July 2016

While recent upticks in commodities prices may not be the recovery institutions are waiting for, the longer-term picture is less flooded with oil and steel. Joanna Lewin explores the commodities landscape

The world is drowning in oil. That’s what is being reported by news publications the world over – and, for the moment, proving hard to challenge. Oil behemoth Russia, together with members of the Saudi-led Organization of the Petroleum Exporting Countries (OPEC), is resisting calls to cut production levels to remedy the current chronic oversupply.

These nations are pumping oil at record rates and major banks are predicting varying but altogether worrying price estimates – some dipping to as low as USD 10 per barrel (bbl)1. That’s despite the recent uptick in oil prices to around USD 40 bbl2. But research by Deutsche Bank posits that placing any long-term certainty on either the sudden turnaround in the oil price or the underlying low level seen throughout the first months of the year is misguided. While there could be a further slump in the price of oil and with it steel, nickel and others, Deutsche Bank analysts say there’s just as much evidence to suggest prices will sustainably rebound in the near-ish future.

Radical response

Although there is a great deal of surplus oil floating around, when looking at barrel numbers, the widely advertised oversupply looks rather more modest. Global production in 2016 is 96.44 million barrels per day (bpd)2. But the world struggles to guzzle more than 94.85 million bpd1, resulting in a surplus 1 million bpd. In 2015, though, there was an overhang of 1.2 million bpd, so this year’s figure is an improvement.

As for steel, the recent and severe rebalancing in the real-estate sector and investments in China triggered a 3.5% decline3 in demand by Chinese construction and manufacturing firms in late 2015. Let’s not forget, China accounts for about half of the world’s steel supply. It has the capacity to produce 1.1 billion tonnes4 of metal per year. China has sold its resulting surplus to nations around the globe for a markedly cheaper price than many other steel exporters could possibly afford.

It doesn’t take an economist to conclude that the reverberations of this situation for the world’s primary steel producers are fairly catastrophic.

Analysts see few signs of the oversupply abating without a radical response from the world’s commodities suppliers, or, if they don’t play ball, more severe tariffs on commodities imports, such as those imposed by the US, of around 260%. The EU, so far, has not imposed tariffs. Efforts are being made to impose anti-steel dumping laws on China, but these are taking time to materialise.

Sebastien Marlier, Senior Commodities Editor at the Economist Intelligence Unit (EIU), says that a material response is necessary before any plateau in oil and other commodity prices can be reached. And as yet, that hasn’t been forthcoming. “It seems major suppliers are still pumping out record amounts of oil and producing significant amounts of metal,” says Marlier.

A March 2016 meeting for oil makers to discuss a production freeze was mooted, but then called off once it became apparent Iran would likely not agree to a deal. And an OPEC meeting in April ended without a deal.

Resisting calls to cut

Maintaining market share is one big reason why OPEC countries seem to be turning a deaf ear to suggestions of cutting oil production, and why China isn’t responding to appeals to lower its metal output. But there’s a more fundamental reason too, believes Marlier. “Cutting production is costly. You might need to close down a whole operation.”

There is also the effect on employment to consider. “Closing down aluminium smelters in China has a strong impact on jobs and on local government revenue, so you see local and even central government being very wary of pushing for closures.”

The World Trade Organization states that countries have the right to protect their businesses’ interests and many Chinese firms are benefiting from the lower prices – an argument put forward by the Chinese Minister of Commerce, Gao Hucheng. He added that the steel situation was “purely market behaviour, not the behaviour of the Chinese or EU governments”. So, until there is a substantial and sustained response from suppliers, there will continue to be substantial oversupply.

But as Grant Sporre, Head of Metals Research, and Michael Hsueh, Head of European Natural Gas and Thermal Coal Research at Deutsche Bank, point out in their research, global demand is healthy, especially when the price is low. The excess supply should therefore drain off within the next few years.

