Once upon a time, oil markets were based on facts. Producers and consumers focused on trying to understand what “would” happen”, whilst the speculators placed their bets on what “could” happen.
In those days – even 20 years ago, as the chart shows – the role of the speculators on the futures markets was very small. They were often wealthy individuals who liked gambling against the professionals. And since the professionals tended to “group-think”, a contrarian view could sometimes provide big profits at the industry’s expense.
Today, however, the world has turned around 180 degrees. Free money from the central banks has destroyed markets’ role of price discovery. Instead, speculation rules and the fundamentals of supply/demand no longer seem to matter on a day-to-day basis:
So far this year, trading in just the WTI futures contract has averaged nearly 10x physical volume
And these aren’t individuals betting their own money as a hobby
The main volume is from hedge funds with deep pockets – who aim to earn their bonus at the end of the year
The difference in approach can be seen with reference to the above chart from the International Energy Agency. It shows the truly dramatic increase in OECD inventories over the past 2 years – at a time when the IEA calculate that OPEC oil production has been steadily climbing to reach “an all-time high” of 33.6mbd.
High inventories and record OPEC production levels would not have been a recipe for price rises in the past, especially when the IEA add that:
“The lower price environment has also forced companies big and small to cut costs and do more with less. As a result, non-OPEC supply is expected to return to growth next year.”
But this is not the world in which we are living today. The hedge funds have free cash from the central banks, and it is getting close to bonus time at year-end. So they need a “story” that will create enough volatility for them to make a profit. And as the 3rd chart shows (of speculative purchases on the futures market), they have found one in the idea that OPEC and Russia will agree a deal to bring the oil market back into balance:
In just 2 weeks, they have bought 100 million barrels of oil (a contract is 1000 bbls) – more than daily production
They have also been busy buying gasoline, even though we are now well beyond the end of the US driving season
The result has been that oil prices have jumped by $6/bbl – despite OECD inventories and OPEC production being at record highs
The issue is that the hedge funds are operating in a parallel universe where financial flows, not product flows, rule.
They don’t care whether the oil market is long or short, or whether there is really any chance of OPEC agreeing substantial output cuts. Nor do they have any interest in speculating whether OPEC and Russia might agree a deal. That is not their business, and not how they make money.
They are paid simply to take free cash from the US Federal Reserve, and to invest it where they can make the most money, as quickly as possible. In terms of the oil market, they are therefore part of the “post-fact economy”, where the details of supply and demand, and inventories, simply don’t matter. If they can make $6/bbl in 2 weeks on borrowed money, why should they care?
Whether the rest of us should care is another issue.
The answer depends on whether one worries about what might happen when the hedge funds decide the party is over, and move on to a new hunting ground:
In the past, policymakers would certainly have cared. As former Fed Chairman, William McChesney Martin, used to argue, the Fed’s job was ”to take away the punch bowl just as the party gets going”
But they too, now live in the “post-fact economy”, and believe “the world is different this time” because they are able to print electronic money
Oil markets are therefore living in the world of the South Sea Bubble, the Dutch Tulip Mania and the Mississippi Company, where speculation is allowed to rule. These rallies are fun whilst they last for those riding the wave, but you don’t want to be on the wrong side when the party ends.
“Within 20 years, we will be an economy or state that doesn’t depend mainly on oil“.
This critical statement from Saudi Arabia’s deputy Crown Prince has been lost in the hype surrounding Q1′s hedge fund-inspired rally in oil, commodities and Emerging Markets. There has seldom been a better example of markets failing to see the bigger picture by remaining focused on day-to-day detail.
But Q2 is likely to see attention return to the fundamentals of oil market supply and demand. This week’s commodities market data showed the hedge funds were already starting to take their bets off the table. This is hardly surprising, with prices having jumped 50% in a matter of weeks:
- Iran is successfully re-entering the market, with its exports to India already up 4-fold since January to 500kbbl/day, and other Asian countries also keen to buy
- US storage operators are resorting to ever-more desperate manoeuvres to stop their tanks from over-flowing
As I warned last month, the rally had nothing to do with a rebalancing of oil markets – either via major cuts in production, or a sudden increase in demand. Instead, it was all about the funds betting, correctly, that further stimulus was on the way from the central banks. As the Financial Times noted:
- By the end of March, the funds had built a record long position of 579m bbls in Brent/WTI
- This was equivalent to almost 6 days of global demand
But last week, they began to take their profits and close their positions. Chemical markets thus face major challenges:
- Prices for the major petrochemicals are highly correlated to crude oil prices – most are more than 95% correlated
- So sales managers are already busy raising their prices to try and maintain their margins
- Purchasing managers are meanwhile building inventory to protect their own margins
And they are not alone. The Q1 rally spread across the commodity sector, and led to major bond and share price rises for commodity exporters and Emerging Markets. But none of the move was real. It was simply the hedge funds spotting a short-term opportunity for profit, based on the realisation that another central bank panic was on the way.
