The Great Unwinding of the central banks stimulus policies is underway, as discussed last week. Oil markets have been one of the first to feel the change, as the chart shows, with prices finally falling out of the ‘triangle’ shape built up since 2008. The value of the US$, interest rates and the S&P 500 will also be impacted as the Unwinding continues.
The ‘triangle shape’ is one of the most interesting ’technical’ shapes. It monitors the balance of power between the bulls (seeking to push prices higher) and the bears (trying to take them lower). And the oil triangle since 2008 has been particularly interesting as in reality it has monitored the balance between:
- The financial players, trading electronically on the futures markets second by second
- The physical players, actually using the product for transport, heating and other ‘real’ purposes
Essentially what has happened is that the market long-ago stopped being based on supply/demand fundamentals. Instead it became driven by financial players. In hindsight, we can see there were two stages to this development:
Stage 1, 2005 – 2008
- Investment banks had made easy gains from 2005 onwards, by buying large volumes of futures contracts
- Prices then collapsed back to the historical $30/bbl level at the end of 2008
Stage 2, 2009 – 2014
One set of statistics highlights the change that took place (data from ThomsonReuters):
- 2005: Just 920,636 contracts were traded in the US WTI futures market
- 2008: There were 21,485,557 contracts traded
- 2011: There were 41,943,006 contracts traded
Futures markets had originally been created to allow producers and consumers to hedge positions. The blog helped to develop the contract in its early days when working for ICI in Houston, Texas. It still believe they have a valid purpose.
But as the blog noted as long ago as July 2010, the financial players’ strategy have reversed the normal working of the markets. They have created a contango structure, where prices for future delivery are higher than today’s.
This is the opposite of the traditional role, where producers hedge their positions and create backwardation – making today’s price higher than tomorrow’s.
FINANCIAL PLAYERS CAME TO DOMINATE OIL MARKETS
Thus oil markets have thus lost their price discovery role since 2005, and have instead been swamped by financial players.
- In 2005, world oil production was 82 million bbls/day of crude: WTI hedging was less than 1 million bbls/day
- By 2011, world oil production was still only 84 million bbls/day: but WTI hedging was now half of the total
History shows that the global economy cannot support oil prices being more than 2.5% of GDP. But since 2009 they have taken 5% of GDP, due to the actions of the financial players. The gap has been bridged by the central banks, creating $35tn (50% of global GDP) of new money on a low-cost basis over the period.
Naturally, prices soared as all this new financial demand appeared. The reason is simple: it takes only a microsecond to create a trade on a futures market, but it takes at least 5 – 10 years to find new oilfields and bring them into production.
Speculators thus began to dominate the market, creating a completely artificial balance between supply and demand – based on financial flows instead of product flows.
THE GREAT UNWINDING OF STIMULUS IS NOW UNDERWAY
But now the central banks are starting to pull back. Logic says you can’t go on printing money forever – in the end, you have to start paying it back, or defaulting.
China was the first to do this last year under the new leadership. Thus Reuters reports its implied oil demand was down 6% in July. Now, the International Energy Agency has reported in its latest Report that:
“Oil supplies were ample, and the Atlantic market was even reported to be facing a glut”
Thus the oil price is finally starting to fall out of its triangle:
- 10 years of historically high prices has led to major new investment, which is finally starting to come online – not only in oil, but also in gas and other energy sources
- At the same time, central bank lending is finally starting to reduce in China and the US
- 10 years of high prices have also led to demand destruction via greater efficiency and conservation efforts
- The result, as the IEA note, is that we suddenly find we face a supply glut as
So the chart is telling us that the financial players are now retreating from the market. In turn, this means physical supply/demand levels will come to drive the process of price discovery once again.
MAJOR OIL PRICE VOLATILITY IS NOW LIKELY
How low will prices go? We can have no idea, as prices have never been this high for so long. Nor can we rule out a further massive stimulus effort by the central banks at some point. But ‘technical trading’ logic would suggest they will fall to at least the 200-day exponential moving average, currently around $70/bbl, and probably lower (red line).
Equally, if price discovery does start to become based on real supply/demand balances again, we will have to watch out for geopolitical issues.
Ironically, there was never a single moment when supplies were interupted whilst prices were high. It was all hype, as the blog described at the time. But today there are real concerns developing on the supply side.
Will Russia cut Europe’s gas supply through the Ukraine in the winter, for example? That could easily push oil prices much higher, as users panicked and tried to substitute oil for gas.
Companies need to urgently prepare for major and unprecedented volatility in energy markets, as the Great Unwinding continues.
