Insight Conversation: Jeffrey Currie

In the latest Insight Conversation video, Jeffrey Currie, global head of commodities research at Goldman Sachs, talked to Paul Hickin about the bank’s call on oil prices and the commodities impact of the US−China trade war.

The big question on everyone’s lips is whether we are going to see a return to oil prices at $100/barrel and beyond. Where do you think the market is going?

We’re not saying $100/barrel oil cannot happen. It’s not our base case, nor do we think it’s very likely. To get a $100 price spike, you need to have a sustainable loss in all of Iran’s exports for an extendable period of time… The key point here is yes, if you had a sustained outage you could see a spike of that magnitude, but in no way is it our base case. Our base case is for a modest decline in inventories in the fourth quarter, which will likely keep prices somewhere around $80/barrel. But the faster and sooner the Iranian barrels are lost, the greater the upside potential, because it’s harder and more difficult for the non-Iranian producers in OPEC to respond to that kind of disruption.

The key question is spare capacity. Can Saudi Arabia, OPEC and Russia deliver and make up what’s lost from, not just Iran but also Venezuela, if it experiences further falls in production?

It’s all a question of time. Always, when we ask this question, how much spare capacity does Saudi Arabia and OPEC have, it’s all a question of how long you are willing to give them. The longer you give them, the more rigs they put into the field, and the greater the spare capacity. In the last four months, we have seen a 20% rise in drilling in Saudi Arabia. You have already lost 700,000 b/d of Iranian exports and inventory built, which tells you there is a lot more oil in the market.

If we were to lose all of those Iranian barrels really quick right now, it would likely create a big problem, because we don’t think it will have the Partitioned Neutral Zone [estimated at 500,000 b/d] and other fields up and running until you get into the first quarter of next year. And then let’s not forget that the Permian has huge pipeline capacity expansions coming online in the third quarter of next year. So the longer we wait, the higher the probability of seeing global spare capacity increase to be able to accommodate almost any type of disruption. Now a $100/barrel price spike would likely require not only Iranian barrels being out on a sustainable basis, but something along the lines of Venezuela happening that would create further upside. So the short answer to your question: readily available spare capacity we would put at 800,000 b/d, remember that we have already lost 700,000 b/d, and Saudi Arabia is already at 10.7 million b/d. As you get into the first quarter that [spare capacity] begins to grow to the 1.5 million b/d range, and as we look further out into the second half of next year, there’s not an issue.

Goldman Sachs has a very bearish view on oil in 2019. Please explain your thinking.

Fast-cycle capital, as well as production, [has] fundamentally altered the way the oil market trades. What do I mean by fast cycle? Let's think about deepwater: that's what we call long cycle. You make an investment today, and it’s 5−10 years before you get the output. You make an investment in shale, and you get it almost immediately. That fast-cycle nature changes the response the industry has to a lack of spare capacity. Another way to say it is that it’s taking out oligopolistic market structure and turning it into a competitive market. That hasn’t changed.

Once we debottleneck [pipeline and midstream infrastructure] in the second half of next year, we think we will see very rapid growth in shale production, which will push us back into the new oil order or that “lower for longer environment.” Our target for oil prices at the end of next year is $70/barrel on a Brent basis, and then $60/barrel in the long term.

Earlier this year, you said you were at your most bullish in a decade regarding commodities demand. How has that view changed?

We’ve only reduced our demand expectations modestly, and when we think about the core behind the “most bullish in a decade” view, it was driven by three observations. First, strong robust late-cycle global demand growth, which we are seeing across the commodity complex. Second, supply curtailments in places like OPEC, as well as China: remember they cut back due to the anti-pollution and anti-corruption issues. And third, pipeline constraints in the Permian. Those were the core factors.

If we look at the demand component, I want to go over why late cycle really matters. And if there is one point I want to emphasize, it’s that commodities are driven by demand levels, while financial markets are driven by demand growth rates. Let me go over why that’s the case. We have the level of demand at 100 million b/d right now. It took the entire business cycle for the demand level to continue to grow to that level, and when demand gets up to that high level, it begins to stress the ability for the system to supply. So it’s the level of demand exceeding the level of supply, which creates a bullish market for commodities. Financial markets care about the growth rates, because they are expectations about the future: if the growth rate is good, it tells you to have a positive outlook in the future. So when we think about the current environment, with a late cycle the demand level gets really high and you draw down your inventories – that creates the bullish backdrop.

This is why commodities like oil give you a negative correlation against other asset classes. When demand begins to slow as interest rates rise, like we are seeing right now, you still have a situation in which the demand level exceeds the supply level, which stresses the ability of the system to supply and creates the upward price spike.

So what have we done with our demand growth rates? We had an expectation in oil of 1.75 million b/d when we wrote that report you are referring to. It’s now 1.6 million b/d. We took down emerging markets by 250,000 b/d, but increased the US in the developed markets by 100,000 b/d. So we have the US exceeding expectations, which is putting upward pressure on the dollar. The higher dollar is increasing funding costs in emerging markets, which is slowing growth expectations in those parts of the world, which is why we are reducing them. And you go back and you think about this: we are raising the US and reducing emerging markets, the exact opposite of what we did in the 2000s. In the 2000s, month after month I was taking down US oil demand and raising Chinese and emerging market demand. We had a very weak dollar backdrop over that time period. You had a robust China that needed to consume oil and other commodities, so the US was that marginal consumer who had to make room for the Chinese consumer, and you had a really weak dollar to achieve that redistribution of oil. Today it’s a similar dynamic, not as strong obviously as we saw before. The US is the engine of global growth right now and the strong dollar is making room for the US to continue to move forward. Put it all together, and it’s not that we have really taken down our demand forecast, it’s really that we have made room for the US.

What about about the US-China trade spat. How does that play out for commodities in general?

So far [the impact] has been relatively small. Our economists estimate the impact on China at 20 basis points on GDP growth – and in a 6.5% GDP growth environment it’s not that large – and then on the US they estimate it at below 5 basis points. So it’s relatively small, less than a 100,000 b/d when thinking in terms of oil demand.

Now to understand why it’s not having a big impact, let’s think about two bookend commodities: oil and soybeans. Oil was left out of the Chinese retaliation, but let’s use it as an example. Oil is completely fungible – it can be redistributed and moved around the world. Soybeans are not…

Overall, global soybean production comes out of China, the US, Brazil and Argentina, so there aren’t really any options for China to substitute away from the US, but Brazil and Argentina… Brazil cannot replace those US exports.

When we think about a lot of the goods that were targeted by the Chinese, they were very fungible goods, in which what we’ll likely see is a redistribution of supplies to avoid consumption of either Chinese or US goods that are going into either one of those countries. You will still get an inflationary pressure because you still get goods coming in, like soybeans, and that will have an impact on inflation in China and the US. However, I think the key takeaway here is that it’s modestly inflationary. It reinforces the inflationary trends already in place… but the impact on growth is relatively modest.

Do you feel the same about the metals side, given the tariffs on steel and aluminum?

With metals, it has definitely had an impact in the US on pricing – you can see it in the physical premium in aluminum as well as steel. Now in terms of it creating a supply response, it’s still relatively small and modest at best, which means it’s likely to be more inflationary than it is to be stimulative to supply. I think the one that has been hit the most is copper. When we look at copper right now, global demand growth is running at around 2.8%, so it has not been hit significantly. But the market itself was short copper a few weeks ago, which is an indication that people are quite bearish about global growth prospects. I think a lot of that is to do what’s going on with the trade war.