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
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.
Slowly but surely the myths over supposed supply shortages in the crude oil market are being exposed. As leading US investment magazine Barron’s wrote this week:
“In May, U.S. production hit its highest monthly average level since 1988 and is projected to keep rising. Domestic supplies have piled up in storage, especially on the Gulf Coast, and market watchers think supplies could get perilously high this fall when refineries traditionally shut down units for seasonal maintenance….
“A pipeline linking Cushing to Gulf Coast refineries has relieved a glut of oil at the hub, shrinking stockpiles there to the lowest level in six years, but analysts say supplies could start building again this fall. New pipelines bringing oil from Canada and the Northern U.S. to Cushing are expected to open in late summer or early fall.”
Supplies “perilously high”. “A glut of oil”. This is the reality after 3 years of record high annual oil prices.
It is also the background to last week’s decision by the US Administration to approve condensate exports. In turn, this is a likely game-changer for global oil markets and long-suffering petchem producers. They probably mark the first step in a return to a more normal relationship between oil and gas prices:
- Oil has 6x the energy content of natural gas, and its logistics are more flexible
- So it has normally sold for around 9 times natural gas levels, as the chart shows
- Currently it sells at a massive premium to this of around 25 times gas prices
- This is only due to the influence of pension funds and hedge funds, who bid up prices in response to the Fed’s money-printing, as they raced to find a ‘store of value’
But there has never been any reason for this premium in terms of supply/demand balances. Quite the opposite, in fact. Not only have there been no supply disruptions in the past 5 years to justify the premium. But supply has grown to such an extent in the US that it is close to running out of storage.
Thus we may well be getting close to the end-game of this particular story.
2 events suggest that the world may be about to return to a more normal relationship between oil and gas. The first is that oil trading has slowed almost to a stop:
- Oil traders have made desperate efforts to push up oil prices in response to the terrible events in Iraq
- They have been in danger of losing their bonuses, as volatility has almost disappeared
- Early in June, a whole week passed with just a 30c/bbl range in daily closing prices
- But now their push to the upside appears to have failed, as Iraq’s exports are clearly not reduced by the fighting
- As a result, we can expect their next push to be downwards, to pressure prices as summer driving season ends
The second event is the US decision to allow exports of condensate (a light form of naphtha) in order to keep supplies under control:
The key issue is that US demand is not recovering, as the blog has noted with shale gas developments. So the US administration had to allow condensate exports to take place, as there will soon be nowhere to store all the new oil production. As Reuters noted at the weekend:
“The U.S. oil boom has created a glut of light oil and condensate that Gulf Coast refineries, largely built to run heavy crudes, have been unable to fully absorb.”
The world “glut” is important. US propane is already heading in increasing quantities to China and elsewhere to boost propylene production. Now large quantities of US condensate will be also heading into export markets. This is very good news for those European and Asian crackers that have been under pressure from low-cost US ethane. They will soon have US condensate suppliers lining up to supply them with cheaper product.
In turn, this will likely prove the first step towards returning oil prices to their normal relationship to natural gas. Unless geo-political events intervene, today’s weakening demand growth combined with growing energy surpluses in the US and elsewhere can lead to only one possible outcome.
If something seems to be ‘too good to be true’, then it usually is. This may be the learning for the world’s largest pension funds, as they plan their next moves in commodity investment.
Their involvement jumped from 2009 after central banks began stimulus programmes, as the blog discussed last month. The funds were looking for a ‘store of value’ to protect investment values, as they feared the Federal Reserve’s actions would increase inflation and drive down the value of the US$.
Oil markets seemed the perfect ‘escape route’, particularly as expert commentators assured them that commodities were now in a never-ending supercycle. And for a while, everything seemed to work perfectly, as the tidal wave of new cash sent prices soaring:
• A total of $439bn was ‘invested’ in commodity markets at the end of September, according to Barclays Capital. This was nearly 3 times total investment in 2008 ($160bn)
• By comparison, just $10bn was ‘invested’ in 2000
Overall, the Financial Times reports that financial speculators now account for 70-75% of all commodity market activity. Genuine industry players, seeking to hedge their future profits, are just 25%-30%. This is exactly the reverse of the position when futures were first established.
Speculators no longer just provide liquidity, but have instead taken over the market.
As always, the early entrants did best. They bought before the rush of new players, and sometimes made enormous profits. In particular they benefited from the ‘roll’ common to futures markets, where buyers tend to pay a premium for future delivery, which then disappears as the contract rolls towards the due date.
Now, the game is getting closer to an end. Total returns from commodity trading in 2012 are mostly negative, with crude oil returns down 15.9% so far. The chart shows how different markets have slowly begun to unwind:
• Cotton prices were the first to tumble last year
• Coffee prices then fell, as consumers could not afford to buy
• Now crude oil is looking weak
The ‘network effect’ has helped to support crude prices until recently, as buyers abandon other markets and focus on the seemingly strongest contracts. But in the end, the speculators have killed the goose that laid the golden eggs. Today’s record high prices mean that supply and demand balances are gradually becoming more important again.
