Oil is making the headlines ahead of Algiers meeting – MUFG

Derek Halpenny, Research Analyst at MUFG, notes that the Brent crude oil price fell nearly 3.0% yesterday but has held above the USD 45pbl since breaking above that level in early August.

Key Quotes

“The drop yesterday on the news that Iran would not agree to a production cap leaves crude oil vulnerable to further declines if this is reluctance is confirmed again by Iran and perhaps more importantly there is little indication from Iran of a willingness to compromise. Oil prices have stabilised today in the hope that indeed there will be a positive signal given over the prospect of a deal, possibly in November.

Iran continues to argue that it must return its production to levels that prevailed prior to the introduction of sanctions. That would imply production increasing from the current 3.6mn barrels per day to over 4.0mn, between a 10-15% increase. Saudi officials have expressed optimism that a deal could be done by November. Saudi Energy Minister, Khalid Al-Falih stated that the gap between OPEC countries over a production freeze is getting “very very close together”.

The stability of oil prices has been a key factor behind the reduction in FX volatility and as can be seen below, the correlation between crude oil and the DXY Index has been very tight. Over the short-term, we see greater risk to the downside for crude oil prices despite the optimism expressed by the Saudi Energy Minister. Firstly, it seems unrealistic to believe that Iranian oil production will have reached north of 4.0mn barrels per day by the time of the Vienna meeting in November and any deal that might be done will perhaps centre on a freeze that would not begin until well into 2017.

The fact that the Saudis also seem a lot more flexible about doing a deal now may well reflect increased Saudi concerns over a renewed downturn in oil prices. Of course, earlier this month, the IEA released an updated assessment of the oil market predicting the supply glut would last longer and a balance between demand and supply would not be achieved until late 2017. The IEA Executive Director Fatih Birol repeated this assessment in Algiers yesterday. The downbeat assessment was based on a “marked slowdown” in demand from China and India. Furthermore, even if a production freeze is agreed there may well be scepticism in the market over it being adhered to or having the desired impact of supporting prices, especially if global demand remains weak.

A renewed drop in crude oil prices we believe would have greater consequences for monetary policy in the euro-zone and Japan than in the US. Both the ECB and the BoJ officially target an inflation rate including energy while we suspect upward pressure on inflation in the US is building based on a gradual tightening of the US labour markets and hence the Fed are likely to maintain more of a focus on domestically generated inflation risks fuelled by potential wage inflation. EUR/USD downside risks are beginning to emerge once more.”