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
Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same. Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.
The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story. So the chart above instead combines 5 “shock, horror” stories, showing quarterly oil production since 2015:
- Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015. OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
- Russia has also been much in the news since joining the OPEC output agreement in November 2016. But in reality, it has done little. Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
- Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
- Venezuela is an OPEC member, but its production decline began long before the OPEC deal. The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
- The USA, along with Iran, has been the big winner over the past 2 years. Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!
But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April. Not much “shock, horror” there over a 3 year period. More a New Normal story of “Winners and Losers”.
So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday? Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble. The answer lies in the second chart from John Kemp at Reuters:
- It shows combined speculative purchases in futures markets by hedge funds since 2013
- These hit a low of around 200mbbls in January 2016 (2 days supply)
- They then more than trebled to around 700mbbls by December 2016 (7 days supply)
- After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)
Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently: “Several of them had little or no experience or even a basic understanding of how the physical market works.”
This critical point is confirmed by Citi analyst Ed Morse: “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.”
Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:
“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).
OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION
The hedge funds have been the real winners from all the “shock, horror” stories. These created the essential changes in “crowd behaviour”, from which they could profit. But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:
- Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
- This level has been linked with a US recession on almost every occasion since 1970
- The only exception was post-2009 when China and the Western central banks ramped up stimulus
- The stimulus simply created a debt-financed bubble
The reason is simple. People only have so much cash to spend. If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy. Chemical markets are already confirming that demand destruction is taking place.:
- Companies have completely failed to pass through today’s high energy costs. For example:
- European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
- They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)
Even worse news may be around the corner. Last week saw President Trump decide to withdraw from the Iran deal. His daughter also opened the new US embassy to Jerusalem. Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.
As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities. Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz. It is just 21 miles wide (34km) at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.
As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”. Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets. We must all learn to form our own judgments about the real risks that might lie ahead.
Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.
The post Oil prices flag recession risk as Iranian geopolitical tensions rise appeared first on Chemicals & The Economy.
OPEC is living in the past with its recent announcement of new quotas.
The simple fact is that the arrival of US shale production means OPEC are no longer the swing producer, able to control the world market. The quotas will have little effect in themselves, as most of the participants will cheat. Instead, they will simply help to boost US oil and gas production, whilst turbo-charging the use of smart meters.
OPEC’s core problem was also highlighted by the recent announcement by the US Geological Survey of:
“The largest estimate of continuous oil (shale) that USGS has ever assessed in the United States.The Wolfcamp shale in the Midland Basin portion of Texas’ Permian Basin province contains an estimated mean of 20 billion barrels of oil, 16 trillion cubic feet of associated natural gas, and 1.6 billion barrels of natural gas liquids
“The fact that this is the largest assessment of continuous oil we have ever done just goes to show that, even in areas that have produced billions of barrels of oil, there is still the potential to find billions more.”
The US is already well on the way towards energy independence within the next 5 years, as BP have reported. OPEC’s move will therefore prove totally counter-productive, as it will simply support the growth of natural gas, renewables, and energy efficiency. (This inter-active map from the University of Texas shows the dramatic growth in the role of gas and renewables for US electricity production).
Saudi Arabia had therefore adopted the right policy in the summer of 2014, in recognising that market share was the key to success. Anyone who cuts back on oil sales today in the hope of higher prices, risks being unable to sell in the future. But, of course, Saudi has now had to change course for geopolitical reasons, as I discussed last week. With President-elect Trump about to take office, it can no longer rely on its Oil-for-Defence deal with the USA.
Trump’s arrival will add to OPEC’s problems, as his 100-day Action Plan aims to:
“Lift the restrictions on the production of $50tn worth of job-producing American energy reserves, including shale, oil, natural gas and clean coal.”
Fracking technology is now well understood in the US, and becoming very efficient due to the introduction of horizontal drilling techniques. It is therefore unlikely that OPEC’s new quotas will have much impact on the global oil market. Most OPEC and non-OPEC producers will cheat, as usual. And today’s temporarily higher prices are simply going to further increase the overall supply glut by incentivising higher US oil and gas output:
The recent price rises have already enabled US producers to lock in very attractive margins into 2019
They will also support US oil exports into Asia, one of OPEC’s key markets. BP is currently sending the first shipment, of 3 million barrels, and others such as Sinopec and Trafigura are following
They will also support US natural gas production, where the US became a net exporter last month. US gas exports have already risen 50% since 2010, and the US Energy Department expects it to become the world’s 3rd largest exporter after Australia and Qatar by 2020. This is very bad news for oil demand, as it means gas will be even more competitive in world energy markets.
