The past few weeks have been a nightmare for the many hedge funds who gambled on higher oil prices. They obviously hadn’t realised that OPEC’s November quota agreement was most unlikely to lead to a major rebalancing of today’s vastly over-supplied market. But as I suggested in December:
“The simple fact is that the arrival of US shale production means OPEC are no longer the swing producer, able to control the world market. The quotas will have little effect in themselves, as most of the participants will cheat. Instead, they will simply help to boost US oil and gas production, whilst turbo-charging the use of smart meters.”
Now the funds are finally starting to bail out of their positions. As John Kemp of Reuters reported this week under the headline Hedge funds rush for exit after oil trade becomes crowded:
“Hedge funds cut their bullish bets on oil by the largest amount on record in the week to March 14, according to the latest data published by regulators and exchanges. Hedge funds and other money managers cut their combined net long position in the three main futures and options contracts linked to Brent and WTI by a record 153 million barrels in just seven days. The reduction in the net long position coincided with the sharp fall in oil prices, which started on March 8 and continued through March 14.
“Before the recent sell off, hedge fund managers had boosted their net long position in Brent and WTI by 530 million barrels between the middle of November and the middle of February. Funds amassed a record 1.05 billion barrels of long positions, while short positions were cut to just 102 million barrels, the smallest number since oil prices started slumping in 2014. But large concentrations of hedge fund positions, and an imbalance between the long and short sides of the market, often precede a sharp reversal in oil prices.”
Another sign of the hedge funds’ problem is that even after this sell-off, ThomsonReuters data shows their net position on WTI is still higher than in early August 2014 – just before the price collapse from $105/bbl began. Or as Bloomberg noted:
“The value of long positions for Brent and West Texas Intermediate crude, the global and U.S. benchmarks, reached a combined $56 billion on Feb. 23“.
$56bn is an awful lot of oil to have to try and sell in a falling market. And of course, the hedge funds are well behind savvy traders such as Vitol and TOTAL, who have been selling their barrels of stored oil for some time.
Already, WTI prices are back at the $48/bbl level seen at the end of November, before the rally began. Equally important is that the contango in the futures market has collapsed – with prices for May 2018 now just $0.30/bbl higher than for May this year. $0.30c/bbl won’t pay insurance and storage costs for a year, so all that stored oil will now have to be sold, as quickly as possible.
US SHALE OIL OUTPUT IS RAMPING UP VERY QUICKLY
The funds, and many observers, have simply failed to recognise that the structure of the US shale oil market has completely changed in the past 2 years. As I discussed 18 months ago under the heading, Oil price forecasts based on myths, not proper analysis, each well no longer has to be redrilled every few months, .
Today, the Permian Basin in Texas/New Mexico has become the showpiece field for modern shale production. Latest EIA data shows its production next month is forecast to be 2.3mbd, nearly half of total shale production of 5mbd. It also has almost of a third of the 5443 ‘Drilled but Uncompleted” wells, now waiting to produce oil and gas in the major shale fields. And as the chart above shows:
Its oil production per rig has more than doubled over the past 2 years due to horizontal drilling
Each rig now produces 662 bbls/day compared to 288 bbls/day in March 2015
Since May last year, the number of rigs in operation has more than doubled – from only 137 to 300 last month
As each rig normally takes 6 – 9 months to finish its work, the major expansion of production is still to come
Unsurprisingly, major oil producers are heavily invested in the field, with ExxonMobil having just spent $5.6bn to buy 3.4bn bbls of oil equivalent reserves. As the Forbes chart shows, EM’s cash operating cost was already less than $10/bbl last year. And EM now plans to more than double its rigs in the Basin to 25 after the investment closes.
Of course geopolitical events, such as a US bombing of N Korea, could change these dynamics overnight.
But anyone still gambling on higher oil prices and a rapid rebalancing of the market, probably has a very nasty shock ahead of them. The simple fact is that not only are US inventories at near-record levels but, as the top chart shows, the US is now also exporting 5mbd of crude and oil products – and this volume is rising month by month.
It would be no surprise at all, if prices fell back to their median level since 1861 of $23/bbl in the next few months. And they might have to go even lower, temporarily, as many producers happily hedged themselves at $50/bbl for the rest of this year, when the speculative bubble was at its height.
Trading oil markets used to be hard work.
