Analysts mull British exit’s complex impact on oil

By Nathanial Gronewold | 06/29/2016 07:54 AM EDT

Could crude oil prices fall back down into the $30s over the next few months?

Could crude oil prices fall back down into the $30s over the next few months?

Based on yesterday’s oil price rally, that wouldn’t appear to be the case. The crude value seemed set to recover from the hit that virtually all markets took following the June 23 vote in the United Kingdom, where a majority voted for the country to leave the European Union. Oil traders also grew bullish on reports of falling output in Venezuela, a plunge in U.S. stockpiles and reports of a possible supply disruption out of Norway.

But signs that U.S. economic indicators could slip in the months to come, coupled with any other downbeat economic data from Europe and China, might take the wind out of oil traders’ sails. Last week’s "Brexit" surprise could also tip the scales toward recession, given early indications that Britain’s divorce from the European Union may not be amicable, adding to longer business condition uncertainty, just as a summer driving season was expected to bolster demand for crude.


"If the trade-weighted dollar index starts skyrocketing again, we’re definitely going to have some carnage out there in the energy field," said Brett Ewing, chief market strategist at First Franklin Financial Services.

Prior to the British vote to leave the European Union, troubling U.S. indicators underscored the murky picture that has so far kept the Federal Reserve from increasing interest rates. A dismal May jobs report and reports of declining business investment are causing concern.

Ewing said other indicators his firm tracks suggest economic strengthening, and he expects the jobs numbers to rebound shortly, suggesting no risk of a further drop in U.S. gross domestic product expansion.

But he admits that the longer and more drawn-out the Brexit talks become, the greater the risk will be that investors will embark on a massive "flight to safety" to the U.S. dollar, sharply increasing the dollar’s value. That could tip the U.S. economy into recession and hit oil prices hard, he argues.

"In our notes throughout the year and in our research, we’ve been saying no recession call. I think that we would obviously have to modify that given the referendum vote last week," Ewing said. Without clarity on how Britain breaks with the European Union, markets will react negatively, "and that’s the ticket to recession, right there," he said.

First Franklin analysts fear that lingering uncertainty over Brexit and the future of the European Union lasting into the fall might be the straw that breaks the camel’s back, triggering a market panic that would send oil prices tumbling again, somewhat a repeat of the sharp drop seen at the beginning of this year.

In a note published yesterday, lawyers at Baker Botts LLP said a more drawn-out Brexit negotiation is probably in store.

The law firm predicts little movement on the British vote until October, when the U.K. government could start the Article 50 process, the part of the original E.U. treaty spelling out how a country could leave the European Union. So far, reports suggest London prefers negotiations that would avoid the Article 50 process.

Should Article 50 be ultimately triggered, negotiations would begin on four different fronts, a complex process that could see uncertainty linger for years, Baker Botts attorneys argue in their assessment.

"This will be a monumental task, in particular for the U.K., and it is doubtful whether it can be completed within the two-year time period contemplated by Article 50 E.U. treaty," they wrote.

"The impact of Brexit on areas such as competition, state aid, trade, and financial markets is, to a large extent, based on speculation and no clear answers can be provided at this time," they continued.

Strengthening dollar

Jeff Quigley, director of energy markets at Stratas Advisors, agrees that investors piling into the U.S. dollar as economic uncertainty grows will put pressure on oil prices. But he said he believes the effect will be short-lived. Market fundamentals will likely come to the fore as the oil price pulls back, reflected in a tightening of the crude oil supply-demand gap that would support firmer pricing.

The British exit did compel Stratas to revise its oil price outlook, Quigley acknowledged. Nevertheless, "our feeling is that most of the impacts are going to be pretty much short-term," he explained.

"The obvious strengthening of the dollar is bad for the oil price," he noted. "The reality is, that’s just going to create a tighter market where the price is going to have to come back up, and shale is going to have to come back in eventually."

Quigley also noted that the outlook for Venezuela is so far bullish on the oil price, though less so than some might expect. With a potential loss of half of Venezuelan exports as the economic crisis there bites into oil production, Stratas analysts see positive effects on the oil price by $6 to $8 per barrel, he said.

Quigley sees no imminent risk of a U.S. recession because of Britain’s move or other factors.

"I think that there’s a lot of uncertainty with what’s going on in the U.S., like in terms of the political environment," he said. "Just looking at the data, it’s hard to see indicators to a recession. Now, Brexit threw everybody for a loop, but I think it’s really possible that a lot of this is overblown."

Venezuela’s falling oil production may be one of only a few arguments for supporting a call for higher crude oil prices this summer. Quigley points to strong U.S. gasoline demand as another.

Other factors that could trigger another financial panic include potentially weaker Chinese economic growth should Beijing’s stimulus efforts fail. Greece could also look for a way to withdraw from the eurozone as that nation’s debt problems linger on unresolved. Oil production from Libya and Nigeria may rebound.

U.S. oil output could start growing again, depending on how oil companies respond to the recent rebound to $50 per barrel.

As others earlier predicted, Norway-based energy industry research firm Rystad Energy saw signs that oil companies tapped their drilled but uncompleted wells as the $50-per-barrel rate held over recent weeks. This will likely lead to production leveling out, the firm said.

Analysts there believe that around 800 of these wells will be put into production as companies need to bring in more cash needed to pay down debts. These wells will bring at least an additional 300,000 barrels a day to U.S. production for the second half of this year, a volume of crude that "will be more than sufficient to balance the base production decline," Rystad said.

In notes issued to clients yesterday, Brian LaRose and Walter Zimmermann, both with market technical analysis firm United-ICAP, see potential for the oil price to fall back to as low as the high $30s.

"From a technical perspective we have no reason to alter our bearish view," LaRose wrote.