was the 21-month negotiation with the Iranian government regarding the country's nuclear ambitions, ambitions that led to an embargo by Western countries starting in 2012. Iran is fourth among countries with the most oil reserves, approx. 158 billion barrels (YE2014, BP Statistical Review). Iranian light and heavy crude are the two main export specialties. Iranian crude is similar to that of other Gulf countries such as Saudi Arabia, Kuwait or Iraq. Iran exported mainly light crude to Europe until the 2012 embargo, the heavier types being diverted to Asia. A return of Iranian barrels to Europe could replace supplies from Saudi Arabia and Nigeria, but would also compete with the Urals. In this week's editorial, we analyze the consequences of this historic agreement which will allow for the return of Iranian oil to the world market in due time.
Focus of the week
Possible consequences of the return of Iranian oil
Oil prices rallied around 40% after hitting lows of USD 46 a barrel for Brent and USD 43 for WTI. After a drop that had reached USD 70 per barrel from June 2014 to January 2015, determined by the excess supply of 1.0 Mb/d in 2014 and 2.0 Mb/d in Q1 2015 from US shale, Brent prices are on the rise and they seem to have found technical support near USD 60 a barrel. Indeed, if we could go back in time to January we would find a very different market sentiment. At the time there was no clear indication where to locate the floor for oil prices, with estimates as high as USD 20 a barrel in the short term. However, a combination of strengthened demand (also supported by China's development of strategic oil reserve), with a decline in the number of drillers in US shale fields, supply shocks (Libya) and the low oil price itself (at levels not seen since the first half of 2009) have begun to restore market sentiment and have opened the door for a price recovery. Speculative money poured into upfront contracts and ETFs betting on rising prices. So we end up with a physical market that is still oversupplied, but incorporates a more favorable outlook for 2015 and beyond. There is little doubt that efficiency gains from unconventional US producers and concentrated extraction efforts on major fields have helped drive down production costs. This along with a growing fracklog in Texas and North Dakota were perhaps the main reasons why oil prices appear limited to the upside for the near term. With prices rising, US shale producers would begin completing wells adding volumes to the already existing supply surplus, accelerating the decline in prices.
Eventually Iran came too! After more than a decade of diplomatic attempts to handle Iran's nuclear program, the Islamic Republic and its P5+1 counterparts (the United States, Russia, China, France, the United Kingdom and Germany) have finally reached an agreement in Vienna that allows removal of Western sanctions. As for oil prices, the news is bad as it means more barrels coming into an already oversupplied market. However, the suspension of sanctions is not expected to be implemented before the first half of 2016, which erases some fears about a price depression caused by a flooding of the Iranian oil market held in storage. As we have said, Iran lacks the ability to significantly increase production and exports due to years of underinvestment in manufacturing infrastructure. There is however the matter of the 30-40 million barrels believed to be held in storage (mostly in tankers) that could make it to market. Nonetheless, not drowning the market with these barrels in order not to lower prices further is also in Iran's interest, a fact which leads us to believe that the release of crude oil in storage can be gradual (they are salable reserves only after the end of sanctions). There is a side effect that is already visible in relation to the response of other Gulf nations to Iran's return to the market. It is hard to believe that the Saudis can leave room in terms of OPEC quotas to adjust to Iranian production, which makes the scenario that OPEC production increases in 2016 the most likely, at the expense of non-OPEC producers, hence US shales.
The count of operational rigs in the big three shale basins in the US (Permian, Eagle Ford and Williston) has shrunk visibly in recent months, but may have already bottomed out. This is most evident in Permian fields, but with WTI prices in the fifties per barrel it appears that US core shale placements are generating enough profitability to maintain the number of drillers and even support an increase in them. Perhaps it is equally important to take a look at Weekly Equity prices 17 July 2015 Bank 3 Akros forward to see at what levels shale producers can forward sell their production in order to evaluate the level of profitability and therefore the evolution in the number of drills and in future production. As already mentioned, cost deflation has been the first line of defense for shale producers, but growing volumes from OPEC and solid Russian production could impact shale output and delay the price recovery more than as previously foreseen. According to recent polls, the market believes that an increase of 750 barrels per day could come from Iran by mid-2016.
We believe that crude oil prices could come under pressure in the short to medium term due to the Iranian pact even if the announcement of a definitive solution to the Greek crisis could act as support for prices. Despite our assumptions of a slow return to higher prices, given the Iranian volume surplus from 2016-17 onwards, we maintain our Brent estimate at USD 60 per barrel for 2015, USD 70 for 2017 and USD 80 for 2018+. As mentioned above, the impact of additional production and exports from Iran will only be visible from 2016 (and perhaps only significantly in the second half of the year), allowing the market to rebalance itself and absorb downward pressure on prices (through growth in demand, reduced non-OPEC supply and increase in Saudi Arabian refining capacity).