You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it. You had to watch for breaking economic and political news. And you needed your own supply/demand balances. Plus you had to guess how the fabled ”Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.
Today’s trading world is completely different:
More than half of all trading is done by machines at ultra-high speed. These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models
Then you have the hedge funds, and even some pension funds, with quarterly targets for profit. They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up. They have to play the momentum game of finding a story, and jumping on it as quickly as possible
In addition, of course, there are still producers and consumers, who actually need to buy or sell oil. They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others. But in the “real world” outside of financial trading, they are the only people who matter
New data from the CME highlights the change. It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels). Actual physical production, by comparison, is around only 92 million barrels per day. The speculative tail is indeed wagging the dog.
The chart above shows the current net position of the speculators, which is at a record 371k contracts. It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.
The only problem – for players in the real world – is that the “story” isn’t true. Today’s headlines may say that OPEC has 82% compliance, but this was only because of Saudi Arabia – which cut 564kb versus the promised 486kb, according to the Reuters data above. Outside the GCC countries, not much happened. Venezuela – which led lobbying for an output cut – delivered only 18% of its promise, and Russia only cut 117kb versus its promised 300kb.
“Who cares?”, you might say, if you are one of the highwaymen or a momentum trader. Talk is cheap, and you can tell the media it is early days, and countries take time to adjust. They love an easy story, just as you do, and believe their viewers want a quick trading tip – not a boring discussion about rising US inventories for oil (up another 6mb last week) and gasoline inventories (now actually above the upper limit of the normal seasonal range).
You certainly don’t want to dive into the detail of rising US shale production (already back at April’s level), and rising numbers of drilling rigs (back to November 2015 levels). And you certainly won’t discuss the 5300 drilled but uncompleted oil/gas wells, where producers only have to turn the tap to start earning revenue.
Well, not just yet, anyway. Maybe in a week or two, it might be time to learn a new script. After all, “what goes up, comes down”. The dream scenario for the paper traders would be if today’s major rally was followed by a major collapse. After all, the refinery maintenance season will soon be starting, causing physical demand to drop.
Of course, all this volatility has a price. The market is a zero-sum game where overall, the consumer and the producer pay the cost of the speculator’s outsize profits. And in the geo-political world, there is one major loser – Saudi Arabia.
The Saudis know that President Trump doesn’t support the ‘Oil for Defence‘ agreement made 70 years ago, which protected them in 1990/1991 when Iraq invaded Kuwait. So they have to stay close to the other OPEC members, and make the major share of the cuts. But what will happen in Saudi, if and when prices fall back – say to the $30/bbl level seen a year ago?
Oil prices, and those of natural gas, have been on a wild ride over the past year, as the chart confirms. It shows US WTI prices divided by 6, as this enables a comparison with natural gas prices in terms of energy content:
Oil prices have come down a long way from their 2008 and 2010-2104 peaks
Natural gas prices have similarly never recovered to their 2006 and 2008 peaks
But both saw major increases last year as US production temporarily declined from its peak levels
As the US Energy Information Administration (EIA) reported, US oil production was down 4.5% in December versus 2015, and natgas production was down 3.5% in October versus 2015. Yet as the EIA forecasts:
“U.S. crude oil production averaged an estimated 8.9 million barrels per day (b/d) in 2016 and is forecast to average 9.0 million b/d in 2017 and 9.3 million b/d in 2018. Forecast dry natural gas production increases by an average of 1.4 Bcf/d in 2017 and by 2.8 Bcf/d in 2018″
In natgas, the EIA’s commentary confirmed the market’s underlying weakness:
“US Natgas prices in 2016 were the lowest in nearly 20 years (and) In November 2016, the United States became a net exporter of natural gas on a monthly basis for the first time since 1957″.
Oil markets are also still in surplus, as the International Energy Agency reported last month:
“Global oil supplies in November edged up to a record high 98.2 mb/d, as a drop in non-OPEC output was more than offset by higher OPEC production. OPEC output stood 1.4 mb/d higher than a year ago
OECD inventories have drawn 75 mb since reaching a historical high in July, but remain 300 mb above the five-year average
Refinery crude intake in 1Q17 is forecast to grow by only a modest 310 kb/d y-o-y, after growing by only 350 kb/d growth in 4Q16″
Nothing has really changed in terms of underlying supply/demand balances during the year. In turn, this raises the question as to why prices have risen so strongly, particularly in recent weeks?
