“Those who cannot remember the past are condemned to repeat it“. George Santayana
9 months ago, it must have seemed such a good idea. Ed Morse of Citi and other oil market analysts were calling the hedge funds with a sure-fire winning strategy, as the Wall Street Journal reported in May:
“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.
“Group officials made the case for how supply cuts from the Organization of the Petroleum Exporting Countries would reduce the global glut…. Mr. Morse of Citigroup said he arranged introductions between OPEC Secretary-General Mohammad Barkindo and the more than 100 hedge-fund managers and other oil buyers who have met with Mr. Barkindo in Washington, D.C., New York and London since October…
“After asking what OPEC planned to do to boost prices, fund managers came away impressed, Mr. Morse said, adding that some still text with the OPEC leader.”
Today, however, hype is disappearing and the reality of today’s over-supplied oil market is becoming ever more obvious. As the International Energy Agency warned in its latest report:
“In April, total OECD stocks increased by more than the seasonal norm. For the year-to-date, they have actually grown by 360 kb/d…”Whatever it takes” might be the (OPEC) mantra, but the current form of “whatever” is not having as quick an impact as expected.”
As a result, the funds are counting their losses and starting to withdraw from the market they have mis-read so badly:
Pierre Andurand of Andurand Capital reportedly made a series of bullish bets after meeting a Saudi OPEC official in November, but saw his fund down 16% by May 5
Once nicknamed “God” for his supposed ability to forecast the oil market, Andy Hall’s $2bn Astenbeck Capital fund lost 17% through April on bullish oil market bets
In a sign of the times, Hall has told his investors that he expects “high levels of inventories” to persist into next year. Consensus forecasts in April/May that prices would rally $10/bbl to $60/bbl have long been forgotten.
OIL MARKET FUNDAMENTALS ARE STARTING TO MATTER AGAIN
This therefore has the potential to be a big moment in the oil markets and, by extension, in the global economy.
It may well be that supply/demand fundamentals are finally starting to matter again. If so, this will be the final Act of a drama that began around a year ago, when the young and inexperienced Mohammed bin Salman became deputy Crown Prince and then Crown Prince in Saudi Arabia:
He abandoned veteran Oil Minister Naimi’s market-share strategy and aimed for a $50/bbl floor price for oil
This gave US shale producers a “second chance” to drill with guaranteed profits, and they took it with both hands
Since then, the number of US drilling rigs has more than doubled from 316 in May 2016 to 763 last week
Even more importantly, the introduction of deep-water horizontal drilling techniques means rig productivity in key fields such as the vast Permian basin has trebled over the past 3 years from 200bbls/day to 600 bbls/day
The chart above shows what the hedge funds missed in their rush to jump on the OPEC $50/bbl price floor bandwagon.
They only focused on the weekly inventory report produced by the US Energy Information Agency (EIA). They forgot to look at the EIA’s other major report, showing US oil and product exports:
US inventories have indeed remained stable so far this year as the blue shaded area confirms
But US oil and product exports have continued to soar – adding nearly 1mb/day to 2016′s 4.6mb/day average
This means that each week, an extra 6.6mbbls have been moving into export markets to compete with OPEC output
Without these exports, US inventories would have risen by another 13%, as the green shaded area highlights
In addition, the number of drilled but uncompleted wells – ready to produce – has risen by 10% since December
These exports and new wells are even more damaging to the OPEC/Russia pricing strategy than the inventory build:
Half-way across the world, India’s top refiner is planning to follow China and Japan in buying US oil
US refiners are ramping up gasoline/diesel exports, with Valero planning 1mb of storage in Mexico
As Naimi warned 2 years ago, Saudi risked being marginalised if it continued to cut production to support prices:
“Saudi Arabia cut output in the 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.”
How low oil prices will go as the market now rebalances is anyone’s guess.
But they remain in a very bearish pattern of “lower lows and lower highs”. This suggests it will not be long before they go below last year’s $27/bbl price for Brent and $26/bbl for WTI.
Oil markets are the proverbial “canary in the coalmine”. They are showing us what happens when the rose-tinted glasses provided by stimulus policy are removed. Now markets have to return to their true role of price discovery, based on the fundamentals of supply and demand.
This makes them very dangerous indeed. Some large players in the energy markets will go bankrupt as a result, as happened with Enron in the dotcom bubble and GM in subprime. Some of their trading partners will also go bankrupt. Many companies have no contingency plans – they never realised this could, and would, happen one day.
One problem is that fundamental analysis requires investors to think about the reality behind the headlines – rather than just repeat them:
- Many seriously paid attention when Venezuela and Ecuador called for an OPEC meeting, not realising these countries are increasingly irrelevant within the group. Why would the Gulf Co-operation Council (GCC) countries, who are the keys to OPEC policy, take any notice of their views?
- Similarly, why does anyone waste their money buying oil with the idea that Russia is likely to cutback production and work together with the GCC? Have they not noticed, for example, that Russia and the Saudis are on opposite sides in Syria, or that Russia is a long-time ally of Iran?
