Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost

Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear

Saudi Arabia’s U-turn to revive oil output quotas is not working and fails to address the changing future of oil demand, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Saudi Arabia’s move into recession comes at an unfortunate time for its new Crown Prince, Mohammed bin Salman (known to all as MbS).

Unemployment is continuing to rise, threatening the social contract. In foreign affairs, the war in Yemen and the dispute with Qatar appear to be in stalemate. And then there is the vexed issue of King Salman’s ill health, and the question of who succeeds him.

This was probably not the situation that the then Deputy Crown Prince envisaged 18 months ago when he launched his ambitious “Vision 2030” programme and set out his hopes for a Saudi Arabia that was no longer dependent on oil revenues. “Within 20 years, we will be an economy that doesn’t depend mainly on oil . . . We don’t care about oil prices — $30 or $70, they are all the same to us. This battle is not my battle.”

The problems began a few months later after he abruptly reversed course and overturned former oil minister Ali al-Naimi’s market share policy by signing up to repeat the failed Opec quota policy of the early 1980s.

His hope was that by including Russia, the new deal would “rebalance” oil markets and establish a $50 a barrel floor under prices. In turn, this would boost the prospects for his proposed flotation of a 5 per cent stake in Saudi Aramco, with its world record target valuation of $2tn.


But, as the chart above shows, the volte face also handed a second life to US shale producers, particularly in the Permian basin, which has the potential to become the world’s largest oilfield. Its development had been effectively curtailed by Mr Naimi’s policy.

The number of high-performing horizontal drilling rigs had peaked at 353 in December 2014. By May 2016, the figure had collapsed to just 116. But since then, the rig count has trebled and is close to a new peak, at 336, according to the Baker Hughes Rig Count.

Even worse from the Saudi perspective is that oil production per Permian rig has continued to rise from December 2014’s level of 219 barrels a day. Volume has nearly trebled to 572 b/d, while the number of DUC (drilled but uncompleted) wells has almost doubled from 1,204 to 2,330.


Equally disturbing, as the second chart from Anjli Raval’s recent FT analysis confirms, is that Saudi Arabia has been forced to take the main burden of the promised cutbacks. Its 519,000 b/d cut almost exactly matches Opec’s total 517,000 b/d cutback.

Of course, other Opec members will continue to cheer on Saudi Arabia because they gain the benefit of higher prices from its output curbs.

But we would question whether the quota strategy is really the right policy for the Kingdom itself. A year ago, after all, Opec had forecast that its new quotas would “rebalance the oil market” in the first half of this year. When this proved over-optimistic, it expected rebalancing to have been achieved by March 2018. Now, it is suggesting that rebalancing may take until the end of 2018, and could even require further output cuts.

Producers used to shrug off this development, arguing that demand growth in China, India and other emerging markets would secure oil’s future. But they can no longer ignore rising concerns over pollution from gasoline and diesel-powered cars.

India has already announced that all new cars will be powered by electricity by 2030, while China is studying a similar move. China has a dual incentive for such a policy because it would not only support President Xi Jinping’s anti-pollution strategy, but also create an opportunity for its automakers to take a global lead in electric vehicle production.

It therefore seems timely for Prince Mohammed to revert to his earlier approach to the oil price. The rebalancing strategy has clearly not produced the expected results and, even worse, US shale producers are now enthusiastically ramping up production at Saudi Arabia’s expense.

The kingdom’s exports of crude oil to the US fell to just 795,000 b/d in July, while US oil and product exports last week hit a new record level of more than 7.6m b/d, further reducing Saudi Arabia’s market share in key global markets.

The growing likelihood that oil demand will peak within the next decade highlights how Saudi Arabia is effectively now in a battle to monetise its reserves before demand starts to slip away.

Geopolitics also suggests that a pivot away from Russia to China might be opportune. The Opec deal clearly made sense for Russia in the short term, given its continuing dependence on oil revenues. But Russia is never likely to become a true strategic partner for the kingdom, given its competitive position as a major oil and gas producer, and its longstanding regional alliances with Iran and Syria. China, however, offers the potential for a much more strategic relationship, which would allow Saudi Arabia as the world’s largest oil producer to boost its sales to the world’s second-largest oil market.