Imagine that 5 years ago, you had been asked by your Board to forecast future oil prices. And suppose you had prepared a forecast which said:
- Oil demand growth will slow in the West, as cars become more fuel-efficient and ageing populations drive less
- Demand growth in the emerging economies will be supported temporarily by real estate lending bubbles
- The USA will allow domestic production to expand onshore, and will see its output soar
- US natural gas prices will tumble back to their historical levels around $4/MMBTU
The Board would probably have nodded its collective head, and thought this outlook was certainly quite credible.
Then suppose you added some extra detail and, for example, suggested that it was most unlikely there would be any supply shortages? Again, the Board would have nodded its head and felt it had done well in asking you for this Study.
Encouraged, you might have added that the US might well see record inventory levels, as supply increased well ahead of demand. You might even have shown an inventory forecast like the chart above, to demonstrate the potential.
It shows the history of US oil inventories since records began in 1982. And there indeed, 5 years later, we see that inventories have reached a record high.
At this point in your presentation, promotion and a large bonus would have seemed certain. But then the Board chairman would have remembered to ask one more question:
“Could you give us your price forecast over this period, please”?
To which you would reply that you were now going to surprise them. And seeing the look on their faces, you would quickly add that prices might not fall back to historical levels below $30/bbl.
A puzzled chairman might then reply:-”I see, you think prices might rise a little whilst the lending bubble took place in emerging countries? You think this might increase their demand on a temporary basis?”
“More than that“, you would reply. “In fact I see them rising to record levels on a an annual basis of $100/bbl or more, and staying there for 3 or more years“.
At this point, the Board would probably start to wonder if you were, in fact, completely mad. The chairman would shake her head in disbelief. How could someone capable of such clear analytical thinking, she would wonder, then get the price issue so wrong. Your potential promotion would disappear into thin air.
By now readers will, of course, have realised that the above is actually the history of the past 5 years. No Board chairman could ever have expected that policymakers would:
The question for today’s Board meeting is therefore clear. “Do you really believe that oil prices can continue to be kept at today’s elevated levels by this combination of forces? Or do you worry that supply and demand may well soon bring us down with a bump?
WEDNESDAY EVENING UPDATE. The US government reported that oil inventories reached a new record last week, at nearly 400 million barrels. Whilst US GDP grew just 0.1% in Q1. One day markets will finally wake up to the fact that all the stimulus in the world cannot produce growth, when fertility rates are falling and life expectancy increasing. When they do, they may well rapidly start to question why oil prices are at record levels along with oil inventories.
Oil futures markets are a wonderful thing, in theory. They are supposed to enable price discovery, whilst their liquidity is meant to enable companies to reduce inventory levels. Instead of tying up working capital, they can simply go to the market and buy what they need, when they need it.
But the chart above, of US oil and product inventory since 1983, suggests they are currently failing to do their job:
- 30 years ago, average inventories were ~75 days of demand (blue column), and oil prices were ~$30/bbl
- Inventories then reduced very steadily till they were ~45 days in 2003, with prices still ~$30/bbl
- Clearly over this period, markets were performing the role for which they were intended
But then things began to change around 10 years ago, from 2004 onwards.
First of all, prices began to rise under the influence of the US Federal Reserve’s refusal to increase interest rates. Instead it kept them low to support consumer spending and the subprime housing market. As the blog identified at the time, this artificially-created demand meant the margin of spare supply became dangerously low globally.
This also encouraged hedge funds to think of commodities as a new asset class, separate from stocks and bonds. This is, of course, nonsense, as commodities only have a value in respect of their overall role in the economy. They cannot be separated from their end-use, and the interest rate environment.
The period since 2009 shows how damaging these changes have been:
- Prices collapsed in 2008 with the subprime bubble
- Oil and financial markets should then have been allowed to stabilise at a sustainable level
- But of course policymakers couldn’t leave well alone, and instead embarked on $33tn worth of stimulus
- As a result, oil prices leapt back to all-time record annual levels above $100/bbl
- And at the same time, inventories rose to average ~60 days as these high prices encouraged a supply surplus
As we also know, regulators also encouraged the growth of high-frequency trading, in the belief that high prices in financial markets would in turn stimulate consumer demand and restore economic growth. Even today, they still fail to understand their objective is impossible, due to the world’s earlier demographic dividend now turning to demographic deficit. But the end result has been, as Michael Lewis discusses in his new book ‘Fast Boys’:
“The United States stock market, the most iconic market in global capitalism, is rigged. If it wasn’t complicated, it wouldn’t be allowed to happen. The complexity disguises what is happening. If it’s so complicated you can’t understand it, then you can’t question it.”
