There were only two winners from the past 3 months of OPEC’s “Will they?, Won’t they?” debate on output cutbacks.
Iran wasn’t one of them – although the talks did emphasise its renewed ability to control the OPEC agenda. Nor was Saudi Arabia, forced to accept the lion’s share of the proposed cutbacks.
Instead, the US shale producers were big winners, with some saying they were “dancing in the streets of Houston” when the “deal” was announced last week. Who can blame them, given that production costs according to Pioneer now range between $2.15/bbl – $12.27/bbl in the vast Permian Basin field.
But the really big winners were the owners of the futures markets. As the head of the NYMEX commodities business boasted – “the OPEC talks have been great for our business“. Looking at the data, one can see what he means:
More than 1.7 million contracts traded just on Brent futures on ICE last Wednesday
Each contact represents 1000 barrels, so that is an astonishing 1.7bn barrels of oil – around 18x daily production
The NYMEX WTI contract traded 2.4m contracts – around 26x daily production
In total, therefore, volume on the major Western futures markets was a record 44x daily production
And, of course, last week was no exception in highlighting the dominance of the futures market is setting oil prices. As the chart above shows, their trading volume has rocketed since the central banks began their stimulus programmes. It averages nearly 12x physical volume so far this year, versus just 3x in 2006 – and just 1x in 1996.
As one observer rightly noted, the trading had all the signs of a buying frenzy. For in the real world, it is highly unlikely that the production agreement will achieve its promised goals:
Russia has never, ever, participated in an OPEC quota, and is very unlikely to actually cut production this time
Equally important is that OPEC production itself is likely to rise as Nigerian and Libyan output continues to recover
And, of course, oil inventories are already at record levels, and will likely rise further as production increases in the USA, Brazil, Canada and Kazakhstan
Unsurprisingly, most of the selling was being done by producers, delighted at being able to hedge their output into 2019. They sold so much, the forward curve moved from being in contango (where tomorrow’s price is higher than today’s), to backwardation (where tomorrow’s price is lower than today’s). This confirms that analyst talk of shortages and cutbacks is pure wishful thinking.
Even more worrying for the oil bulls is that the rise in the US$ is also reducing demand in the major Emerging Markets. Oil is priced in US$, and this has risen by 10% or more against many currencies in the past few months. And any recession in 2017, which seems likely based on the chemical industry outlook, will further weaken demand.
But the OPEC meeting did highlight one critical development. For the first time since the 1980s, Saudi Arabia sided with OPEC in terms of agreeing cutbacks. This has only happened twice before in history – during the 1973/4 Arab Oil Boycott, and the 1979/85 Oil Crisis.
Both times, Saudi was worried that its critical Oil-for-Defence deal with the USA might not deliver promised support:
In 1973, President Nixon was facing impeachment over the Watergate scandal, and the Arab world was up in arms over US support for Israel in the Yom Kippur War
In 1979, President Carter was facing defeat in his re-election bid, and the Iran hostage issue meant US support again became unreliable
Today, the 1945 pact between President Roosevelt and King Saud (pictured above) is effectively dead. President-elect Trump no longer sees the USA as the “leader of the free world”, and it is most unlikely that he would send military support to Saudi if it was attacked. The fact that the US is now on the way to becoming energy self-sufficient by 2021 means it has no real need for Saudi oil any more, as I suggested 2 years ago:
”Suddenly the Saudis face a critical question – does the US still need the 1.3 million barrels/day they supplied in 2013?
And if not, will the US still be prepared to defend Saudi from attack, as it did during the first Gulf War in 1990-1991?
This is the question that keeps senior Saudi officials and Ministers awake at nights in Riyadh”
This the New Normal world in action. Old certainties are disappearing, and we do not yet know what will replace them.
China’s New Normal policies are taking global commodity markets in a new direction, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Commodity prices could well have further to fall, now China’s business model has changed. It is no longer aiming to achieve high levels of economic growth by operating an export-focused development model, supported by vast infrastructure spending. Instead, its New Normal policies aim to boost domestic consumption, by creating a services-led model based on exploiting the opportunities created by the power of the internet.
The only problem is that markets have failed to notice this change. They have fallen victim to the phenomenon of “anchoring” as identified by Nobel Prizewinner Daniel Kahneman, and assume the New Normal is similar to the Old Normal. Thus, much analysis on commodity markets still focuses on guessing “when will the rally begin?”