- Equally puzzling is the idea that Iranian calls for production cutbacks are a serious policy statement. Iran’s priority is to recover its historic market share as quickly as possible – of course, this would be made easier if others cut back, but why would anyone do this?
So all credit to the International Energy Agency for trying to help investors go up the learning curve as fast as possible in their new Monthly Report. As they note:
“Persistent speculation about a deal between OPEC and leading non-OPEC producers to cut output appears to be just that: speculation. It is OPEC’s business whether or not it makes output cuts either alone or in concert with other producers but the likelihood of coordinated cuts is very low. This removes one driver of bullishness
“Another widely-held view is that OPEC production, other than Iran, will not grow as strongly in 2016 as it did in 2015. Although it is still early in the year, Iraqi output in January reached a new record and it is possible that more increases could follow. Iran has ramped up production in preparation for its emergence from nuclear sanctions and preliminary data suggests that Saudi Arabia’s shipments have increased. Thus, another driver might be removed.
“Another driver of bullishness is that oil demand growth will receive a boost from the collapse in oil prices to below $30/bbl. We retain our view that global oil demand growth will ease back considerably in 2016 to 1.2 mb/d – at 1.2% still a very respectable rate – but our analysis so far sees no evidence of a need to revise it upwards. Estimates by the International Monetary Fund that global GDP growth in 2016 will be 3.4% followed by 3.6% in 2017 is heavily caveated with risks to growth in Brazil, Russia and of course slower growth in China. Economic headwinds suggest that any change will likely be downwards.”
These comments are from the world’s leading energy watchdog. They could hardly be more direct. And their conclusion is equally blunt:
“On the assumption – perhaps optimistic – that OPEC crude production is flat at 32.7 mb/d in Q116 there is an implied stock build of 2 mb/d followed by a 1.5 mb/d build in Q216. Supply and demand data for the second half of the year suggests more stock building, this time by 0.3 mb/d. If these numbers prove to be accurate, and with the market already awash in oil, it is very hard to see how oil prices can rise significantly in the short term. In these conditions the short term risk to the downside has increased”.
They describe the market as being “awash with oil” and they do not exaggerate. The chart above shows record US inventories for oil and petroleum products – these have just reached 500 million barrels for the first time in history- an astonishing 50% more than the 1982-2008 average. And Q1 is a seasonally strong period for demand.
All eyes are, of course, on Iran and its return to Western markets. But US producers are equally desperate to sell. How else can they hope to bring inventories down to normal levels again? And at the moment, they are paying to store a product whose price is falling day-by-day, which must upset a lot of CFOs. Plus, of course, the banks are pushing for companies to reduce their debts as quickly as possible.
Companies who intend to be Winners will already be making plans to ensure their survival – whatever 2016 may bring. And they will also be planning to take advantage of the Opportunities that are now available, as we describe in our new 5 Critical Questions Study. This will be published very soon, and I would be delighted if you wanted to subscribe.
OECD oil inventories have never been higher. They were 2.9mb at the end of July, and are expected to have risen further since then, according to energy watchdog the International Energy Agency:
- In terms of days of forward cover, they are now at 63 days in the OECD overall
- They are at 68 days in Europe and well above normal in Asia and the US
- China has also been filling its strategic reserve at the rate of 380kb/d all year
And of course, it will not be long before Iran returns to world markets as sanctions are eased. Iran expects to increase its volume by 1.5mb/d by the end of 2016.
Yet media headlines continue to focus on the “noise” around around markets, rather than the bigger picture. This is great for traders, who know they have at least 3 trading opportunities a week to move prices up or down – the weekly US inventory data from the American Petroleum Institute on Tuesday, and from the Energy Information Administration on Wednesday, plus the drilling rig report on Friday.
But it is really irrelevant for everyone else. The inventories are so large that they simply cannot be reduced to normal level within weeks, or even months. And it therefore can’t possibly matter if US production growth is estimated to have risen 100kb/day, or reduced 200kb/d. For a start, these are just estimates – not final figures. And even if they were accurate, the impact on the global market is too small to be noticed.
The problem is that a decade of central bank stimulus means a whole generation of analysts have never had to worry about understanding supply/demand balances. Instead they have made enormous sums of money by using the ‘buy-on-the-dips’ model in oil markets as in other financial markets. In this looking-glass world, bad news is always good news, as it means central banks will keep interest rates low and print more money to invest in oil futures markets.
Nobody can be sure this won’t happen again. This is why we have a $100/bbl oil price Scenario in our Study with ICIS, How to survive and prosper in today’s chaotic petrochemical markets: 5 Critical Questions every company and investor needs to answer. It would be naive not to believe this could happen again, especially as the latest jobless data suggests the recent US recovery is weakening once more.