We all know that it is very dangerous to bet against the Federal Reserve. We also know that the Brent oil price is a badly-broken marker, which anyone with deep pockets could easily manipulate. So it is not difficult to understand how this combination of forces has led to today’s position, where no single market now knows what it is pricing.
But suppose, just for a moment, that China’s new leadership is totally committed to its current policy of allowing the country’s property bubble to burst, as discussed last week? As the Wall Street Journal warns, the alternative does not bear thinking about:
“Without stronger oversight of China’s lending practices, the country risks a financial crisis that could send the economy into a nosedive. And that could wreak havoc on global growth, weighing particularly on other emerging markets that rely on demand from the world’s second-largest economy”
After all, a year ago the leading property developer, China Vanke, was able to borrow $800m for 5 years at an interest rate of just 2.6% – less than the rate paid by most governments. Brazil, then riding high in investor ratings, paid 4.6% in the same month.
The major central banks and governments have now been manipulating markets for a decade. Companies need to realise that this, and this alone, is the foundation for the consensus view that oil prices will remain above $100/bbl.
If China is serious about its new economic direction, as the blog suspects, then this cosy cartel could well break up. And the new leadership certainly appears to be serious. As official news agency Xinhua wrote Monday:
“Any talk about an incoming stimulus package is misleading and those anticipating the kind of stimulus China unleashed following the 2008 global financial crisis are likely to be disappointed. The sweeping measures did help China’s economy recover rapidly but also led to overcapacity, skyrocketing house prices and a credit boom, all of which the authorities are now trying to rein in.”
Believing that President Xi and Premier Li will change course could well prove to be a bigger mistake than betting against the Fed.
WEDNESDAY EVENING UPDATE: Data released by the US Energy Information Agency showed crude oil inventory in the Houston region is now at record levels, and expected to continue growing. Bank of America forecast this will soon be selling at a $13/bbl discount to Brent.
It seems that cotton prices are about to return to normal levels again. The blog’s detailed discussion of the issues last September highlighted how current Chinese government policies seemed doomed to fail, at enormous cost to the wider world. It now looks as though China’s new leadership agrees with this conclusion.
Since late 2008, the previous leadership’s policies had placed China in the role of ’buyer of last resort’ for global cotton markets. This has now become unsustainable, as global cotton reserves today are enough to make 3 pairs of jeans for every person in the world.
The policy had, however, had some support until recently from the drought which reduced last year’s US cotton crop. Hedge funds were also buyers of cotton futures in the belief that China’s growth story would continue. But neither of these supports is as strong today:
- Barron’s reports that US cotton planting is increasing, whilst there are also expectations of an El Nino weather pattern which would boost rainfall and the size of the cotton crop
- Equally important is that speculative hedge fund players are starting to worry about likely China growth levels in the next few years, as the lending bubble is unwound
In addition, it seems that we are seeing a change take place in China’s own policy. The previous policy had been to buy cotton at double world prices for storage, in order to protect domestic farm incomes. The result had been that China had increased its cotton inventory five-fold over the past 2 years.
Now the government is to subsidise farm incomes directly. This, of course, will encourage more domestic production whilst reducing the need for imports. It will also achieve the government’s main aim of supporting job creation.
But it is not good news for those exporting to China. Its cotton imports were down 36% in January, and this downturn seems likely to continue. So the US may well be producing more cotton at a time when the world’s largest importer is reducing its volumes. It doesn’t take an expert to work out what could happen to prices as a result.
The next few months will therefore be critical, as world markets today are still operating against the background of a tight supply position caused by China’s stockpile and the US drought. The new US crop won’t be ready for delivery until December, and clearly weather or other issues could still intervene.
But importantly, the December futures contract is already trading at a 13% (11.5c/lb) discount to the current month. This implies traders are starting to assume that prices will return to their traditional pre-2009 range, highlighted by the green dotted lines in the chart.
This would be a major development for cotton markets and the global polyester industry. PTA/polyester would face even greater over-capacity problems – unless, of course, crude oil prices also fell to match the lower cotton prices.
This highlights how the unwinding of the failed stimulus policies of the past 5 years will cause major collateral damage, even to those who have continued to behave sensibly.
Whisper it quietly to your friends in the oil business. But oil prices are looking very vulnerable. Producers and the central banks have done a great job in creating the myth of imminent shortages – these have always been ‘just about to happen’ as a result of supply disruptions or the long-promised recovery in global growth.
