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.
“By Monday, the third straight day of flooding, the aftermath of Hurricane Harvey had left much of the region underwater, and the city of Houston looked like a sea dotted by small islands. ’This event is unprecedented,’ the National Weather Service tweeted. ‘All impacts are unknown and beyond anything experienced.’”
This summary from the New York Times gives some idea of the immensity of the storm that struck large parts of Texas/Louisiana last week, including the 4th largest city in the US. And this was before the second stage of the storm.
I worked in Houston for 2 years, living alongside the Buffalo Bayou which flooded so spectacularly last week. The photo above from the Houston Chronicle shows the area around our former home on Saturday, still surrounded by water. Today, as the rest of America celebrates the Labor Day holiday, the devastated areas in Texas and Louisiana will be starting to count the cost of rebuilding their lives and starting out anew:
Some parts of the Houston economy will recover remarkably quickly. It is a place where people aim to get things done, and don’t just sit around waiting for others to do the heavy lifting
But as Texas Governor Abbott has warned, Harvey is “one of the largest disasters America has ever faced. We need to recognize it will be a new normal, a new and different normal for this entire region.”
The key issue is that the Houston metro area alone is larger in size than the economies of Sweden or Poland. And as Harris County Flood Control District meteorologist Jeff Lindner tweeted:
“An estimated 70% of the 1,800-square-mile county (2700 sq km), which includes Houston, was covered with 1½ feet (46cm) of water”
Already the costs are mounting. Abbott’s current estimate is that Federal funding needs alone will be “far in excess of $125bn“, easily topping the costs of 2005′s Hurricane Katrina in New Orleans. And, of course, that does not include the cost, and pain, suffered by the majority of homeowners – who have no flood insurance – or the one-third of auto owners who don’t have comprehensive insurance. They will likely receive nothing towards the costs of cleaning up.
SOME PARTS OF THE ECONOMY HAVE THE POTENTIAL FOR A QUICK RECOVERY
Companies owning the large refineries and petrochemical plants in the affected region have all invested in the maximum amount of flood protection following Katrina, when some were offline for 18 months
Oil platforms in the Gulf of Mexico are used to hurricanes and are already coming back – Reuters reports that only around 6% of production is still offline, down from a peak of 25% at the height of the storm
It is hard currently to estimate the impact on shale oil/gas output in the Eagle Ford basin, but the Oil & Gas Journal reports that 300 – 500 kb/d of oil production is shut-in, and 3bcf/d of gas production
ExxonMobil is now restarting the country’s second-biggest refinery at Baytown, and Phillips 66 and Valero are also restarting some operations, whilst ICIS reports that a number of major petrochemical plants are now being inspected in the expectation that they can soon be restarted
Encouragingly also, it seems that insurance companies are planning to speed up inspections of flooded properties by using drone technology, which should help to process claims more quickly. Loss adjusters using drones can inspect 3 homes an hour, compared to the hour taken to inspect on roof manually. But even Farmers Insurance, one of the top Texas insurers, only has 7 drones available – and has already received over 14000 claims.
RECOVERY FOR MOST PEOPLE AND BUSINESSES WILL TAKE MUCH LONGER
For the 45 or more people who have died in the floods, there will be no recovery.
Among the living, 1 million people have been displaced and up to 500k cars destroyed. 481k people have so far requested housing assistance and 25% of Houston’s schools have suffered severe or extensive flood damage.
These alarming statistics highlight why clean-up after Harvey will take a long time. Basic services such as water and sewage are massively contaminated, with residents being told to boil water in many areas. The “hundreds of thousands of people across the 38 Texas counties affected by Harvey” using their own wells are particularly at risk.
And as the New York Times adds:
“Flooded sewers are stoking fears of cholera, typhoid and other infectious diseases. Runoff from the city’s sprawling petroleum and chemicals complex contains any number of hazardous compounds. Lead, arsenic and other toxic and carcinogenic elements may be leaching from some two dozen Superfund sites in the Houston area”
FEW IN HOUSTON HAVE FLOOD INSURANCE
Then there is the issue that, as the chart from the New York Times shows, most of those affected by Harvey don’t have home insurance policies that cover flood damage. Similarly, a survey in April by insurer Aon found that:
“Less than one-sixth of homes in Harris County, Texas, whose county seat is Houston, currently have active National Flood Insurance Program policies. The county has about 1.8 million housing units.”
As the Associated Press adds:
“Experts say another reason for lack of coverage in the Houston area was that the last big storm, Tropical Storm Allison, was 16 years ago. As a result, people had stopped worrying and decided to use money they would have spent for insurance premiums on other items.”