This approach ignores the potential for prices to instead fall further, back to the levels common before their China-inspired boom began in 2003, as no other country or region can possibly replace China now its demand has stalled.
The problem is that the vast expansions of recent years have been based on two false assumptions. The first was that up to 3bn people were about to become middle class by western standards. The second was that this would drive a ‘super-cycle’ of new demand.
In its paper The rise of the middle class in the PRC in 2011, the Asian Development Bank argued: “Using $2–$20 (purchasing power parity) per capita daily income as the definition of middle class, majority of households in the PRC have become middle class by 2007.”
Understandably, many people heard the words “middle class” but didn’t understand the definition. Yet as the Pew Research Center reported recently: “People who are middle income live on $10-20 a day, which translates to an annual income of $14,600 to $29,200 for a family of four. That range merely straddles the official poverty line in the United States—$23,021 for a family of four in 2011.”
Pew’s report also confirmed that 84 per cent of the world’s population have incomes below the US poverty line. It also noted that 87 per cent of all those earning more than $50 a day live in North America and Europe, with just 1 per cent living in Africa, 4 per cent in Latin America and 8 per cent in Asia.
The wishful thinking was compounded by the stimulus policies adopted by central banks from 2004, first through the subprime bubble and then through quantitative easing. By keeping interest rates very low and then printing trillions of dollars, they created massive bubbles in financial and property markets. In turn, this created one-off ‘wealth effects’ which temporarily appeared to have boosted consumer demand.
Prices of key raw materials such as oil, copper, iron ore and cotton raced higher, in some cases to new all-time highs. The investment thesis was simple: the coming supercycle would inevitably require unprecedented volumes of raw materials, and provide earnings to match for those companies who chose to invest in the new capacity required. The commodity bubble thus paralleled earlier dotcom and subprime bubbles in featuring extravagant optimism and a surge in debt. Investors came to believe that a new investment paradigm was in place, under which previous valuation models no longer mattered.
Importantly also, they felt they had the power of the US Federal Reserve behind them, as the Fed continued to assume that creating a wealth effect through a rising stock market was key to economic stability. Since 2000, a whole generation of investors has been brought up to believe that the ability to forecast the Fed’s intentions is therefore more important than understanding the fundamentals of supply and demand. Investment success has instead flowed from following the ‘buy-on-the-dips’ theory.
Now it seems the commodity bubble is bursting. And, as before, investors may discover to their cost that leading companies of the bubble era have been, in Warren Buffett’s immortal phrase, “swimming naked” – paralleling Enron and WorldCom in dotcom times, Lehman Bros and AIG in subprime. The recent share price performance of some commodity bubble companies certainly suggests this time may not be so different after all.
Equally worrying is that commodity-exporting countries in a wide arc from Brazil through South Africa, Asia, Australia, the Middle East and Russia are now seeing major downturns in their economies, whilst vast surpluses have been created in key products. For example, oil inventory is at record levels around the world; aluminium surpluses are enough to build 16,000 747s; cotton inventories are enough to produce 129bn T-shirts.
A further problem with the commodity bubble is that the downturn is not contained within national borders. Developed country investors and companies had been delighted to fund EM commodity export expansions, due to the higher prospective yields on offer. Thus a recent paper from the Bank for International Settlements noted: “Outstanding USD-denominated debt of non-banks located outside the US stood at $9.2tn at September 2014, having grown from $6tn at the beginning of 2010.”
Too many companies and investors remain in denial about recent developments in commodity prices. They seem determined to wear their rose-tinted glasses until the last possible minute, suggesting that prices still have further to fall. But more rational observers may instead worry about the after-shocks that will impact those companies, countries, investors and lenders who chose to believe that China’s seemingly insatiable appetite for commodities had created a new investment paradigm
Oil prices have fallen around $5/bbl, since my suggestion last week that a “New oil price fall was a matter of “when”, not “if”“. It thus seems increasingly likely they are resuming their fall back towards $30/bbl, as we discussed in last week’s pH Report webinar.
Financial players clearly misread the market when they assumed earlier this year that prices would ‘inevitably’ move higher, and now we will all suffer for their mistake, as markets continue their Great Unwinding.