Absorbing supply

Pointing to the US’s tight oil production, for example, the pair cite encouraging figures that indicate supply absorption. Output is already well below its mid-2015 peak of 5.5 million bpd and will likely fall to 4.2 million bpd by the end of the year. This has allowed them to forecast medium-term prices rising towards USD 50-55 bbl by next year, more than the amount needed for many US producers to break even.

If oil prices really do fall to lows of USD 10 bbl, Sporre and Hsueh say that, for example, planned capital expenditure (capex) might be “ratcheted so low as to engender a greater likelihood of a V-shaped recovery in prices over three to five years”. Before it even got to firms shelving capex, OPEC nations would get involved, they add.

EIU analysts agree with this logic. The group’s central scenario is for a sustained pick-up in the oil price as soon as the second half, and particularly the final quarter, of 2016. And Marlier thinks that Russian production is bound to drop at some point. “Russian producers will have trouble sustaining their current production levels. Dwindling investment and growing cash restraints have made it difficult.”

The Brent Crude price is currently around USD 40 bbl – a step in the right direction. However, Marlier believes this current upturn will be short-lived, given the broader prevailing conditions. “When you consider that shale oil producers have been so slow to reduce production, the recent recovery isn’t really what we mean by a material recovery – we are expecting that later on in the year,” he says.

So there is good and bad news. The price increases seen of late are unlikely to last, but a more meaningful recovery is on its way. “While it’s too soon to say ‘we’ve seen the worst’ we can already say, ‘it could be worse’,” says John MacNamara, Global Head of Structured Commodity Trade Finance at Deutsche Bank. He notes that Brent Crude and West Texas Intermediate were both about USD 27 bbl back in the depths of last winter – and are now pushing USD 40. Iron ore has been floating around the USD 50s when at the start of 2016 it was in the USD 30s, and zinc is now heading towards USD 1,800 per metric ton, up from USD 1,500.

Efficiency gains

While financial institutions are taking a broadly doom-and-gloom attitude and gravitating to low commodities price estimates, corporates are far more upbeat.

On a recent trip to the US, MacNamara was struck by a comment made by someone at a Houston oil corporation. “We’ve never been this efficient,” they said. MacNamara explains this stance: “When oil is USD 100 bbl, everyone focuses on growth and the ample cost-base cover means no one looks too closely at the bills. At below USD 30 bbl, they check every nickel and dime to be sure they don’t spend what they don’t have.”

In any case, for many European corporates, the advantages of low commodity prices actually outweigh the disadvantages. A price recovery may offset some of these benefits.“For the majority of European corporates, energy and oil are a cost, rather than a revenue, consideration,” says Marlier. “At the end of the day, the benefits will likely exceed the costs.”

But there are also risks for corporates. “Stock prices and market sentiment have moved in line with oil prices, which could affect corporates negatively. So, for those who were expecting a boost to European markets as a result of lower oil prices, this hasn’t really been as clear as in previous commodity cycles.”

As for financial institutions, Marlier says: “The exposure for European financial institutions is far less than for US ones. And even for them, they have very diversified portfolios and relatively limited exposure to the energy sector.”

Uncertainty reigns

During all of this discussion, commodity prices are still fluctuating. Oil prices are likely to continue to yo-yo as short-term factors cause short-lived spikes. But what is clear is that the response from OPEC nations and Russia will be key to oil prices settling, and Chinese economic stability will underlie metal prices rising.

With Russia likely to be forced to cut production due to cash considerations, further OPEC discussions to freeze output will probably be slated. And if prices really do dip to levels predicted by some of the big banks, then OPEC is likely to impose a freeze anyway.

While it wouldn’t be wise to say with any certainty that prices have hit a floor and can only go up, it is fair to predict that the oil price is far more likely to rise. And as oil is the great driver in market sentiment for metal prices, and therefore inescapably tied, it’s looking all right for them too.


The world’s top 5 oil producing nations:

1. US: 13,973,000 bbl/day
2. Saudi Arabia: 11,624,000 bbl/day
3. Russia: 10,853,000 bbl/day
4. China: 4,572,000 bbl/day
5. Canada: 4,383,000 bbl/day

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