So now, as one would expect, the smart funds are not hanging round to see what happens next. Of course, US oil inventories will reduce as we head into the main driving season. But fundamentals didn’t drive the rally, and the funds know all-too-well that sudden rallies can disappear as quickly as they appeared.
Attention is thus likely to turn to last week’s 5 hour Bloomberg interview with the deputy Crown Prince of Saudi Arabia. It confirmed, as I have argued for the past 18 months, that Saudi is focused on making plans for the post-oil world and highlighted, for example:
“His obsession with moving the Saudi economy away from oil…Aramco’s new strategy will transform it from an oil and gas company to an energy/industrial company”.
Companies and investors have to follow market trends, as they cannot afford to be on the wrong side of 50% rallies. But they also have to recognise that the biggest rallies always occur in bear markets. Oil’s next move may well be another 50% decline, and as I warned last month:
” If prices collapse again as the hedge funds take their profits, companies will face the risk of bankruptcy as we head into Q3. They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory”.
Financial players have become convinced in recent months that the oil price will rise. And so far, this has been a self-fulfilling prophecy. Their buying has led to oil being stored all over the world – in tankers floating at sea and in shale oil wells, as well as in storage tanks.
Unsurprisingly, prices have rallied as all this product was being taken off the market. But whilst it easy to buy oil in an over-supplied market, the buyers now face the more difficult task of trying to resell it at a profit as we move into the seasonally weaker months of Q3.
The chart above from the Wall Street Journal shows how the volume of oil in floating storage more than trebled between January – May, and is still more than twice the earlier level. The volume comes from traders taking advantage of the difference between current and future prices (the contango) to buy today and sell to hedge funds and other financial buyers at a guaranteed profit in the future.
But Iran has also been storing oil on ships, to release on world markets if sanctions are lifted following a deal on the nuclear issue, perhaps in the next few weeks
In addition, of course, there is the record volume of oil inventory in the US, as I discussed last week. Plus US shale producers have drilled 3000 wells in preparation to pump up to 1.3mbbls/day of oil once prices have moved higher.
And in Europe, as the second WSJ chart shows, oil storage has hit a record level of 61mbbls.
And finally, recent months have seen strong buying by China to fill its strategic petroleum reserve. It had decided to raise the reserve to 100 days of normal demand. But as a Sinopec executive told Reuters back in March this programme will soon be complete.
It clearly makes no sense for prices to rise on such artificial/temporary types of demand, when the International Energy Agency suggests surplus production is currently running at 2mb/day.
The problem is the record amounts of money that have gone into commodity hedge funds. This has fallen slightly from the $80bn peak seen in 2013, but still stands at $69bn today. And, of course, $69bn buys a lot more oil today than it did when prices were at $100/bbl in 2013.
These mounting surpluses are making life more and more difficult for producers in Europe and W Africa. As I noted last year, Nigeria has lost its entire export market to the US, worth 1.3mb/day, and is instead having to send its oil all the way to Asia. Now N Sea producers are facing the same problem, with tankers carrying the equivalent of a week’s consumption by the UK now heading to Asia instead.
Of course, as the saying goes, “money talks”. So as long as financial players keep buying in financial markets, oil supplies will keep increasing. But unused oil can’t keep being held in storage forever. Eventually the fundamentals of supply/demand balances will cause prices to fall back to historical levels of $30/bbl or lower.
We cannot know what might be the catalyst for this development. Perhaps it will be a panic over Greece, or an Iranian agreement, or something else entirely. But barring geopolitical upset, it is not a question of “if”, but of “when”.
In recent years, financial markets have believed that “everything is for the best in this best of all possible worlds“. Good news has taken markets higher. So has bad news – as investors assume policymakers will apply more stimulus.
As a result, a whole generation of managers and analysts has grown up without having to learn the fundamentals of supply/demand analysis. And many of those in the older generation have gone bankrupt, as a result of failing to understand that central bank liquidity has destroyed markets’ prime role of price discovery.
But now the Great Unwinding of these central bank policies is underway. And last week’s developments in oil markets provided a classic example of the bumpy ride now ahead, as investors adjust to the world of the New Normal.
