OPEC's supply cut, trade war, and India

In this blog, we delve deeper into the recent global developments and how they may have a bearing on India's economy.

Dec 11, 2018 11:12 IST India Infoline News Service

The 175th meeting of the Organization of Petroleum Exporting Countries (OPEC) was largely inconclusive on the first day. However, on the second day, the supply cuts agreed upon were larger than anticipated. While the market was expecting an overall cut of 1mn bpd, the larger OPEC group agreed upon a total supply cut of 1.2mn bpd.
 
Out of this supply cut, the OPEC countries will contribute 0.8mn bpd. OPEC allies such as Russia and Mexico will chip in with another 0.4mn bpd of crude. OPEC has agreed to exempt Iran, Venezuela and Libya from supply cuts for now. With demand crossing 100mn bpd, this is likely to slightly widen the demand-supply gap and keep prices buoyant. This was evident from the sharp 6% jump in Brent crude prices on Friday after the supply cut consensus.
 
Crude oil: How will it pan out and what does it mean? 
Chart Source: Bloomberg
Chart Source: Bloomberg
 
The sharp fall in the price of Brent crude (shaded in the chart above) is critical to understanding the economics of crude oil as it stands today. The rally to $86/bbl was triggered by the US sanctions on Iran, which were to go effective in a more comprehensive way from November 5th. However, by October it was quite clear that some of the largest importers of oil from Iran like China, India, Japan, and Korea would be exempted from sanctions. This may have obviated the undersupply concerns and resulted in a sharp fall in oil prices.
 
For the largest member of the OPEC, Saudi Arabia, it is a choice between Scylla and Charybdis. On the one hand, the OPEC is under pressure from Donald Trump not to constrain oil supply as higher prices would dent demand. On the other hand, Saudi Arabia and other OPEC nations cannot afford to let prices go too low. There are two aspects to the supply cut proposal. OPEC and the extended group have agreed upon a supply cut of 1.2mn bpd. Secondly, countries like Iran, Libya, and Venezuela will not be able to participate in the supply cuts due to obvious reasons. This shortfall will have to be made up by other OPEC members, principally Saudi Arabia.
 
But the real problem for the OPEC is demand and not supply
 
While the apparent reason for the sharp fall in oil prices since October is dilution of Iran sanctions, there is a larger problem underneath. The challenge is that the IMF and the World Bank have estimated a 30-40bps impact on global GDP growth due to an economic slowdown caused by the trade war. While a temporary truce was worked out between the US and China during the G-20 Summit in Buenos Aires, the finer details have not been shared. Even this truce is likely to suffer a setback with the recent arrest of the Huawei CFO in Canada. Huawei is a marquee Chinese company, and this is likely to further strain relations between the US and China. There is also the challenge for OPEC regarding its reducing influence. 
 
Source: International Energy Agency

The chart above hints at three interesting points. First, the OPEC market share has been falling steadily and is expected to dip below the 40% mark by next year. Within the OPEC, Saudi Arabia accounts for about 1/3rd of the OPEC output. To influence oil prices, OPEC will require the support from non-OPEC players like Russia and Mexico. Second, as the projections show, with every production cut the OPEC is going to lose market share to the US. Lastly, there have been questions over the credibility of OPEC itself. Indonesia walked out of OPEC in 2009 and Qatar walked out recently. If a major oil producer like Iran chooses to exit the OPEC, then the relevance of the OPEC may come under question. The 175th meeting of the OPEC is not just about supply but also about the relevance of the cartel.
 
Forget oil and Fed rates; the real problem lies elsewhere
 
The US Fed meets on 18th and 19th of December to take a call on rates. The CME Fed Watch is currently assigning a probability of 73.2% to a 25bps rate hike in the December meeting but the view is not very convincing. It either indicates that the Fed could change its mind or that the Fed may go for a pause after a symbolic rate hike in December. The real challenge for the Fed, however, lies elsewhere. We are talking of the inverted Yield curve in the US.
 
 
Source: Thomson Reuters
 
The yield curve plots the yield on different tenures of debt. Long-term debt has a higher yield than short-term debt as there is a higher risk. Hence, a yield curve normally has a positive slope. However, there are extreme conditions when the yield curve gets inverted. In the US, an inverted yield curve has always hinted at a recession in the next 1 to 2 years. This is because a negative yield curve shows that investors don’t want to bet on the future. Recently, in 1998 and in 2005, the inverted yield curve was a precursor to a recession over the next 2 years.
 
The US market has been correcting sharply in the last few days due to this very reason of an inverted yield curve. Remember, inverted yield curves have done huge damage to growth and market value of assets in the past.
 
Why do oil and the US yield curve matter to India?
 
A supply cut of 1.2mn bpd should serve as a floor for the oil prices. The experience in 2016 was that the supply cut by the OPEC and Russia resulted in a gradual acceleration in crude oil prices. This is not great news for India, which relies on oil imports for nearly 80% of its daily crude requirement. The recent decision on doubling ethanol blending may, at best, have a marginal impact. Higher crude prices will mean a higher trade deficit and also the current account deficit (CAD) crossing the 3% mark. Further, oil is inflationary due to its strong downstream effects on Indian products.
 
The bigger worry for India is the inverting US yield curve. Historically, an inverted yield curve has signalled a slowdown and this could dampen the order books for export-oriented businesses such as IT, Pharma, and auto ancillaries. A negative yield curve also implies global risk-off trade that could favor safer markets and safer currencies. Hence, it could be a key data point to watch out for.

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