China also offers a potential solution to the vexed question of the Saudi Aramco flotation, following the recent offer by an unnamed (but no doubt state-linked) Chinese buyer to purchase the whole 5 per cent stake. This would allow Prince Mohammed to avoid embarrassment by claiming victory in the sale while avoiding the difficulties of a public float.

The Chinese option would also help the kingdom access the One Belt, One Road (OBOR) market for its future non-oil production. This option could be very valuable, given that OBOR may well become the largest free-trade area in the world, as we discussed here in June.

In addition, and perhaps most importantly from Prince Mohammed’s viewpoint, the China pivot might well tip the balance within Saudi Arabia’s Allegiance Council, and smooth his path to the throne as King Salman’s successor.

Paul Hodges and David Hughes publish The pH Report.

The post Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear appeared first on Chemicals & The Economy.

Oil market supply/demand finally begins to matter again as commodity funds withdraw

WTI Sept17

Its been a long time since oil market supply/demand was based on physical barrels rather than financial flows:

  First there was the subprime period, when the Fed artificially boosted demand and caused Brent to hit $147/bbl
  Then there was QE, where central banks gave free cash to commodity hedge funds and led Brent to hit $127/bbl
  In 2015, as the chart highlights for WTI, the funds tried again to push prices higher, but could only hit $63/bbl
  Then, this year, the funds lined up to support the OPEC/Russia quota deal which took prices to $55/bbl

As the Wall Street Journal reported:

“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.

These developments destroyed the market’s key role of price discovery:

  Price discovery is the process by which buyer and seller agree a price at which one will sell and the other will buy
  But subprime/QE encouraged this basic truth to be forgotten, as commodities became a new asset class
  Investment banks saw the opportunity to sell new and highly profitable services to sleepy pension funds
  They ignored the obvious truth that oil, or copper or any other commodity are worthless on their own

There was never any logic for commodities to become a separate new asset class.  A share in a company has some value even if the management are useless and their products don’t work properly.  Similarly bonds pay interest at regular intervals.  But oil does nothing except sit in a tank, unless someone turns it into a product.

The impact of all this paper trading was enormous.  Last year, for example, it averaged a record 1.1 million contracts/ day just in WTI futures on the CME.  Total paper trading in WTI/Brent was more than 10x actual physical production. Inevitably, this massive buying power kept prices high, even though the last time that supplies were really at risk was in 2008, when there was a threat of war with Iran.

Finally, however, the commodity funds are now leaving.  Even Andy Hall, the trader known as “God” for his ability to control the futures market, is winding up his flagship hedge fund as he:

“Complained that it was nearly impossible to trade oil based on fundamental trends in supply and demand, which are now too uncertain.” 

Hall seemed unaware that his statement exactly described the role of price discovery.  Markets are not there to provide guaranteed profits for commodity funds. Their role via price discovery is to help buyers and sellers balance physical supply and demand, and make the right decisions on capital spend.  By artificially pushing prices higher, the funds have effectively led to $bns of unnecessary new capital investment taking place.

NOW MARKETS WILL HAVE TO PICK UP THE PIECES

OPEC Sept17

The problem today is that markets – which means suppliers and consumers – will now have to pick up the pieces as the funds depart.  And it seems likely to be a difficult period, given the length of time in which financial players have ruled, and the distortions they have created.

Major changes are already underway in the physical market, with worries over air quality and climate change leading France, the UK, India and now China to announce plans to ban sales of fossil-fuelled cars.  Transport is the biggest single source of demand for oil, and so it is clear we are now close to reaching “peak gasoline/diesel demand“.

OPEC obviously stands to be a major loser.  Over the past year, the young and inexperienced Saudi Crown Prince Mohammed bin Salman chose to link up with the funds. His aim was keep prices artificially high via an output quota deal between OPEC and Russia.  But history confirms that such pacts have never worked.  This time is no different as the second chart from the International Energy Agency shows, with OPEC compliance already down to 75%.

Consumers will also pay, as they have to pick up the bill for the investments made when people imagined oil prices would always be $100/bbl.  And consumers, along with OPEC populations, will also end up suffering if the shock of lower oil prices creates further geopolitical turmoil in the Middle East.

As always, “events” will also play their part.  As anyone involved with oil markets knows, there seems to be an unwritten rule that says:

   If the market is short of product, producing plants will suddenly have force majeures and stop supplying
   If the market has surplus product, demand will suddenly reduce for some equally unexpected reason

The rule certainly seems to be working today, as the catastrophe of Hurricanes Harvey, Irma and Jose creates devastation across the Caribbean and the southern USA.