One day, possibly not too far away, buyers will realise they have been involved in something very similar to a giant Ponzi scheme. The money being paid over today has provided returns for others. It has not created wealth and secured future pensions.
Consumers around the world have also paid a large part of the price. Whilst when the remaining markets crash, the physical players will be left to pick up what pieces remain.
Brent oil prices have just finished a record sequence of 240 days above $100/bbl. This was longer than the 170 days in 2008. And longer, on an inflation-adjusted basis, than in any previous period of high oil prices.
In Europe, prices were actually higher than in 2008 due to the lower value of the euro versus the dollar. Prices averaged €85.06 at their peak in June 2008. But in 2012, they were above this level continuously from January – May, and peaked 12% higher at an average €94.99 in March.
UK prices have seen similar peaks, due to the weaker £. Tesco are the world’s 3rd largest retailer, and as CEO Philip Clarke noted last week, when revealing disappointing Q1 growth figures:
“A tank of petrol still cost about £70, compared with £45 two years ago. That is an amazing dent in household budgets.”
US oil prices have been slightly weaker than Brent in recent months, but still averaged over $100/bbl from January into May. The reversal of natural gas prices back to long-term averages also helped to support consumer spending.
But even in the US, as the above chart from the American Chemistry Council shows, the damage has been done. Inflation-adjusted sales (orange line) have dropped quite sharply in recent months. As the ACC note:
“The report provides further evidence that the recovery is softening and consumers are again holding back, constrained by persistent unemployment and low wage growth.”
Parabolic price movements are great fun whilst they last. The dot.com technology stock boom was a great example, when prices would jump 1% or 2% a day towards its end. And then, sadly, it all collapsed.
The NASDAQ technology index doubled in a year to reach 5000 during its final, parabolic run-up to March 2000. It then lost half its value in the next 9 months, and carried on falling until it bottomed at 1200 in July 2002.
Today, the above chart of the ratio between WTI crude oil and US natural gas prices is showing the same parabolic picture:
• Gas prices have fallen from $13.4/MMBTU in July 2009 to $2.1/MMBTU
• WTI prices have risen from $33/bbl in January 2009 to $103/bbl
• The ratio has thus almost reached 50:1
Of course, there are lots of reasons for the recent divergence in performance between natural gas and crude oil.
The dramatic rise in shale gas availability has caused gas storage problems. Users have been slow to convert from oil to take advantage of cheap gas prices. And the high-frequency traders have focused on the much larger WTI market when playing their computer games.
But fundamentally, WTI has ~6 times the energy content of natural gas. And its historical average, due to its logistic/storage advantages has been 9.9 times gas prices.
Equally, today’s sustained record oil price levels are not based on either a shortage of product, or strong demand. In fact, the reverse is true, with demand destruction taking place in all major markets.
‘Reversion to the mean’ is the most profitable investment concept. And when markets go parabolic, this is generally a good sign that the trading has become very one-sided. It then only takes a relatively minor incident to change the seemingly-unstoppable trend.
Financial markets continued their start of quarter rally last week. But their volatility amazes even seasoned observers. The US Dow Jones Index has moved at least 100 points in 57 of the last 58 days, for example, whilst crude oil jumped $3/bbl on Friday alone.
Of course, the continued correlation between stock and oil markets is ultimately contradictory. Higher oil and feedstock prices can only do further damage to the prospects for economic recovery in the real economy, in which we all operate. The blog discusses this in the above short interview, recorded with ICIS’s John Baker at EPCA.
But the volatility is likely to continue, as long as markets remain dominated by the high frequency traders and their computer games. Reassuringly, though, there are signs that next month’s G-20 meeting might ban at least some of this dysfunctional trading activity. The blog will tip its hat to Andy Haldane at the Bank of England, and his colleagues, if this can be achieved.
The blog was also reassured by news that German chemical firms are studying “scenarios for a recession” as a result of the current financial market turbulence. Henrik Meincke at Germany’s VCI chemicals trade group told ICIS that “Germany’s chemical industry would be prepared” should a recession occur.
ICIS pricing comments this week, and price movements since the IeC Downturn Alert launched on 29 April, are below:
Benzene NWE, down 28%. “An air of nervousness was compounding the softer sentiment across the benzene market, as was the strict inventory management currently in place across the aromatics chain and downstream markets.”
HDPE USA export, down 25%. “Prices continued to fall during the week. One source suggested some prices have been so low, producers might be trying to sell into China.”
Naphtha Europe, down 16%. “Demand remains poor from both the petrochemical industry and the gasoline sector.”
Brent crude oil, down 13%.
S&P 500 Index down 10%.
PTA China, down 8%. “Buyers had no confidence to purchase cargoes because of poor downstream sales.”