But whilst the blog tips its hat to them for creativity and persistence, frankly the story is wearing a little thin.
The facts of the matter are that prices have hardly moved since the blog suggested last September that the bulls seemed to be running out of ideas to help keep prices at the $100/bbl level:
- The maximum weekly average price has been no higher than $112/bbl
- $105/bbl has been the minimum weekly average – creating a very narrow trading range
And the fundamental rule of purchasing is that when prices are not rising, they are on the way down. No wonder the normally bullish analysts and traders in the investment banks have gone rather quiet. They will face job cuts rather than bonuses if this calm continues.
Most likely, however, this is the calm before the storm. The market has traced out, as the chart shows, probably the most extended triangle shape of all time. And triangle shapes normally end with a bang, not a whimper. Either the bears give up, and allow prices to rocket higher. Or the reverse happens, and prices collapse.
Copper markets may provide a guide to what may happen next. Nicknamed ‘Dr Copper’ for its ability to act as a leading indicator for the global economy:
- Copper prices trebled from $1.4/lb in December 2008 to peak at $4.50/lb in February 2011
- They then collapsed to $3.60/lb in October before stabilising
- But in recent weeks, they have begun another collapse, falling to $3.0/lb last week
There are many reasons for copper’s fall, and most of them also apply to oil. Players have been happy to build inventory in the belief that prices would always recover. Whilst central banks have maintained the flow of easy money at low interest rates. In the absence of real growth, this money had to go into speculation instead.
Copper prices are now at their lowest levels for 4 years, and its decline has been followed by other metals including aluminium, lead, nickel and zinc.
So oil prices may be about to follow. Certainly it seems one major support for them may be about to disappear. As the blog noted last June, Brent has been a broken benchmark for many years. It trades only 1mb/d, yet sets the price for 2/3rds of the market.
Of course, this has been very convenient for everyone involved. But now the ICE futures exchange is starting to discuss adding more grades to the benchmark. And Vitol CEO Ian Taylor has argued it should include oil from W Africa, Kazakhstan and Algeria, as well as Russia and the US.
The key to the short-term outlook is probably China. The market still expects another stimulus package, and is holding on to its cargoes in hope. But if the new leadership continues with its current policies, then in the absence of major global hostilities, prices probably have only one way to go.
The blog was very pleased to see the Nobel Prize awarded jointly to Robert Shiller, whose words of wisdom on housing and stock markets it has cited many times.
Shiller’s key insight, in his book Irrational Expectations and since, has been to confirm Ben Graham’s famous saying:
“In the short term, the market is a voting machine; in the long term, it is a weighing machine”
Or to use the phrase of JM Keynes, “the market can stay irrational longer than you can remain solvent”.
More recently, of course, staying solvent has become ever-more difficult for investors who focus on the fundamentals of supply and demand. They are out-gunned by the high-frequency traders (HFT), who now dominate trading in most major financial markets. These trade millions of shares in a millisecond, and make their money due to the low interest rates provided by the US Federal Reserve and ultra-low trading costs from the exchanges.
Does this matter? PVM, the world’s largest independent broker in oil markets, commented as follows last month:
How come we have allowed a situation to develop where the tail wags the dog? Data is fed automatically into algorithmic models without any censorship and machines then spit out huge volumes of buy and sell orders. Why is this possible? Because the buy and sell orders feed automatically into an electronic trading venue without any human intervention. Anybody who argues that electronic trading has moderated rather than increased price volatility is smoking dope. What they have done is create easy (but not equal) access and enabled a huge increase in volume. Hallelujah! But be careful not to ask too many questions about the quality of the prices and increased liquidity implied?
The chart above shows HFT’s latest “success”. Last Thursday, the world knew that talks were to take place at the White House on the debt/default issue. But the machines only found out as they scanned the morning news reports. So in 5 minutes, they traded the Dow Jones Index up 1% (143 points). And the size of the green bars shows how they kept prices moving upwards for the rest of the day.
In turn, of course, other markets followed their lead. WTI crude oil jumped 1.1% ($1.11/bbl) as the correlation trade worked its magic. Yet nothing actually happened in terms of supply/demand to justify this move.
A few regulators, such as Andy Haldane at the Bank of England, are pushing for change. But all the time the risks are rising. HFT’s dominance means no single market now knows what it is pricing. Repricing could therefore be quite dramatic, when the fundamentals of supply/demand once again become key to price discovery.