Author: NN Investment Partners
Severe hurricanes in the Gulf of Mexico and Caribbean serve to remind investors of the risks counterbalancing favourable market fundamentals.
The growing importance of US production in the global energy mix has also boosted the significance of output disruptions in regions like the Gulf of Mexico, where the storm season is now getting underway. The impact of Harvey, the Category 4 hurricane that battered the Gulf Coast, will take months to assess but some of its effects on energy markets is already evident. The fallout for crude oil demand as a result of reduced refining capacity outpaced supply disruption, which resulted in upward pressure on gasoline prices and a wider spread between West Texas Intermediate and North Sea Brent. The demand fallout may last longer than the supply disruptions and keep the price of WTI under pressure.
Harvey hits key energy production region
Hurricane Harvey, the most powerful storm to hit Texas in more than half a century, took a devastating toll in terms of human lives and property, killing an estimated 50 people and damaging some 200,000 homes. At the same time it left its mark on the Gulf of Mexico energy infrastructure. Home to some 18% of US oil production and about 4% of the country’s natural gas production, the Gulf remains a key energy production region, although its share of output has been declining as a result of shale production, which has increased the importance of onshore operations. The Gulf’s 4% share of US gas production, for example, represents a decline from 26% in 2001.
Harvey’s impact was not limited to offshore facilities, however. After making landfall, it disrupted key US shale regions like Eagle Ford, and as a result, onshore supply disruption exceeded that of previous hurricanes, while offshore was less. The shale revolution and the US’s subsequent ascendancy as the world’s swing producer have also raised the profile of the nation’s storms, making their impact more global in nature rather than merely domestic.
The US has also become the world’s largest exporter of oil products, which means that disruptions to US refineries, production, pipelines and ports also have repercussions abroad. By the end of August, almost 25% of US refining capacity was shuttered, with some 4.4 million barrels a day of refinery production offline. Gasoline inventories, which had already declined during the US summer driving season, were expected to draw down further as a result of the refinery disruptions. Consequently, a sharp rise in gasoline prices was one of the storm’s most immediate effects.
Refinery shutdowns reduce demand for crude oil
Prices for West Texas Intermediate (WTI) crude oil, in contrast, have come under downward pressure despite production halts. This is because the estimated oil production disruption – close to 1 million barrels a day as of end-August – was far less than the reduction in demand for crude, as result of the more extensive refinery shutdowns. Along with the negative effect of refinery outages, the simultaneous closure of US oil pipelines and US ports put further pressure on WTI crude prices.
Seasonal maintenance also reduces demand
These disruptions came at a time when crude demand was already levelling off. With the driving season drawing to a close, refineries were close to heading into yearly maintenance. Prices for North Sea Brent crude oil, the other major international price benchmark for crude oil, had also fallen. The immediate fallout from Harvey caused WTI prices to fall more than Brent, which has since recovered somewhat. European and Asian refinery demand is also expected to rise as a result of the US disruptions. Another factor that softened Brent’s fall is a series of recent attacks on oil fields in Libya, which reduced oil production by some 350,000 barrels a day.
Demand fallout may last longer than supply impact
As a result of these dynamics, the gap between Brent and WTI crude oil prices widened after the hurricane. Market price arbitrage is likely keep this gap within limits, and demand for WTI crude will increase when US oil production, refineries and ports come back online. But if history is a guide, the supply situation may tend to normalize within a month or so, while the demand fallout may last for several months. In combination with a possible reversal in net long speculative positioning in WTI, prices could therefore remain under pressure in the coming months. As things stand today, the storm’s impact is uncertain. Hurricane Irma meanwhile made destructive landfall in the Caribbean before heading to Florida’s west coast, reminding us that the hurricane season has only just begun.
Market dynamics and fundamentals in balancing act
Sharing the headlines with hurricanes has been the international tension surrounding North Korea’s missile tests. So far, investors take the view that the parties involved will remain sensible. Despite the escalation of tensions, their impact on equity markets is becoming less and shorter in time. The rhetoric has been provocative, but in the end sanctions are likely to remain limited to political measures and trade restrictions. Investors are no doubt hoping that in the end all parties will remain sensible and that this geopolitical storm will eventually calm down.
These risks form a counterbalance to the strong fundamentals that in themselves would justify a more positive stance on equities. In our top-down assessment, we continue to observe an important distinction between the fundamentals, which are generally positive, and the market dynamics, which are negative. Spreads are the exception, with both the fundamentals and the market dynamics giving positive signals.
Dynamics vs Fundamentals
At last week’s European Central Bank meeting, the bank’s Governing Council maintained asset purchases at EUR 60 billion a month until December and left interest rates unchanged. The ECB is also performing a balancing act in the face of strong growth and below-target inflation, an act complicated by the euro’s appreciation. Looking ahead, US Federal Reserve governors will grapple with the same paradox of good growth and low inflation when they meet later in September. German elections to be held this month may contain few surprises, but the composition of a new coalition could be important for the future of Eurozone institutions. US President Trump’s agreement with congressional Democrats on a debt ceiling increase may have for now averted a government shutdown, but the three-month extension means markets may be faced with much the same situation again in December.
