Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.
Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:
“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:
• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily
• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”
In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.
Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:
- One set of worries focuses on potential supply disruption from a war in the Middle East
- The other agonises over the US-China trade war and the rising risk of recession
It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.
The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:
“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”
But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.
Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession. The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.
The reason is that consumers only have a certain amount of discretionary income. If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.
“To govern is to choose” and President Trump therefore has some hard choices ahead:
- His trade war with China currently appeals to many voters, Democrat and Republican. But will that support continue as the costs bite? The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
- Similarly, many voters favour taking a hard line with Iran. But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters
History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent. Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.
Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out. Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.
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.
The myth of oil market rebalancing has been a great money-maker for financial markets. Hedge funds were the first to benefit in H2 last year, as Reuters has reported, when:
“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. In return, the funds delivered an early payoff for OPEC through higher oil prices and a shift from contango to backwardation that should have helped drain excess crude stocks.”
Then the investment banks had their day in the sun, raising $19.8bn in Q1 for private equity players anxious to bet on the idea that prices had stabilised at $50/bbl for US shale oil production. This was 3 times the amount raised in Q1 last year, when the price was recovering from its $27/bbl low.
There was only one flaw in the story – the rebalancing never happened. As the chart shows, OECD inventories are now heading back to their previous record highs, having risen 38.5mb since January’s OPEC deal began. As always, most countries failed to follow through on their commitments – non-OPEC compliance was just 66% in March, and Russia is still producing 50kpd more than its quota this month.
US inventories have also continued to rise, hitting all-time peaks, as the second chart confirms. Stocks would be even higher if US crude oil exports hadn’t surged by 90% versus last year to reach 706bpd this month. This is hardly surprising. Major cost-cutting over the past 3 years means that a company such as ExxonMobil now has an average cash operating cost of less than $10/bbl.
US producers have been laughing all the way to the bank, as the third chart confirms, showing the recovery in the US drilling rig count. Not only have they been able to hedge their output into 2019 at today’s artificially high prices. But they have also been able to ramp up their use of modern, highly efficient horizontal rigs. These now dominate drilling activity, and are a record 84% of the total in use – reversing the ratio seen before shale arrived.
It doesn’t take a rocket scientist to work out what will likely happen next:
US production and exports will keep rising as all the new rigs are put to work – there are already 5500 drilled but uncompleted wells waiting to come onstream. Meanwhile, US demand will likely hit a seasonal peak – Memorial Day on 29 May usually marks the moment when refiners finish building inventory ahead of the US driving season
China’s slowing economy will not provide much support. It became a net exporter of fuel products in Q4 last year and February data showed net gasoline exports at 1.05 million tonnes, as they jumped 77% versus 2016. Diesel exports were also up 67% as refiners followed the US in trying to reduce their domestic supply glut
India’s domestic demand is still suffering from the after-effects of the demonetisation programme. It was down 4.5% in January, and was still down 0.6% in March versus a year ago. Japan’s demand is also down, with the government expecting it to fall 1.5%/year through 2022 due to the combined impact of its ageing population and increasing fuel efficiency. S Korean demand is also expected to continue falling for similar reasons
OPEC may well extend its quotas for another 6 months, but this will just give more support to US shale producers. And within OPEC, Iraq plans to boost output to 5mbd by year-end, versus 4.57mbd in February, whilst Libya aims to double its March output of 622kbd, and Iran has already increased its exports to 3mbd for the first time since 1979
Unless geopolitical events intervene, it is therefore hard to see how the myth that the oil market is now rebalancing can be sustained for much longer.
OPEC has a long wait ahead, if it hopes that US drivers will ever go back to SuperCycle levels of driving and gasoline consumption growth. That’s the clear message from new data from the US Dept of Transport showing vehicle miles traveled last year. The chart shows:
□ Average number of miles driven per adult American since 1970 (using over-16 as the normal legal driving age)
□ Average US gasoline price in $/gallon, adjusted for inflation
□ The annual mileage driven rose every year between 1970 – 2004, unless prices increased due to oil price moves
□ Annual mileage is now 6% less than in 2004, even though prices were actually cheaper in 2016 than in 2004
At the same time, US cars have also become more fuel efficient thanks to EPA regulations. Miles/gallon has increased by 28% since 2004 in terms of each model year, even though there has recently been a boom in larger, less fuel-efficient, Sports Utility Vehicle sales. Thus although US gasoline demand hit a new record volume of 9.2mb/day in 2016, the combination of increasing fuel efficiency as older cars are scrapped, plus the continuing decline in miles/driven per adult, suggestes that the best days of the market are behind it.
In addition, of course, major changes are now underway in the US market for mobility. Whilst some people obviously like cars and want to own them, most purchases are because people need to be mobile. In the past, cars were often the only option as US public transport options were relatively limited, particularly for Boomers who had chosen to escape the inner cities and move out to the suburbs. They often needed more than one car to transport the family.
Today, however, the Boomers are driving less as they move into retirement, and are moving back to the cities, whilst the Millennials have much less interest in moving to the suburbs. Both Boomers and Millennials also have other options, such as social media, for meeting up with friends. As a PRIG study has noted, the number of households:
□ ”Without cars increased in 84 out of the 100 largest urbanized areas from 2006 to 2011
□ With two cars or more cars decreased in 86 out of the 100 of these areas during that period”
So market conditions are far more favourable for new business models. Nobody yet knows if car-sharing, or Uber and Lyft type services, or autonomous cars, will prove successful. Nor do we know if the electric cars being developed by GM, Ford, Chevrolet, Tesla and others will prove successful. But what we do know is that gasoline consumption has almost certainly peaked in the US. As the President of GM, Dan Ammam, suggested last year:
“We think there’s going to be more change in the world of mobility in the next five years than there has been in the last 50 years”.