The funds first began to believe in higher prices after the SuperBowl coup back in January, when prices jumped 20% in 2 days. This pushed prices up in very thin trading. But financial players clearly didn’t understand this was just a very clever trading move, and instead decided that it marked the repeat of the Q1 2009 rally. As the chart shows:
- Prices then had bottomed below $40/bbl, but moved into recovery as central banks began stimulus efforts
- Fortunes were made as prices moved up to $125/bbl, due to the scale of the liquidity provided
- And clearly many players thought they saw a similar pattern developing in Q1 this year
- As a result, they are storing oil in tanks all over the world, as well as in floating storage
But this is not 2009 all over again. Central banks are most unlikely to add another $35tn of stimulus to that already supplied. Instead, we are seeing the Great Unwinding of all this stimulus, as China heads in a New Normal direction, and the Eurozone countries start to realise Greece’s debt will never be repaid.
The fundamentals of supply/demand are, of course, of no interest to the commodity funds. As discussed last week, they currently have $69bn to invest in the futures – and $69bn can buy a lot commodities such as oil at today’s lower prices
The result is that we now have record inventory levels in the US and Europe, plus near-record levels of floating storage. Equally important for Asian markets is that China is probably close to ending its buying to build its strategic oil reserve to cover 100 days of demand.
Obviously prices will bounce around from day-to-day and week-to-week. But barring geo-political upset, it is very hard to see why they should not continue their fall, now they have begun to slide again.
There are some signs of a recovery in some markets, but the overall picture is still very quiet for what should be the seasonally strongest quarter of the year for the West. Markets should also have been strong in Asia, in the run-up to this week’s Lunar New Year (LNY), but they have remained relatively quiet.
Yet the relatively mild winter should have caused demand to surprise on the upside. Equally, one would normally expect to see growing confidence about the outlook for March, with the return of China after LNY, and ahead of Easter in the West.
One key issue is that falling oil prices reduce visibility into the real state of demand, just as happens with rising prices:
- When oil prices rise, we are fooled into thinking everything is wonderful, as buyers rush to build inventory ahead of price increases
- The opposite happens when they are falling, as buyers give up trying to ‘catch a falling knife’, and only order on a hand-to mouth basis
So in many ways we are at a cross-roads. Demand appears weaker than it should be, given the time of year. But it is unclear how much of this is due to a running down of inventories, and how much is due to weak underlying demand.
Equally complex is the near-term position on the impact of falling oil prices. Over time, it should be positive, as lower energy costs should leave the consumer with more discretionary spending power.
But in the short-term, there can be a bigger hit to demand – ‘losers’ from lower prices tend to stop spending very quickly, whilst ‘winners’ tend to wait to see if the situation continues, before committing to major new spend.
In place of visibility, we instead have volatility:
- The recent 20% jump in oil prices has caused some buyers to panic, as they had let stocks get too low
- In turn, this has encouraged sellers to take a firm line on volumes, in order to support margins
- But we do not know if this temporary upturn will turn into something more sustainable
The chart of benchmark products above confirms this general picture. Most of the products have stabilised, at least temporarily. US polyethylene prices are still falling, but this is really catch-up. Production outages in Q4 meant the US was largely insulated from the need to export as oil prices tumbled. As ICIS pricing notes:
“Long-term, ethylene prices remain depressed because global oil markets have mitigated much of the US cost advantage on derivatives. As a result, downstream units are running at lower rates because they cannot export products, lowering demand in the US. US ethylene buyers are also showing renewed concerns that a floor in global oil and downstream markets has yet to be found after another downturn in crude.”
This also highlights the key unknown, namely the outlook for oil prices. Those who staged the SuperBowl coup 2 weeks ago ago have clearly not given up. They have so far managed to create price rallies even though the underlying picture on supply/demand gets worse.
This of course, creates added risk for everyone else. We are now heading into a seasonally weak period for oil demand as refineries go down for post-winter maintenance. And despite the hype over the declining numbers of drilling rigs, there are still few signs of any real cutbacks in supply from oil producers.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 60%. “Healthy cracker margins were supporting output throughout January, leading to a surplus of pygas and benzene in Europe.”
Brent crude oil, down 44%
PTA China, down 42%. ”Demand in the key China markets started to slowdown ahead of the Chinese Lunar New Year holiday”
Naphtha Europe, down 41%. “Market fundamentals are marginally less strong when compared with last week.”
¥:$, down 16%
HDPE US export, down 26%. “Prices saw some softening and a widening of ranges on lower ethylene prices and slow demand for the week”
S&P 500 stock market index, up 7%
An astonishing coup appears to have begun 10 days ago, in the last 45 minutes of trading in US oil markets. Yet we still don’t know who master-minded it, or their full objectives. .