Not only is this reducing short-term demand for oil, but it will also turbo-charge the move towards renewables.  Mllions of Americans are now going to want to see fossil fuel use reduced, as worries about the impact of climate change grow.

 

Oil heads back below $30/bbl as hedge funds give up on OPEC

WTI Jul17Those who cannot remember the past are condemned to repeat it“. George Santayana

9 months ago, it must have seemed such a good idea.  Ed Morse of Citi and other oil market analysts were calling the hedge funds with a sure-fire winning strategy, as the Wall Street Journal reported in May:

“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.

“Group officials made the case for how supply cuts from the Organization of the Petroleum Exporting Countries would reduce the global glut….  Mr. Morse of Citigroup said he arranged introductions between OPEC Secretary-General Mohammad Barkindo and the more than 100 hedge-fund managers and other oil buyers who have met with Mr. Barkindo in Washington, D.C., New York and London since October…

“After asking what OPEC planned to do to boost prices, fund managers came away impressed, Mr. Morse said, adding that some still text with the OPEC leader.”

Today, however, hype is disappearing and the reality of today’s over-supplied oil market is becoming ever more obvious.  As the International Energy Agency warned in its latest report:

“In April, total OECD stocks increased by more than the seasonal norm. For the year-to-date, they have actually grown by 360 kb/d…”Whatever it takes” might be the (OPEC) mantra, but the current form of “whatever” is not having as quick an impact as expected.

As a result, the funds are counting their losses and starting to withdraw from the market they have mis-read so badly:

  Pierre Andurand of Andurand Capital reportedly made a series of bullish bets after meeting a Saudi OPEC official in November, but saw his fund down 16% by May 5
  Once nicknamed “God” for his supposed ability to forecast the oil market, Andy Hall’s $2bn Astenbeck Capital fund lost 17% through April on bullish oil market bets

In a sign of the times, Hall has told his investors that he expects “high levels of inventories” to persist into next year. Consensus forecasts in April/May that prices would rally $10/bbl to $60/bbl have long been forgotten.

OIL MARKET FUNDAMENTALS ARE STARTING TO MATTER AGAIN
This therefore has the potential to be a big moment in the oil markets and, by extension, in the global economy.

It may well be that supply/demand fundamentals are finally starting to matter again.  If so, this will be the final Act of a drama that began around a year ago, when the young and inexperienced Mohammed bin Salman became deputy Crown Prince and then Crown Prince in Saudi Arabia:

  He abandoned veteran Oil Minister Naimi’s market-share strategy and aimed for a $50/bbl floor price for oil
  This gave US shale producers a “second chance” to drill with guaranteed profits, and they took it with both hands
  Since then, the number of US drilling rigs has more than doubled from 316 in May 2016 to 763 last week
  Even more importantly, the introduction of deep-water horizontal drilling techniques means rig productivity in key fields such as the vast Permian basin has trebled over the past 3 years from 200bbls/day to 600 bbls/day

The chart above shows what the hedge funds missed in their rush to jump on the OPEC $50/bbl price floor bandwagon.

They only focused on the weekly inventory report produced by the US Energy Information Agency (EIA). They forgot to look at the EIA’s other major report, showing US oil and product exports:

  US inventories have indeed remained stable so far this year as the blue shaded area confirms
  But US oil and product exports have continued to soar – adding nearly 1mb/day to 2016′s 4.6mb/day average
  This means that each week, an extra 6.6mbbls have been moving into export markets to compete with OPEC output
  Without these exports, US inventories would have risen by another 13%, as the green shaded area highlights
  In addition, the number of drilled but uncompleted wells – ready to produce – has risen by 10% since December

These exports and new wells are even more damaging to the OPEC/Russia pricing strategy than the inventory build:

  Half-way across the world, India’s top refiner is planning to follow China and Japan in buying US oil
  US refiners are ramping up gasoline/diesel exports, with Valero planning 1mb of storage in Mexico

As Naimi warned 2 years ago, Saudi risked being marginalised if it continued to cut production to support prices:

“Saudi Arabia cut output in the 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell.  So we lost on output and on prices at the same time.”