Even those with insurance will get hit by the low levels of coverage – just $250k for a house and $100k for contents. Businesses carrying insurance also face problems, according to the Wall Street Journal, as they depend on the same Federal insurance scheme, which:
“Was primarily designed for homeowners and has had few updates since the 1970s. Standard protections for small businesses, including costs of business interruption and significant disaster preparation, aren’t covered, and maximum payouts for damages haven’t risen since 1994.
The maximum coverage for business property is $500k, and the same cap applies to equipment and other contents, far below many businesses’ needs. And even those with insurance find it difficult to claim, according to a study by the University of Pennsylvania and the Federal Reserve Bank of New York after Hurricane Sandy in 2012:
“More than half of small businesses in New York, New Jersey and Connecticut that had flood insurance and suffered damages received no insurance payout. Another 31% recouped only some of their losses.”
Auto insurance is a similar story. Only those with comprehensive auto insurance are likely to be covered for their loss – and even then, people will still suffer deductions for depreciation. According to the Insurance Council of Texas:
“15% of motorists have no car insurance, and of those who do, (only) 75% have comprehensive insurance. That leaves a lot of car owners without any protection.”
In other words, around 1/3rd of car owners probably have no insurance cover against which to claim for flood damage.
HARVEY’S IMPACT WILL BE LONG-TERM
It is clearly too early, with flood waters still rising in some areas, to be definitive about the implications of Hurricane Harvey for Houston and the affected areas in Texas and Louisiana.
Of course there are supply shortages today, and the task of replacement will created new demand for housing and autos. But over the medium to longer term, 3 key impacts seem likely to occur:
It will take time for the supply of oil, gas, gasoline and other refinery products, petrochemicals and polymers to fully recover. There will inevitably also be some short-term shortages in some value chains. But within 1 – 3 months, most if not all of the major plants will probably be back online
It will take a lot longer for most people affected by Harvey to recover their losses. Some may never be able to do this, especially if they have no insurance to cover their flooded house or car. And those working in the gig economy have little fall-back when their employers have no need for their services
The US economy will also be impacted, as Slate magazine warned a week ago, even before the full magnitude of the catastrophe became apparent:
“For the U.S. economy to lose Houston for a couple of weeks is a human disaster—and an economic disaster, too….Given that supply chains rely on a huge number of shipments making their connections with precision, the disruption to the region’s shipping, trucking, and rail infrastructure will have far-reaching effects.”
“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 have been at the centre of the recent myth that economic recovery was finally underway. The theory was that rising inflation, caused by rising oil prices, meant consumer demand was increasing. In turn, this meant that the central banks had finally achieved their aim of restoring economic growth via their zero interest rate policy.
This theory was first undermined in 2014, when oil prices began their fall. There had never been a shortage of oil. Prices rose to $125/bbl simply because the hedge funds saw commodities like oil as a ‘store of value’ against the Federal Reserve’s policy of weakening the dollar.
The theory sounded attractive and plenty of people had initially made a lot of money from believing it. But it didn’t mean that the global economy had recovered. And by August 2014, as I highlighted at the time, oil prices were starting to collapse under the weight of excess supply. As I also suggested in the same post, this meant “major oil price volatility is now likely”. By luck or judgement, this has indeed since occurred, as the chart shows:
□ The 2009 – 2014 rally was dominated by “technical trading”, as oil markets lost their role of “price discovery”
□ August – December 2014 then saw prices crash to $45/bbl
□ Prices rose nearly 50% in early 2015 in a “failed rally”, as hedge funds assumed prices would quickly recover
□ Prices then halved to $27/bbl in January 2016 as the reality of over-supply swamped the market
□ Since then prices have doubled as OPEC combined with the hedge funds to try and push prices higher
□ This rally now seems to have failed, as US shale supply continues to increase
In reality, as I discussed last month, this final rally merely enabled new US production to be financed. The US oil rig count has doubled over the past year, and each rig is now 3x more productive than in 2014. At the same time, the medium-term outlook for oil demand in the key transport sector is becoming more doubtful, with China and India both now moving towards Electric Vehicles as a way of reducing their high levels of air pollution.
A measure of how far the market has moved was seen at last week’s Clean Energy Ministerial meeting, which:
“Set a collective aspirational goal for all EVI members of a 30% market share for electric vehicles (EVs) by 2030. It does so with the aim of taking advantage of the multiple benefits offered by electric mobility for innovation, economic and industrial development, energy security, and reduction of local air pollution.”
Already oil price targets, even amongst the optimists, are now being revised downwards. Nobody now talks about a “quick return” to $100/bbl, or even to $70/bbl. Instead the hope is that possibly they might return to $60/bbl at some point in the future – others merely hope that today’s $50/bbl level can be maintained.
Hope, however, is not a strategy. And in the absence of major geopolitical disruption, it seems likely that the hedge funds will continue to withdraw from the market and leave supply/demand fundamentals to once again set the price. In turn, this will challenge the reflation and recovery myth that grew up whilst the funds were boosting their bets on the oil and commodity markets.