It is also hard to disregard the argument of Ford’s chairman, Bill Ford, who argued in his 2011 TED talk that current driving habits would inevitably lead to gridlock, as:
“The average American spends about a week a year stuck in traffic jams, and that’s a huge waste of time and resources….
OPEC might have felt able to ignore Ford’s commentary back in 2011. But today, the growth of car-sharing, Uber and Lyft, electric cars and autonomous vehicles suggests it would be unwise for it to ignore the major changes underway in the world’s largest single market for gasoline.
How much of your day’s wage does it cost you to buy a US gallon of gasoline? This chart from Bloomberg shows the answer for 61 countries, based on prices for 95 octane grade at the end of Q2:
Bankrupt Venezuela is most affordable at 1% of a day’s income (based on GDP/capita)
Kuwait (1%), and the USA, Luxembourg and Saudi Arabia at 2%, are the other most affordable Top 5 countries
In the rest of the G7 countries, Canada is 9th at 3%; Japan is 14th at 4%; whilst Germany (17th), the UK (22nd) and France (23rd) are at 5%; and Italy at 7.5% is 29th
In the BRICs, Russia is 33rd at 9%; Brazil is 49th at 16%; China 50th at 17%; and India 61st at 80% (not a typo)
These are fascinating results as they explain why today’s lower oil prices have not led to a major increase in gasoline consumption. Instead, they confirm that demand patterns in today’s New Normal world are driven by Affordability, not absolute price.
Affordability, of course, depends on more than just the absolute price. Helpfully, Bloomberg also sort the data in terms of average annual gasoline cost (based on the amount of gasoline used per year in 2013, as a percentage of salary), as shown in the second chart:
Venezuela is still most affordable at 0.3%, even though the average driver uses 120 gals/year
China. Hong Kong, Turkey and Belgium make up the Top 5 at 0.5% of average annual salary – using 10 gals, 28 gals, 9 gals and 38 gals respectively
In the G7, France is 6th at 0.5% using 36 gals; Italy (18th), Germany (19th) and the UK (22nd) are all at 1% using 48 gals, 79 gals and 74 gals respectively; Japan is 34th at 1.3% using 114 gals; USA is 47th at 1.9% using 420 gals; and Canada is 58th at 2.7% using 327 gals
In the other BRIC countries, Brazil is 56th at 2.5% using 54 gals; Russia is 52nd at 2% using 88 gals and India is 20th at 1% using 5 gals
2 key conclusions can be drawn from this data.
The first is that analyses suggesting that Country A has enormous potential to double gasoline consumption by comparison with Country B are missing the point. If the cost of a gallon of gasoline in India is 80% of the average daily wage, it is no surprise that the average Indian only uses 5 gallons/year. Unless wages rise dramatically – which would require major policy changes over decades – the country is going to remain near the bottom of the table.
Secondly, one also needs to look at the relative affordability of gasoline in terms of annual spend. As President Obama noted in April:
“The reality for the average American family is that its household income is $4,000 less than it was when Bill Clinton left office.”
Essentially, therefore, the average American is already having to prioritise their discretionary spending. And so whilst they might, or might not, like to drive more miles – the decision to do this won’t just be based on the cost of gasoline, even if the incremental cost of a single gallon is only 2% of daily income.
The gasoline data thus confirms that companies cannot rely on economic growth to drive revenue and profit growth, now that the Boomer-led SuperCycle has ended. The Winners in this New Normal world will be those who can best meet people’s basic needs – for food, water, shelter, health and mobility – in the most sustainable way.
In turn, this suggests that companies need to adopt new service-led business models. These models will no longer simply be based on the value of the product, but will also include the global value provided by the product.
Famously, when Bill Clinton ran his successful presidential campaign in 1992, his advisers would remind him of the key message with just one phrase “Its the economy, stupid!”. Today’s policymakers would do well to maintain a similar focus on the oil price, if they want to understand today’s lack of demand.
Somehow, everyone seems to have forgotten that oil prices over $50/bbl have always led to recession in the past. Similarly, they are now 5% of global GDP, compared to a normal level of half this. So it is hardly surprising that hard-pressed consumers cannot afford much discretionary spend. They have no spare cash after paying to heat their homes, and fuel their cars.
This would be bad enough on its own. But prices in two major markets – Europe and China – are actually at all-time record highs. So it is hardly surprising that domestic demand in both areas is particularly slow. As the charts show (Europe left, China right):
• Brent oil prices are now €87/bbl in Europe, due to the weakness of the euro. This is above the peak level of 2008 (€86/bbl), when oil hit a record $144/bbl
• China’s prices are also at records. The government capped them in 2008, to avoid social unrest during the Olympics. Today, gasoline is at Rmb 9630/t and diesel at Rmb 8810/t, compared to June 2008’s peaks of Rmb 6980/t and RMB 6520/t
China’s gasoline price for 90 RON is thus $4.60/US gal ($1.20/litre), compared to current US prices of $3.75/gal. European prices are even higher at $8.00-$9.00/US gal.
Wages have not gone up to reflect today’s record prices. And unemployment is considerably higher in most countries than back in 2008. So it is hardly surprising that ordinary people are cutting back on everything but real essentials.
Every policymaker should have a version of Bill Clinton’s slogan hung in their office, to remind them of the crushing burden this imposes on the economy. “Its the oil price, stupid!”.