Focus on commodities

One driving factor behind OPEC's ambition to reduce oil production is that the largest producer, Saudi Arabia, wants to list and sell off around 5 percent of its national oil company, Aramco. Attempts to buoy up oil prices are therefore a way of trying to increase the value of the company.

However, price rises for crude oil, which gained momentum from the agreement at the end of last year, did not last long. There is great focus now on whether OPEC's agreement will be extended, but Handelsbanken commodity analyst Martin Jansson says this is of minor importance in the light of developments in the United States.

"American shale oil production during the first quarter of this year exceeded my most optimistic scenario. The extreme growth there will, firstly, continue throughout the year and, secondly, absorb the entire OPEC cut in less than twelve months," he says in a podcast arranged by Catella Funds.

The key, according to Martin Jansson, is that shale producers have managed to lower the breakeven so much, to between 35 and 40 dollars per barrel. Oil prices bottomed out at 28 dollars about a year ago and, when the price rose to 45-50 dollars, there was a relatively sharp increase in activity.

Another market-influencing factor last year was the lifting of sanctions against Iran, which led the country to resume its oil exports. Production quickly got going, but there is clear evidence that Iran has reached its production ceiling.

"Firstly they agreed to the OPEC deal, and secondly production levels for January and February did not even reach the amounts they were granted in the November agreement. This shows that they have reached their technical production ceiling," says Martin Jansson.

Shale oil had its breakthrough during the last boom in the oil industry, which lasted from 2004 to 2014. At the same time there was interest in oil sand extraction in Canada, but this source has not had anything like the same favourable development. While shale oil has returned to the growth rates of 2013-2014, oil sand is on a downward trend, with breakeven at up to 70-80 dollars.

As for deep-sea extraction, this is cheap once put into production but much more expensive to exploit. New prospecting could therefore find it tough, according to Martin Jansson, who is not confident that demand will be sufficient.

"It may be that we are facing a structural change in the industry that causes this market to disappear," he says.

The breakeven level overall is now the same as the breakeven for shale oil. "If shale oil is around 35-40 dollars, then this is the new equilibrium price. We do not need a higher equilibrium price than the one at which it is possible to generate new production," says Martin Jansson, pointing out that OPEC's market power is limited.

"If we look back to the oil crisis of the 1970s, prices were high for 10 years and there was enormous investment outside OPEC. Norway, the UK, Colombia and Angola emerged as new producers, and OPEC was unable to do anything about it."

Demand for oil is growing slowly and will, according to Martin Jansson, continue to do so in the future. This is because of ongoing efficiency improvements and the shift away from fossil fuels – normally a development that would require the US to be involved as a driving force.

However, the new US president, Donald Trump, has spoken critically of new energy sources and it is now instead China driving developments, largely because of the country's pollution problems, which are intensifying the need to cut down on the use of coal and oil.

In China, the price of electricity from solar cells has dropped by around 80 percent in recent years, and one kilowatt now costs about 5 cents. This will provide tough competition in the future, according to Martin Jansson.

"It is this kind of technological development that makes the technology commercial. Now it's possible to have solar panels on the roof and a battery pack in the basement, and then you can basically be self-sufficient. Once this type of technology becomes available to everyone it will be the consumer that drives developments, not the producers," he says.

China's growth has long been on a declining trend. Recently, however, it has been possible to see signs of improvement as the country has used greater economic stimulus, which has accelerated demand for base metals, steel, iron ore and coal. China has also managed to cut its own unprofitable production – last year the country shut down large volumes of production that were not operational but still remained and were like a wet blanket over the market.

"This factor is partially gone, and this year it has even begun to close operational production, which it has never done before. So both supply and demand in China are in a new situation, which has caused the prices of base metals, steel, coal and iron ore to rise," says Martin Jansson.

Anders Wennberg, one of the managers of Catella Hedgefond, points out that China's output of coal has been up and down in the past year. A cutback last autumn caused prices to surge, and was followed by increased production again. Martin Jansson says that the price rise of 150 percent that the country experienced upped costs, since China still imports some coal, and that the imports exceeded what the country gained from closing domestic mines.

Base metals zinc and aluminium have been on an upward trend for a year, and copper prices strengthened somewhat recently. Copper has risen largely because of two major strikes, in Chilean Escondida and in Peru, but expectations of Donald Trump's promised stimulus and the improvements in China have also contributed to the rises.

But the trend is likely to be broken, perhaps even this year.

"We believe the stimulus cycle in China will subside somewhere late in the second half of 2017, so let's say the fourth quarter is the time to exit base metals. But until then it looks interesting. There could certainly be a major change in confidence over Trump's stimulus in the US, but China's cycle appears fairly robust, at least for the first three quarters of the year," says Martin Jansson.

In the case of steel, he calculates that China has passed "peak steel" – production is not likely to continue to grow, which in time will also reduce the demand for iron ore.

In recent years, the trends in equity prices and oil have tracked each other. An interesting question, of course, is whether this connection will continue in the future. Anders Wennberg believes it likely that the relationship will weaken.

"The connection with the stock market has been strong in the past three years, and oil prices have served as a barometer of the economy. But when oil prices come down because of increased supply, my guess is that the link will weaken slightly," he says, and is backed by Martin Jansson.

"What made the stock markets get such a beating in 2015 when oil fell was that oil companies cut their investment budgets by 50 percent for two consecutive years. These budgets are the revenues for other engineering industries. I do not see the same potential to cut back now, so this time we should be more likely to see positive effects on the stock markets."

Base metals could also contribute positively to the stock market, according to Anders Wennberg.

"When it comes to investment, it is clear that higher commodity prices will lead to increased investments in the mining sector, and this will naturally benefit our Swedish engineering industries," he says.

Gold has this year increased slightly from its levels around the beginning of the year, and the price of this precious metal is normally tightly linked to the Fed's interest rate policy. According to Martin Jansson, however, there is one possible element of surprise based on how Donald Trump manages his presidency.

"At some point there will have to be a reckoning, whether we believe that Trump will do what he should or whether there is political chaos – then gold will certainly be something that investors will want to weigh up."

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