As the second chart shows, inflation has already begun to weaken in China as well as in the US and Eurozone economies. China’s move away from stimulus will help to accelerate this move in H2, In turn, markets will likely return to worrying about deflation once more.
Japan is an excellent indicator of this development. Its inflation rate completely failed to take off despite the major rise in oil and other commodity prices. As I have long argued, Japan’s ageing population means that its previous demographic dividend has now been replaced by a demographic and demand deficit.
The US and Eurozone economies are both going through the same process. 10k Americans and 18k Europeans have been retiring every day since 2011 as the BabyBoomer generation reaches the age of 65. They already own most of what they need, and their incomes generally suffer a major hit as they leave the workforce.
Companies and investors therefore need to prepare for a difficult H2. The failure of the latest oil price rally, and the return of deflation worries, will puncture the myth that reflation and economic recovery are finally underway. Political stalemate will increase, until policymakers finally accept that demographics, not central banks, drive demand.
On Monday, I discussed how OPEC abandoned Saudi Oil Minister Naimi’s market share strategy during H2 last year.
Naimi’s strategy had stopped the necessary investment being made to properly exploit the new US shale discoveries. But this changed as the OPEC/non-OPEC countries began to talk prices up to $50/bbl. As CNN reported last week:
“Cash is pouring into the Permian, lured by a unique geology that allows frackers to hit multiple layers of oil as they drill into the ground, making it lucrative to drill in the Permian even in today’s low prices.”
Private equity poured $20bn into the US shale industry in Q1
Major oil companies were also active, with ExxonMobil spending $5.6bn in February
US oil/product inventories have already risen by 54 million barrels since January last year and are, like OECD inventories, at record levels. And yet now, OPEC and Russia have decided to double down on their failing strategy by extending their output quotas to March 2018, in order to try and maintain a $50/bbl floor price. US shale producers couldn’t have hoped for better news. As the chart shows:
US inventories would be even higher if the US wasn’t already exporting nearly 5 million barrels/day of oil products
It is also exporting 500 kb/d of oil since President Obama lifted the ban in December 2015
Nobody seems to pay much attention to this dramatic about-turn as they instead obsess on weekly inventory data
But these exports are now taking the fight to OPEC and Russia in some of their core markets around the world
None of this would have happened if Naimi’s policy had continued. Producers could not have raised the necessary capital with prices below $30/bbl. But now they have spent the capital, cash-flow has become their key metric.
The second chart confirms the turnaround that has taken place across the US shale landscape, as the oil rig count has doubled over the past year. Drilling takes between 6 – 9 months to show results in terms of oil production, and so the real surge is only just now beginning. Equally important, as the Financial Times reports, is that today’s horizontal wells are far more productive:
“This month 662 barrels/d will be produced from new wells in the Permian for every rig that is running there, according to the US government’s Energy Information Administration. That is triple the rate of 217 b/d per rig at the end of 2014.”
Before too long, the oil market will suddenly notice what is happening to US shale production, and prices will start to react. Will they stop at $30/bbl again? Maybe not, given today’s record levels of global inventory.
As the International Energy Agency (IEA) noted last month, OECD stocks actually rose 24.1mb in Q1, despite the OPEC/non-OPEC deal. And, of course, as the IEA has also noted, the medium term outlook for oil demand has also been weakening as China and India focus on boosting the use of Electric Vehicles.
The current OPEC/non-OPEC strategy highlights the fact that whilst the West has begun the process of adapting to lower oil prices, many oil exporting countries have not. As Nick Butler warns in the Financial Times:
“Matching lower revenues to the needs of growing populations who have become dependent on oil wealth will not be easy. It is hard to think of an oil-producing country that does not already have deep social and economic problems. Many are deeply in debt.
“In Nigeria, Venezuela, Russia and even Saudi Arabia itself the latest fall, and the removal of the illusion that prices are about to rise again, could be dangerously disruptive. The effects will be felt well beyond the oil market.”
OPEC and Russia made a massive mistake last November when when they decided to try and establish a $50/bbl floor for world oil prices. And now they have doubled down on their mistake by extending the deal to March 2018. They have ignored 4 absolutely critical facts:
Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels”
At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
But at $50/bbl, they could
Former Saudi Oil Minister Ali Naimi understood this very well. He also understood that OPEC producers therefore had to focus on market share, not price, as Bloomberg reported:
“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”
Naimi’s strategy was far-sighted and was working. The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:
Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016
But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets. Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives. They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:
“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”.
This gave the shale producers the window of opportunity they needed. Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.
As a result, the number of rigs in the Permian Basin has nearly trebled. At 309 last week, the rig count is already very close to the previous peak.
The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested. And it is now too late for OPEC to do anything to stop its development.
On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.