A Scenario based on a continuation of the $50/bbl price level is clearly also possible – we have, after all, seen prices stay around this level for most of 2015. But my own view is that the current market is fundamentally unstable, due to today’s record inventory levels. It only needs a few people to start selling – perhaps because they need the cash for something else, and prices could quickly spiral downwards to $25/bbl. And this Scenario although seemingly impossible to many, is where prices have been for most of history.
US supply growth may now be plateauing after a period of very rapid growth – US output was up 1.7mb/day last year, for example. But Russian output is at post-Soviet Union peaks, with its revenues supported by the collapse of the rouble, whilst Saudi continues to pump at high levels. And at the same time, demand growth is clearly weakening.
Emerging markets have been responsible for most of the world’s economic growth since 2008 – but they are now seeing major cash outflows – the worst since the 2008 Crisis. And China’s New Normal direction for its economy is sending commodity exporting countries into recession.
It seems wishful thinking to imagine these developments will quickly reverse.
The latest EU olefin operating rates (OR%) were very disappointing, even though they were not a surprise. As the chart shows, ethylene rates were just 81% (based on APPE data). They were far below the 90%+ rates that were normal before the crisis began.
These rates would normally have left the industry in crisis mode as regards profitability. But they were “rescued” by the parallel collapse in refinery runs, and the shortage of propylene/butadiene caused by the major shift to ethane feeds in the USA.
The second chart, from the International Energy Agency, highlights the truly startling change in German refinery runs since the financial crisis. Germany is the EU’s largest and most prosperous country. Its refinery runs hardly ever fell below 2.1mbd before 2008. Since then, they have never reached this level, and were just 1.8mbd in February.
This average 18% fall in refinery runs gave major support to effective olefin OR%, as almost all EU crackers are based on refineries – either for naphtha or LPG. The high co-product values for propylene/butadiene were also critical in enabling the industry to deliver strong profitability.
Over the past 18 months, the main investment analysts have argued that high oil prices would have no impact on the global economy. Now, new forecasts suggest their optimism has been misplaced.
The chart above gives the International Energy Agency’s latest forecast of likely oil demand growth this year:
• It has been reduced by a further 0.3mbd since January
• Total 2012 oil demand growth is forecast to be just 0.8mbd
• Global economic growth is now forecast at just 3.3%, down from 4%
Sustained high oil prices are indeed reducing economic growth, and oil demand itself, just as they have done every time in the past.
Even the idea that China would “inevitably” see strong demand growth has proved wishful thinking. The IEA forecasts just a 0.4mbd increase in China’s oil demand this year. And even that may turn out to be over-optimistic, given the clear slowdown now underway.
As the blog has long feared, the chemical industry will now have to pick up the pieces, after the damage has been done:
• Today’s oil and feedstock price levels mean that working capital costs are very high compared to historical levels. This reduces the cash available for product and market development.
• They also increase market volatility. The lack of inventory means small changes in demand can cause major swings in market prices, if producers or consumers have to cover supply chain problems.
• Even more critically, as we are seeing with the Petroplus refinery bankruptcy, there is a real risk of supply disruptions for feedstocks and raw materials, if key plants can no longer afford to operate.
Product price changes since the 29 April peak, with ICIS pricing comments, are below:
HDPE USA export (purple), down 14%. “US spot export prices are still too high for large quantities to be sold in many markets”
PTA China (red), down 10%. “Buying activity slowed down clearly as compared with last week because the persistently weak downstream polyester sales curtailed buying interest”
Naphtha Europe (brown dash), down 7%. The Petroplus bankruptcy led traders to build inventory in anticipation of “stronger demand from both the gasoline blending sector and petrochemical end-users”
Brent crude oil (blue dash), down 6%
Benzene NWE (green), down 4%. “Price ideas edged up in line with stronger US and Asia numbers as well as steady-to-firm energy costs”
S&P 500 Index (pink dot), down 2%
The blog’s argument that there is no shortage of crude oil seems finally to be going mainstream.
Equally, its concern over the impact of today’s high prices, especially by comparison with natural gas, is also now starting to be highlighted.
Thus the Wall Street Journal notes:
“Oil inventories in the Western world are now high.
“U.S. net imports of oil have dropped on weaker demand and surging domestic production. So even though stocks have remained relatively flat since early 2009, the number of days of import cover has jumped. As of October, inventories covered 224 days of net imports, the highest level since early 1995.
“In Europe, at the sharper end of the (potential Iran) embargo, International Energy Agency data show a less benign, but hardly alarming picture. On a 12-month rolling average to take account of seasonal swings, stocks covered roughly 140 days of net imports in October. That is 10 days less than in mid 2010, but in-line with the average of the past five years.”Meanwhile the New York Times reports:
“Nationwide, the average household using oil spent $2,298 on heat last year, compared with $724 spent by gas users and $957 spent by electricity users, according to the Energy Department. This year, heating oil users are expected to spend 3.7% more than last year, while natural gas customers are expected to spend 7.3% less and electricity users will spend 2.4% less.”