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.
Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same. Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.
The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story. So the chart above instead combines 5 “shock, horror” stories, showing quarterly oil production since 2015:
- Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015. OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
- Russia has also been much in the news since joining the OPEC output agreement in November 2016. But in reality, it has done little. Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
- Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
- Venezuela is an OPEC member, but its production decline began long before the OPEC deal. The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
- The USA, along with Iran, has been the big winner over the past 2 years. Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!
But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April. Not much “shock, horror” there over a 3 year period. More a New Normal story of “Winners and Losers”.
So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday? Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble. The answer lies in the second chart from John Kemp at Reuters:
- It shows combined speculative purchases in futures markets by hedge funds since 2013
- These hit a low of around 200mbbls in January 2016 (2 days supply)
- They then more than trebled to around 700mbbls by December 2016 (7 days supply)
- After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)
Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently: “Several of them had little or no experience or even a basic understanding of how the physical market works.”
This critical point is confirmed by Citi analyst Ed Morse: “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.”
Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:
“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).
OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION
The hedge funds have been the real winners from all the “shock, horror” stories. These created the essential changes in “crowd behaviour”, from which they could profit. But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:
- Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
- This level has been linked with a US recession on almost every occasion since 1970
- The only exception was post-2009 when China and the Western central banks ramped up stimulus
- The stimulus simply created a debt-financed bubble
The reason is simple. People only have so much cash to spend. If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy. Chemical markets are already confirming that demand destruction is taking place.:
- Companies have completely failed to pass through today’s high energy costs. For example:
- European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
- They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)
Even worse news may be around the corner. Last week saw President Trump decide to withdraw from the Iran deal. His daughter also opened the new US embassy to Jerusalem. Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.
As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities. Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz. It is just 21 miles wide (34km) at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.
As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”. Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets. We must all learn to form our own judgments about the real risks that might lie ahead.
Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.
The post Oil prices flag recession risk as Iranian geopolitical tensions rise appeared first on Chemicals & The Economy.
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.
”Sometimes I’ve believed as many as six impossible things before breakfast.”
Oil traders know how the Queen felt in Lewis Carroll’s famous book, Alice Through the Looking-Glass. The list of impossible things that they are being asked to believe grows almost by the day:
Last week, prices jumped 4% on the basis that strong demand meant US inventories had fallen 14.5 mb in a week. But the drop was more likely due to offshore rig shutdowns and oil import delays caused by Hurricane Hermine
They were also asked to believe that Russia and Saudi Arabia would agree a deal to “rebalance oil markets” – even though the deal would not involve any production cuts, and would allow Iran and Nigeria to increase output
Equally impossible was the earlier claim that China’s domestic demand would drive major price rises – when in reality some of this demand was one-off filling of strategic storage, and the rest was to increase diesel and gasoline exports from its teapot refineries into the Asian market, where margins are crashing as a result
Before this was the claim that falling US drilling rig counts would collapse domestic oil production, even though cost-cutting meant industry major Pioneer said its Q2 production costs ranged between $2.25/bbl – $12.25/bbl
Plus there is still a widely held view that Russia will have to cut output due to low prices, when in fact it is producing record volumes due to its production costs being less than $20/bbl
And, of course, “everyone knew” earlier this year that Iran would never be able to boost oil production to its forecast levels after a nuclear deal – yet its current production is already only 200kpd below its year-end target of 4mbd
There are 100 other “stories” that have appeared in recent years to justify the myth that the world is running out of oil, and that prices need to be much higher than their median value for the past 150 years of $23/bbl.
These “stories” have helped fuel a speculative mania, which has proved highly profitable for commodity brokers and trading exchanges. $51bn has so far moved into speculative commodity trading so far this year – the most since 2009. And central banks have been very happy to supply free cash to support the speculation, in the hope this might help to create inflation and so reduce the cost of the debt created by their stimulus policies.
But, of course, those who actually use the oil – individual consumers, chemical companies etc – then have to pay the higher prices created by the mania. So the end result is to reduce demand and weaken the global economy.
This clash between reality and illusion has created the near-record levels of volatility that we are seeing in oil markets so far this year. But as the chart above confirms, each rally has only produced a pattern of “lower highs and lower lows” – each rally has been weaker than the last one, and prices go lower once it fails.
High levels of volatility are normally a sign that a mania is coming to an end. Oil prices will then be left to find their own value, on the basis of real market fundamentals of supply and demand. That, after all, is the key role of any market, to provide “price discovery”.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 54%
Naphtha Europe, down 53%. “Prices rise sharply on Brent hike”
Benzene Europe, down 53%. “US production as well as a lack of Asian imports earlier this year have strengthened US benzene prices into September.”
PTA China, down 40%. “High demand seen in July and August would likely not appear again, in the face of upcoming holidays and shrinking seasonal usage.”
HDPE US export, down 27%. “PE exports rose as the domestic market slackened, with production and sales figures for the month down by low single digit percentages, according to industry data.”