Macroeconomic scenario
After the fall below zero in the winter months, which triggered the ECB QE on government bonds, inflation in the Eurozone is gradually but continuously rising again. The risk of deflation has not disappeared from the world, on the contrary it is strengthening in the Asian continent (ex-Japan). But in much of the G7 the process of bottoming is evident and should continue. A first and important factor was the stabilization of energy and raw material prices, but in recent months core inflation has also started to rise again, and in this case the cause is above all the improvement in the economic situation. In the Eurozone, inflation gradually fell from 1.6% in July 2013 (last reading above 1.5%) to 0.3% in November 2014, from there drastically accelerating the decline to a minimum of -0.6% A/ A in January (identical to the previous cyclical low of July 2009) from which it gradually rose to return to 0.3% in May (0.2% Y/Y the June preliminary).
Core inflation has behaved quite differently: after remaining in the range between 0.7 and 1.0% from September 2013 until the end of 2014, it fell to an all-time low of 0.6% Y/Y (touched in January, March and April) but in the latest reading it rose to 0.9% in May (0.8% the flash estimate for June), returning within the range of the last 2 years. In the USA, inflation is more sensitive to oil prices, and fell from 2.1% (July 2014) to -0.2% (April 2015), returning to 0.0% in May. Core inflation, however, has been in the range between 1.6% and 2.0% for almost 3 years and the latest reading is 1.7%. In the Eurozone the situation is fairly homogeneous: in Spain inflation has just returned to zero (0.0% in June, it was -1.5% in January), in Italy it has been at 0.2% A/ for two months (May and June) A (minimum – 0.4%), in France it was 0.3% in May. In Germany, the harmonized CPI rose from -0.5% (January) to 0.7% Y/Y (May), but fell back to 0.1% in June (the May figure is a clear outlier compared to both other German data and the rest of Europe). As for core inflation, in Italy it is at 0.8% (June preliminary), France is at 0.6% (May) and Spain at 0.5% (May). In Germany in May it had jumped to 1.4% but it is probable that in June it fell by a similar amount to the drop (6 tenths) of the preliminary headline data, settling on levels close to those in Italy. If in February Italian core inflation had fallen below that of France and Germany for the first time in history, now it seems that the data are lining up again.
Looking forward, even if the crude inflation rate (headline) remains very low, the outlook is becoming less and less negative. The deflationary push at the end of 2014 was largely exacerbated by the collapse in energy prices, which stabilized after an initial technical rebound in the last three months. Following the sharp fall in unemployment, wage growth is picking up both in the USA and in the United Kingdom and Germany. In the US, the Employment Cost Index (quarterly) had remained between 1.5% and 2.0% throughout 2013 and the first half of 2014, but has accelerated in recent quarters to reach 2.5% Y/Y in 1Q 2015 All while the US unemployment rate is approaching the 5.0% level, traditionally consistent with the onset of wage inflation tensions. We are probably still far from returning to a normal Phillips curve (direct relationship between unemployment and wage growth), due to the presence of a large output gap (many labor market measures are far from full resource utilization), but the deflation risk is a long way off.
In the Eurozone, the situation changes depending on where you look: in many countries (including Spain and Italy) the unemployment rate is close to multi-year highs and wages are still showing low growth, although higher than that of the inflation (in the first quarter of 2015 Italy +1.1% Y/Y, Spain +1.2% Y/Y and France +1.6% Y/Y). But in Germany the unemployment rate is at historic lows and wage negotiations show a clear awakening of demands: wage growth was around 2.0% between the second and fourth quarters of 2014, jumping to 3.2% Y/Y in the latest data available (Q1 2015). Thus, in the Eurozone the quarterly wage growth index in Q1 returned above 2.0% (at +2.2% Y/Y) for the first time since the third quarter of 2012 (after having reached a low of 0.7% in the first quarter 2014).
In terms of outlook on inflation, in the Eurozone we are also starting to see the effects of QE, which has been in place for a long time in the USA, UK and Japan. The impact on the exchange rate was evident (although difficult to measure), the one on growth more complex. The weakening of the Euro affects inflation both directly (by making important products more expensive) and indirectly, by promoting growth. But QE goes further, and it cannot be a coincidence that since the beginning of the year the monetary aggregates have been accelerating sharply, which is being reflected in a greater growth in loans to households and businesses. Weekly Equity 17 July 2015 Banca 11 Akros The credit crunch in the Euro area seems to be over (however here too the situation is very different between North and South): M3 growth has gone from 1.1% Y/Y in May 2014 to 5.0% as of May 2015; loans to households in the same period went from +0.5% to +1.4% while the growth of loans to (non-financial) companies turned positive again in May for the first time since the beginning of the crisis (from -2.6% Y/Y in May 2014 to +0.1% in May 2015). Both the Fed and the ECB expect inflation to continue gradually climbing back towards targets, while remaining below targets for the foreseeable future. The ECB expects price growth at 0.3% for 2015, followed by 1.5% in 2016 and 1.8% in 2017. The Fed expects core inflation at 1.3-1.4% in 2015, accelerating to 1.6-1.9 % in 2016 and 1.9-2.0% in 2016. Based on these expectations, the Fed should start raising rates this year and very gradually normalize monetary policy over the next few years, while the ECB will continue QE until at least September 2016 and could start raising rates in 2017 (hopefully).
Attachments: equity we 17 Jul 2015.pdf