1. Saudi reaffirmed its market share policy. Last weekend saw a clear statement by Saudi Arabia’s Oil Minister, Ali al-Naimi, that the Kingdom did not intend to cut production to support oil prices. Announcing that production had increased to around 10mb/d, Naimi added:
“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.”
2. China has run out of oil storage. On Wednesday morning, Sinopec told Reuters that:
“China’s commercial and strategic oil storage is almost full, leaving little room for Asia’s top oil consumer to keep up its soaring import growth and adding downward pressure to an already oversupplied market. China’s purchases to fill its strategic petroleum reserves was one of the main drivers of Asian demand since August of last year, with the nation’s importers buying cheap crude to fill oil tanks despite slowing economic growth. But with storage capacities approaching their limits, China’s crude imports will likely stay flat or rise only slightly this year.
3. US oil inventories at new record high. On Wednesday afternoon, Reuters also reported that:
“U.S. crude inventories soared last week to extend their record build into the eleventh consecutive week. Crude inventories rose 8.2 million barrels to 466.7 million last week, another 80-year high record, compared with analysts’ expectations for an increase of 5.1 million barrels.”
Yet on Thursday, as the chart shows, Brent prices suddenly soared by $4/bbl as Saudi launched air strikes into the Yemen. Excited analysts rushed to suggest this created a “geo-strategic premium” for prices and could mean the end of Middle East oil shipments. This reaction highlighted the consensus view that prices will always trend higher.
Interestingly, however, Friday’s trading saw prices fall back to their starting point.
The move thus confirms my fear that the world has a very bumpy ride ahead. Until very recently, as the above chart shows, hedge funds have also consistently assumed that oil prices will always rise (red line). This positioning has continued since 2006, even during the collapse of H2 2008.
US oil producers have taken the same view, with the Wall Street Journal suggesting many are effectively storing oil today by drilling thousands of wells in anticipation of higher prices, but not yet pumping from them.
The hedge fund logic has been simple, that it makes sense to ‘buy on the dips’. But more recently, however, there are signs their thinking is finally changing. More hedge funds are now negative on prices than ever before (green shading). Last Thursday’s abortive rally may well cause more to rethink their positions in the future.
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 52%. “Sources are wary of crude oil pricing going forward, with building stocks in both Asia and the US likely to spark a sell-off in the coming weeks, according to some analysts. Any major shifts on crude oil would potentially have a massive impact on benzene pricing.”
Brent crude oil, down 46%
Naphtha Europe, down 39%. “Summer gasoline blending plus Asian and European petrochemical demand combined with spring refinery maintenance work have tightened prompt supply.”
PTA China, down 40%. “Excess PTA inventories in the key China markets continued to dampen market sentiment, with inventory levels likely to continue to build up in the near term.”
HDPE US export, down 23%. “US export prices remained unchanged this week”
¥:$, down 16%
S&P 500 stock market index, up 5%
Warren Buffett is the world’s most successful investor, earning $62bn from his investments by 2009. But if he had instead channelled this money through hedge funds, and still been equally successful, he would have ended up with just $5bn. They would have taken the other $57bn.
Hedge funds have thus been the most successful way in recent years of parting investors from their cash. The concept was that they would earn their vast fees (normally 2%/year and 20% of gains) by making money in up and down markets.
This, of course, was an easy game to play when the Western BabyBoomers (those born between 1946-70) were all in their peak consumption and savings years. Markets boomed then, as described in chapter 2 of the new ‘Boom, Gloom and the New Normal’ free eBook.
But as the chart above shows, life has been more difficult over the past decade. It comes from the GMO investment fund, and looks at the relative performance since 1996 of three types of portfolio:
• Those holding very volatile stocks, “high beta” (yellow line)
• Those holder ‘safer’, less volatile stocks, “low beta” (blue)
• Those holding the entire universe of stocks (red)
Unsurprisingly, the high beta stocks held by many hedge funds did very well until 2000, when the Boomers began to leave the peak consumption 25-54 age group. Since then, they have underperformed quite badly. Overall, they have earned just 3.8% annually since 1996 – much less than the steady 6.8% of the low beta stocks.
Or, as GMO put it, “remarkably, an asset class that purports to be an ‘alternative’ source of returns, with low correlation to equity markets, turns out to be simply another way to take downside equity market risk….once fees are taken into account, hedge funds appear to offer nothing beyond a way to sell insurance against sharp market declines“.
Blog readers whose pension funds invest in hedge funds may have cause to remember this conclusion when they examine their next statement.