How low oil prices will go as the market now rebalances is anyone’s guess.

But they remain in a very bearish pattern of “lower lows and lower highs”.  This suggests it will not be long before they go below last year’s $27/bbl price for Brent and $26/bbl for WTI.

 

Oil prices under pressure as US oil/product exports ramp up

US oil exports May17

On Monday, I discussed how OPEC abandoned Saudi Oil Minister Naimi’s market share strategy during H2 last year.

Naimi’s strategy had stopped the necessary investment being made to properly exploit the new US shale discoveries. But this changed as the OPEC/non-OPEC countries began to talk prices up to $50/bbl. As CNN reported last week:

Cash is pouring into the Permian, lured by a unique geology that allows frackers to hit multiple layers of oil as they drill into the ground, making it lucrative to drill in the Permian even in today’s low prices.”

  Private equity poured $20bn into the US shale industry in Q1
  Major oil companies were also active, with ExxonMobil spending $5.6bn in February

US oil/product inventories have already risen by 54 million barrels since January last year and are, like OECD inventories, at record levels. And yet now, OPEC and Russia have decided to double down on their failing strategy by extending their output quotas to March 2018, in order to try and maintain a $50/bbl floor price. US shale producers couldn’t have hoped for better news.   As the chart shows:

  US inventories would be even higher if the US wasn’t already exporting nearly 5 million barrels/day of oil products
  It is also exporting 500 kb/d of oil since President Obama lifted the ban in December 2015
  Nobody seems to pay much attention to this dramatic about-turn as they instead obsess on weekly inventory data
  But these exports are now taking the fight to OPEC and Russia in some of their core markets around the world

None of this would have happened if Naimi’s policy had continued.  Producers could not have raised the necessary capital with prices below $30/bbl.  But now they have spent the capital, cash-flow has become their key metric.

US rigs May17The second chart confirms the turnaround that has taken place across the US shale landscape, as the oil rig count has doubled over the past year. Drilling takes between 6 – 9 months to show results in terms of oil production, and so the real surge is only just now beginning.  Equally important, as the Financial Times reports, is that today’s horizontal wells are far more productive:

“This month 662 barrels/d will be produced from new wells in the Permian for every rig that is running there, according to the US government’s Energy Information Administration. That is triple the rate of 217 b/d per rig at the end of 2014.”

Before too long, the oil market will suddenly notice what is happening to US shale production, and prices will start to react.  Will they stop at $30/bbl again? Maybe not, given today’s record levels of global inventory.

As the International Energy Agency (IEA) noted last month, OECD stocks actually rose 24.1mb in Q1, despite the OPEC/non-OPEC deal. And, of course, as the IEA has also noted, the medium term outlook for oil demand has also been weakening as China and India focus on boosting the use of Electric Vehicles.

The current OPEC/non-OPEC strategy highlights the fact that whilst the West has begun the process of adapting to lower oil prices, many oil exporting countries have not.  As Nick Butler warns in the Financial Times:

“Matching lower revenues to the needs of growing populations who have become dependent on oil wealth will not be easy. It is hard to think of an oil-producing country that does not already have deep social and economic problems. Many are deeply in debt.

“In Nigeria, Venezuela, Russia and even Saudi Arabia itself the latest fall, and the removal of the illusion that prices are about to rise again, could be dangerously disruptive. The effects will be felt well beyond the oil market.”

US Permian’s shale oil surge highlights OPEC’s failed strategy

Pioneer May17
OPEC and Russia made a massive mistake last November when when they decided to try and establish a $50/bbl floor for world oil prices.  And now they have doubled down on their mistake by extending the deal to March 2018. They have ignored 4 absolutely critical facts:

  Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
  The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels
  At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
  But at $50/bbl, they could

Former Saudi Oil Minister Ali Naimi understood this very well.  He also understood that OPEC producers therefore had to focus on market share, not price, as Bloomberg reported:

“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”

Permian rigs May17Naimi’s strategy was far-sighted and was working.  The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:

  Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
  Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
  The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016

But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets.  Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives.  They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:

“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance”.

This gave the shale producers the window of opportunity they needed.  Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.

As a result, the number of rigs in the Permian Basin has nearly trebled.  At 309 last week, the rig count is already very close to the previous peak.

The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested.  And it is now too late for OPEC to do anything to stop its development.

On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.