The answer is simple, and captured in the second chart showing net speculative positions in the WTI futures market. As Reuters reported last month:
“Hedge funds have amassed a record bullish position in crude oil in anticipation OPEC and non-OPEC oil producers will succeed in rebalancing the market and reducing excess stocks next year. Fund managers accumulated a net long position equivalent to 796 million barrels in the three main futures and options contracts linked to Brent and West Texas Intermediate by Dec. 13. The net position almost doubled from a low of 422 million barrels four weeks earlier.”
Those doing the buying have adopted a high-risk strategy. Of course, the year-end is a great time to move markets, when many players are out of the office. But they are betting against some well-known and well-established facts:
The market is well supplied, and major players such as Shell suggest the world may be close to “peak demand”
OPEC’s record in implementing output cuts is poor, and Russia has never cut production as promised
Saudi Arabia and its GCC partners are the only ones likely to cut production. As I discussed last month, it cannot rely on President Trump to support the critical ‘Oil-for-Defence’ deal agreed in 1945 between King Saud and President Roosevelt. It dare not, therefore, break with its Arab neighbours and keep pumping.
But other OPEC members are unlikely to provide major support.
Iran is highly likely to keep pumping. President Rouhani faces re-election in May, and his position has just become more difficult with the death of former President Rafsanjani.
Libya’s output has already trebled over the past 6 months to 750kbbls/day, and could potentially return to previous levels of 1.6 million bbls/day if the civil war comes to an end.
Nigeria is also capable of increasing output, with its Oil Minister recently claiming it had reached 1.9 mb/d
Others such as Iraq and Venezuela are equally doubtful
The issue is simple. Cash in the bank is the priority for all the major oil producers.
US producers are in best shape, as they have been able to hedge their production at today’s high prices. But cash is the priority for other producers too. The UAE is the only OPEC member in the Middle East/N Africa able to balance its budget at $50/bbl, as the IMF has noted. OPEC also faces another fundamental problem:
Cartels can only operate on the basis of trust – each member has to believe others will take the pain of cutbacks
The OPEC cartel has never seen this level of trust
The only time cuts took place effectively was in 1981-1985, when Saudi cut production from 10.3mb/d to 3.6mb/d
Unless Saudi does this again, which appears unlikely due to its own budget needs, history would suggest the output cuts will fail to achieve their target. And, of course, as prices fall, so countries will have an incentive to sell more in order to boost revenues, creating a vicious circle. Hedge funds will also quickly reverse their speculative positions.
What this may mean for political stability in the Middle East and N Africa is a question for another day. In the meantime, it is clear that OPEC’s output agreement is a highly risky gamble. If it fails, prices could easily fall a long way very quickly, given today’s surpluses.
OPEC is living in the past with its recent announcement of new quotas.
The simple fact is that the arrival of US shale production means OPEC are no longer the swing producer, able to control the world market. The quotas will have little effect in themselves, as most of the participants will cheat. Instead, they will simply help to boost US oil and gas production, whilst turbo-charging the use of smart meters.
OPEC’s core problem was also highlighted by the recent announcement by the US Geological Survey of:
“The largest estimate of continuous oil (shale) that USGS has ever assessed in the United States.The Wolfcamp shale in the Midland Basin portion of Texas’ Permian Basin province contains an estimated mean of 20 billion barrels of oil, 16 trillion cubic feet of associated natural gas, and 1.6 billion barrels of natural gas liquids
“The fact that this is the largest assessment of continuous oil we have ever done just goes to show that, even in areas that have produced billions of barrels of oil, there is still the potential to find billions more.”
The US is already well on the way towards energy independence within the next 5 years, as BP have reported. OPEC’s move will therefore prove totally counter-productive, as it will simply support the growth of natural gas, renewables, and energy efficiency. (This inter-active map from the University of Texas shows the dramatic growth in the role of gas and renewables for US electricity production).
Saudi Arabia had therefore adopted the right policy in the summer of 2014, in recognising that market share was the key to success. Anyone who cuts back on oil sales today in the hope of higher prices, risks being unable to sell in the future. But, of course, Saudi has now had to change course for geopolitical reasons, as I discussed last week. With President-elect Trump about to take office, it can no longer rely on its Oil-for-Defence deal with the USA.