Equally important is the rise of energy efficiency as a topic for action. This was first flagged by ExxonMobil in 2009, when they argued:
“The most important ‘fuel’ of all, will be energy saved through fuel efficiency“.
Now, thanks to climate change, efficiency has reached the top of the political agenda. Smart meters will soon provide more than a billion consumers with the ability to avoid wasting energy, as the World Energy Council report this month:
“China is the leader of the smart metering market with 250 million units, in Asia plans are underway to reach 70% coverage, and 40% of American households have a smart meter. At European level, Italy and Sweden are the leading examples (close to 90% of consumers have smart meters). Furthermore, the Energy Efficiency Directive requires EU member states to deploy smart meters by 2020.”
The arrival of smart meters means that consumers now have an alternative to paying higher prices, as they can more easily identify where they are wasting energy, and cut back.
Developments such as the growth of US oil and gas production, plus the growth of smart meters, means that the energy world is going through major change. In this New Normal world, OPEC risks becoming irrelevant if it continues to try and turn back the clock to the 1970s with its pricing policies.
Fracking has completely changed the outlook for US natural gas supplies, as the above chart from the latest Energy Information Agency 2014 annual report shows:
- It forecasts a 56% increase in total natural gas production from 2012 to 2040
- This is largely due to growth in shale gas (green) and tight gas (brown)
- Shale gas output will double from 9.7 Tcf in 2012 to 19.8 Tcf in 2040
- Its share of total U.S. natural gas output increases from 40% in 2012 to 53% in 2040
- Tight gas production increases 73%, but its share stays relatively constant
Changes of this magnitude lead to a vast number of unexpected consequences, some good and some bad. And even good changes, involving an increase in demand, create major disruption for both producers and consumers.
A blog reader has thus suggested that the adjustment process followed by hydrochloric acid (HCl) could be a useful Case Study. The idea is to illustrate the opportunities and challenges created by this revolution in energy supply.
THE IMPACT OF FRACKING DEMAND ON HYDROCHLORIC ACID
We all carry HCl inside us, as an essential part of the gastric acid in our digestive system. It is also a core product for the chloralkali industry, and has a wide range of industrial uses. More recently, it has become a key part of the fracking process, as the FracFocus website describes:
“An acid stage, consisting of several thousand gallons of water mixed with a dilute acid such as hydrochloric or muriatic acid: This serves to clear cement debris in the wellbore and provide an open conduit for other frac fluids by dissolving carbonate minerals and opening fractures near the wellbore.”
As a result, supply/demand fundamentals for HCl are going through major change.
One key issue is that around 75% of all HCl has historically been used internally by companies for PVC and polyurethane production. Only 25% has gone onto the external market for water/swimming pool disinfection, steel pickling, food processing and other uses.
Nobody had dreamed that shale gas developments would impact HCl, so producers and consumers have been running hard to try and catch up. Price volatility has thus become a major feature of the market.
Initially prices soared, as it was impossible to create new supply overnight:
- HCl is often produced as a by-product of other chloralkali processes, with this source often known as ‘fatal’ supply
- On-purpose production can also take place by combining chlorine with hydrogen in the presence of UV light
More recently, prices collapsed by 40% between December and May, according to ICIS pricing data. But they have since rallied 40% as the US market then became very tight, as ‘fatal’ supply was reduced by outages at Bayer and DuPont, whilst BASF’s Geismar plant has been on turnaround.
A key part of the problem is that HCl logistics are relatively inefficient, as it is usually transported as a 35% concentration in water. So it can take a long time to refill supply chains, once they become empty, as an excellent report by Bill Bowen in ICIS news describes.
Further volatility is likely as the year progresses, due to the new capacity due to come online. This will increase US capacity by around 20%, with most scheduled to start-up between now and year-end.
Will this new capacity now create temporary over-supply, and more price volatility? Nobody knows. We are only at the very start of the fracking revolution. Today’s certainties can easily become irrelevant tomorrow.
What does seem certain is that we all need to learn about what can happen when long-established supply/demand fundamentals are challenged by a major new development like fracking.
The HCl market thus highlights how a company’s ability to manage today’s more volatile world is becoming critical to its current and future profitability.