What happened to oil prices? Prices jumped 8% in the last 45 minutes of trading on Friday 30 January, taking Brent to $53/bbl and US WTI to $50/bbl. And by Tuesday they had surged still higher, taking Brent to $59/bbl and WTI to $54/bbl. This meant prices had risen 20% in just 2 days.
This would be astonishing at any time, in any major financial market. But it is almost incredible in today’s oil market.
Prices have surged even as the US has been reporting record levels of oil inventory, as the chart shows. Last week, they were the highest-ever seen since records began in 1982. And US oil production of 9.2mbd is also at the highest level since records began in 1983.
Clearly the people who master-minded the coup knew what they were doing.
How did it all happen? Traders were winding down at month-end, and leaving their offices early on the Friday afternoon ahead of the SuperBowl weekend. A record 114 million Americans were planning to watch the American football final. And large numbers were planning viewing parties for friends, family and colleagues.
Suddenly, a flood of “buy orders” appeared in the last 45 minutes of trading. With trading volumes low, the buyers concentrated their firepower and achieved spectacular results. This was clever enough and, of course, entirely legal.
But even cleverer was the way that suddenly “a story” was created to explain why prices needed to go higher. Most people, after all, would think that an all-time record level in inventory meant the market was very weak – particularly as the peak was taking place in January, normally a major month for consumption.
Instead, a story appeared from nowhere that focused on the decline underway in the number of active drilling rigs in the USA. This was spun to suggest it was, as the Wall Street Journal reported, “a sign that crude production may be starting to ebb“.
Who benefits from the surge? The clear winners are the people who developed the concept for the coup and implemented it so effectively. They obviously had deep pockets to fund their market raid, and also extensive knowledge of how to drive it higher in a matter of moments. As Reuters reported on Friday:
“People have only started paying attention to the oil rig count in the past week despite the fact they have been falling for weeks,” said Gene McGillian, analyst at Tradition Energy in Stamford, Connecticut. “I think the people really benefiting from these market gyrations are the high frequency traders (HFT) as volumes are really up.”
Creating “a story” around the rig count was critical, as it meant the HFT traders (who usually provide 50% or more of trading volume), had the necessary news feed for their algorithms to operate. Their volume on a quiet Friday afternoon would overwhelm any trading done on the basis of supply/demand and inventory levels.
Of course, the other people who benefit are oil producers in the US and elsewhere. Most of them will have active trading organisations either in-house, or on contract, in order to manage their sales.
What happens next? We will find out this week. If it was a group of traders, then they will likely step back, having made such a large gain in such a short space of time. They would be foolish to stay in the market, and risk attention turning back to the dire state of the supply/demand balances.
But if it was one or more of the producers at work, then we will likely see further efforts to build on the momentum created. They will need to widen ”the story” to suggest that the energy ”glut” reported by the International Energy Agency is now about to magically disappear.
Hopefully one of the major news media will follow-up and tell us what is really happening.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 59%. “Some tentative upward momentum was seen from derivative markets, but there was still no cause for bullishness due to healthy availability in the region”
Brent crude oil, down 46%
PTA China, down 43%. ”Polyester demand weakened significantly in the latter half of the week”
Naphtha Europe, down 43%. “A prolonged strike at US refineries could drive up demand for crude and oil products in Europe although there is mixed reaction to the industrial action in the markets so far”
¥:$, down 16%
HDPE US export, down 26%. “Prices remained mostly stable during the week”
S&P 500 stock market index, up 5%
Many readers have been taking a well-earned break over the past few weeks. As usual, therefore, the blog is highlighting key posts during August, to help you catch up as you return to the office.
Economic outlook: Great Unwinding of stimulus underway. Q2 results show slowing growth. US retail sales decline in line with incomes, household wealth. India WTO veto marks end of global trade deals. European chloralkali sales indicate slowdown. Boom/Gloom Index indicates slowdown ahead. Q2 operating rates slide bad omen for H2 outlook. US inventory build boosts US GDP
Auto sales: China sales to decline as stimulus ends. Roller-coaster ride in Japan, Russia, Brazil, India. GM focuses on low-cost as Europe remains weak.
Oil prices: Oil breaks out of its triangle, downwards. Fracking creates HCl price volatility.
China, India: Economic rebalancing to take 10 years. Modi highlights need for toilets to spur growth. China polyethylene sales highlight role in housing bubble. China housing market enters New Normal. China low-cost smartphones dominate market. China condom sales droop due to anti-graft campaign.