S&P 500 stock market index, up 9%
US$ Index, up 17%
Both the US and Iran are likely to be moving oil into world markets early in the New Year.
The lifting of the US export ban has led to early announcements of oil sales: Vitol will move the first cargo via the Enterprise terminal in Houston in early January. Iran is expecting to have sanctions lifted around the same time, and is already ramping up production. While the Libyan peace deal implies its volumes should increase again.
Consensus wisdom has failed us, yet again, on these key issues:
- Commentators assured their clients that the US was unlikely to export much, if any, oil if the export ban was lifted. But this defied common sense. Why would the industry spend so much time and effort to achieve the lifting of the ban, if not to use it? And why would the Republican Party make this a centre-piece of policy, just before a Presidential election year, if it was not going to have any impact?
- Similarly we were told that it would take months for Iran to increase its volumes. The same self-appointed “experts” assured us that Iran’s facilities were in a state of near collapse, and so it would be technically impossible for major new exports to begin for months, if not years
This highlights how the waves of central bank created liquidity have destroyed the role of real analysis. Research reports used to be short and concise, and focused on improving their clients’ understanding of critical issues; today, they can be hundreds of pages long, but are instead devoted to measuring alternative performance between companies, sectors and asset classes.
No wonder many people feel confused and uncertain as to what they should believe.
My suggestion is that logic and common sense are usually a good guide to future developments. This has certainly been true of oil markets since the Great Unwinding began in August 2014:
- Logic says the record volume of US inventory will move fairly quickly into world markets. It costs money to store it, whereas a sale will put money in the bank. And the alternative, of waiting for prices to rise, has proved a failed strategy during 2015. Not many Boards, or their bankers, are likely to continue this strategy in 2016
- Similarly Iran is keen to boost its presence on the world stage, and to challenge the leadership of the Gulf States. President Rouhani also needs to show the electorate that he has delivered on a key promise. And Iran has been in the oil business for a very long time, and has kept some oil sales during the embargo
The question of course is where all this new oil will go? Q1 is normally a period of strong demand from a seasonal viewpoint, so that should help. But pricing will be a different issue. US and Iranian crude will essentially be competing in the Asian market. And this is still slowing as China prepares for a difficult 2016.
President Xi has signalled that he intends to “take the pain of restructuring” next year, with major supply side reforms including capacity closures. This makes perfect sense for him, as it means he will then be able to approach reappointment in 2017 with the argument that “the worst is now behind us”. But it means China’s economy will slow further, putting even greater pressure on commodity exporters and pricing.
Thus the chart above from Bloomberg highlights the key issue. S Korea is Asia’s 4th largest oil consumer, and so a key target for all this new oil. As its Ministry of Trade, Industry and Energy has noted:
“U.S. West Texas Intermediate oil must drop $4 to $6 below Dubai crude, the benchmark for Middle East supply. American cargoes must also become cheaper relative to Brent, the marker for shipments from regions including Africa, for them to be viable.“
The oil market was the first to feel the impact of the Great Unwinding of policymaker stimulus nearly a year ago. It had completely lost its key role of price discovery due to the liquidity being supplied by the central banks. This had overwhelmed the fundamentals of supply/demand. And we are still living with the consequences today.
Many traders have only ever known a world where central banks aim to dominate the financial markets – and so they jumped on the recent technical rally in the belief that somehow markets would repeat the 2009 rally.
What it is about the world “massively oversupplied” that these traders find so difficult to understand, you might ask?
This, after all, was the phrase used by the International Energy Agency (IEA) last Friday to describe the current state of oil markets. And yet prices actually ended higher on the day, even though the IEA’s monthly report was crystal clear on the outlook:
“It remains that the oil market was massively oversupplied in 2Q15, and remains so today. It is equally clear that the market’s ability to absorb that oversupply is unlikely to last. Onshore storage space is limited. So is the tanker fleet. New refineries do not get built every day. Something has to give.”
Now a further test of oil markets is underway, with today’s historic agreement between Iran and the major global powers on the nuclear issue. As The Guardian reports:
“In terms of Iran’s ability to sell crude, I think that is where we will see the most immediate loosening up of restrictions. Iran has between 40 and 50 million barrels of crude at sea. Expect this crude to come to the market in short order. They will start competing fiercely to regain market share that they have lost to their Persian Gulf neighbors. Unfortunately for Iran the timing couldn’t be worse. Oil prices are depressed and already there is a glut of oil on the market. Adding Iran’s crude will put further downward pressure on oil prices.”
The Guardian thus confirms that Iran already has around 40mb of oil in floating storage, as I noted 2 weeks ago. It will not be long before this oil starts finding its way to market, even if sanctions are still officially in place. And this volume will be appearing as we move into the seasonally weaker Q3 period for demand. Plus the IEA forecasts that Iran could increase production by up to 800kb/day within a few months of sanctions being lifted.
I have forecast for some time that oil prices would return to their historical $30/bbl or lower level, I see no reason to change my mind today.