Will Saudi Production Cuts Be Enough To Offset An Uncertain Outlook For Oil Demand?

Oil prices have been mixed as traders weigh Saudi Arabia’s announced production cuts and concerns about global demand. Greg Bonnell speaks with Hussein Allidina, Head of Commodities at TD Asset Management, about the path ahead for oil and the outlook for energy markets.

Transcript

Greg Bonnell: News of a Saudi production cut did give the price of oil a bit of a boost earlier this week. But the trade has been choppy amid all these concerns about global growth. Joining us now to discuss the longer-term dynamics in the market, Hussein Allidina, Head of Commodities at TD Asset Management. Great to have you back on the show, Hussein.

Hussein Allidina: Thanks for having me.

Greg Bonnell: So let's talk about this. I mean, this isn't the first time we've seen this playbook, whether it was the Saudis this time, it was OPEC before. You get the production cut. You get a bit of a boost in the price of crude. And then things sort of go sideways in the trade. What's happening in the market?

Hussein Allidina: Yeah, it's a good question. And I think that the macro is concerning. The macro is overwhelming, in my opinion, the relatively constructive micro data that we've seen. We've talked before about how demand is expected to weaken as we get this sort of well-anticipated recession. But the data to date is actually showing still firm demand, whether it's gasoline demand in the US. A couple of days ago, we had demand data out of India, which was at a record high. We've had robust Chinese import data for both March, April, and May.

So I think it's kind of this cross currents between an expected challenge macro, which we believe is forthcoming, right? We've had 400 or 500 basis points of rate hikes that should impact demand growth and economic activity. The contrast, though, is it hasn't yet. If I look at even yesterday, the day we released gasoline demand data or released sort of oil demand data for the US, gasoline demand is averaging above the five-year average, even if I removed the weakness in 2020.

So you've got these sort of, I think, conflicting currents. I think Saudi's decision to unilaterally reduce production by a million barrels a day in the month of July only maybe is meant to clean up the front of the market and/or scare the shorts. But I think this market has been a very challenging one to trade in the first half of the year, very different than last year or the year prior, when you heard about commodity trade houses posting record profits, guys at hedge funds making record numbers.

This year has been a choppy one, partially because China has disappointed expectations, partially because Russian volumes have stayed elevated. I don't think the crude market is going to be able to stand on its own until we see the expected draws in the second half of the year, because the macro, again, is so concerning.

Greg Bonnell: Let's talk about that macro, because what we're basically talking about is the fear of recession.

Hussein Allidina: Yeah.

Greg Bonnell: And we've been living with that fear for quite some time.

Hussein Allidina: Yes.

Greg Bonnell: I think we can dial back into late last year and say, it's coming, it's coming, it's coming. Where is it? And with that kind of uncertainty, what does it actually mean for crude?

Hussein Allidina: Yeah, so I think it's very important. If we don't get a sufficient slowdown -- and we've talked about this, right? If we don't get a sufficient slowdown in demand growth, most balances into the second half of the year point to continued well-above-normal draws in the crude S&D. Again, the recession is sort of anticipated, expected, but we haven't seen it yet. Demand is still exceeding supply. We had draws yesterday. In the Dewey Data the week before, we had a record draw, biggest draw in six years. And these draws are occurring, notwithstanding the fact that you have continued SPR releases.

We've talked about the SPR before. Yesterday's 400,000, 500,000 barrel draw in commercial inventories would have been materially larger if we didn't reclassify 1.8 million barrels out of the SPR into commercial. That stuff ends in June, at the end of June. Those mandated sort of sales by Congress end at the end of June. And I think that the July data will be more transparent or more honest and should show -- again, if these balances are true, should show pretty material draws July, August, September and into the end of the year.

Greg Bonnell: We see some prognosticators pushing out the recession forecast into next year, some saying, hey, maybe we escape it altogether, or you get the soft landing if that is the scenario. And we're in the situation in terms of production for crude. What are we setting ourselves up for? What kind of prices could we see?

Hussein Allidina: Yeah, so I think that the crude market is coiled here, if I look at, again, the level of inventory, the level of spare capacity. And again, given the fact that demand is still exceeding supply, if we don't get this sort of well-telegraphed or anticipated slowdown, I would not be surprised to see oil at $90, $100 a barrel by the end of the year. I think the fear, though, is that this slowdown is going to be so material that the challenges on the supply side get muted. We've talked before, if I don't have demand, the supply constraints don't matter. Again, this is a sort of battle over the course of the very near term that probably becomes far more obvious as we move through the summer.

But again, I think the market is grappling with this idea that the second half is going to be really tight. A lot of that tightness is predicated on Chinese demand growth. It has disappointed relative to expectations through the first quarter, first half of the year. And I think that is in people's sort of psyche and challenging their ability to get long. If you look at positioning in the market, there's very little speculative length in the market relative to history. So I think that if we do get clarity on how bad growth will be, you will see those participants return to the market.

I think one thing, Greg, that's very important to understand as well, or remember for commodities, it's the level of supply relative to the level of demand. Demand growth will slow, but if demand doesn't fall in absolute terms so that it is below supply, I still have draws. So the second derivative is important, but the absolute level of demand, so long as it stays above supply, that means inventory draws. And we've seen years of inventory draws. So we don't have a ton of cover, and why I think prices could move higher if the demand slowdown is not material.

Greg Bonnell: So that's some of the medium and longer-term dynamics in the market. In the short term, if we're worried about the economy, so many asset classes obviously are hinging on the next moves from the central bank. We've all been -- we've always been central bank watchers.

Hussein Allidina: Yes.

Greg Bonnell: But now, I feel like we're more keen than ever. We've got the Fed coming up next week. Is that the next big catalyst to see what comes out of that meeting, what comes out of their mouths in terms of people trying to figure a range of asset classes, including commodities?

Hussein Allidina: Yeah. So the macro, the sort of fixed income market is a driver, I think, of other markets. And if we continue to see Fed rate hikes or central bank rate hikes, as we've seen in Canada, as we've seen in Australia, that does challenge risk sentiment for sure. And it challenges growth expectations. I'm not as smart on the fixed income market as Scott or Alex on our team. I listen to what they have to say. But one thing, anecdotally, -- I was just speaking with my team about this before I came down, this 400, 500, 550 basis point rate hike increase hasn't really impacted. It hasn't impacted me. It hasn't impacted a bunch of folks that I talked to, because my mortgage hasn't reset, because my car payment hasn't reset.

So I think we have to appreciate that the transmission mechanism -- monetary policy transmission mechanism takes time. I think that's what folks are sort of grappling with. Growth will slow. How much does it slow and how much further monetary policy tightening there is over the course of the next little while, I think, is going to drive risk sentiment. That risk sentiment - that macro eating the micro - continues until the micro can stand on its own. If we continue to see 10 million barrel draws in crude, if we continue to see an improvement in the crude structure, that is kind of when I think crude can trade on its own absent the macro headwind.

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