Trump’s arrival will add to OPEC’s problems, as his 100-day Action Plan aims to:
“Lift the restrictions on the production of $50tn worth of job-producing American energy reserves, including shale, oil, natural gas and clean coal.”
Fracking technology is now well understood in the US, and becoming very efficient due to the introduction of horizontal drilling techniques. It is therefore unlikely that OPEC’s new quotas will have much impact on the global oil market. Most OPEC and non-OPEC producers will cheat, as usual. And today’s temporarily higher prices are simply going to further increase the overall supply glut by incentivising higher US oil and gas output:
The recent price rises have already enabled US producers to lock in very attractive margins into 2019
They will also support US oil exports into Asia, one of OPEC’s key markets. BP is currently sending the first shipment, of 3 million barrels, and others such as Sinopec and Trafigura are following
They will also support US natural gas production, where the US became a net exporter last month. US gas exports have already risen 50% since 2010, and the US Energy Department expects it to become the world’s 3rd largest exporter after Australia and Qatar by 2020. This is very bad news for oil demand, as it means gas will be even more competitive in world energy markets.
Equally important is the rise of energy efficiency as a topic for action. This was first flagged by ExxonMobil in 2009, when they argued:
“The most important ‘fuel’ of all, will be energy saved through fuel efficiency“.
Now, thanks to climate change, efficiency has reached the top of the political agenda. Smart meters will soon provide more than a billion consumers with the ability to avoid wasting energy, as the World Energy Council report this month:
“China is the leader of the smart metering market with 250 million units, in Asia plans are underway to reach 70% coverage, and 40% of American households have a smart meter. At European level, Italy and Sweden are the leading examples (close to 90% of consumers have smart meters). Furthermore, the Energy Efficiency Directive requires EU member states to deploy smart meters by 2020.”
The arrival of smart meters means that consumers now have an alternative to paying higher prices, as they can more easily identify where they are wasting energy, and cut back.
Developments such as the growth of US oil and gas production, plus the growth of smart meters, means that the energy world is going through major change. In this New Normal world, OPEC risks becoming irrelevant if it continues to try and turn back the clock to the 1970s with its pricing policies.
There were only two winners from the past 3 months of OPEC’s “Will they?, Won’t they?” debate on output cutbacks.
Iran wasn’t one of them – although the talks did emphasise its renewed ability to control the OPEC agenda. Nor was Saudi Arabia, forced to accept the lion’s share of the proposed cutbacks.
Instead, the US shale producers were big winners, with some saying they were “dancing in the streets of Houston” when the “deal” was announced last week. Who can blame them, given that production costs according to Pioneer now range between $2.15/bbl – $12.27/bbl in the vast Permian Basin field.
But the really big winners were the owners of the futures markets. As the head of the NYMEX commodities business boasted – “the OPEC talks have been great for our business“. Looking at the data, one can see what he means:
More than 1.7 million contracts traded just on Brent futures on ICE last Wednesday
Each contact represents 1000 barrels, so that is an astonishing 1.7bn barrels of oil – around 18x daily production
The NYMEX WTI contract traded 2.4m contracts – around 26x daily production
In total, therefore, volume on the major Western futures markets was a record 44x daily production
And, of course, last week was no exception in highlighting the dominance of the futures market is setting oil prices. As the chart above shows, their trading volume has rocketed since the central banks began their stimulus programmes. It averages nearly 12x physical volume so far this year, versus just 3x in 2006 – and just 1x in 1996.
As one observer rightly noted, the trading had all the signs of a buying frenzy. For in the real world, it is highly unlikely that the production agreement will achieve its promised goals:
Russia has never, ever, participated in an OPEC quota, and is very unlikely to actually cut production this time
Equally important is that OPEC production itself is likely to rise as Nigerian and Libyan output continues to recover
And, of course, oil inventories are already at record levels, and will likely rise further as production increases in the USA, Brazil, Canada and Kazakhstan
Unsurprisingly, most of the selling was being done by producers, delighted at being able to hedge their output into 2019. They sold so much, the forward curve moved from being in contango (where tomorrow’s price is higher than today’s), to backwardation (where tomorrow’s price is lower than today’s). This confirms that analyst talk of shortages and cutbacks is pure wishful thinking.
Even more worrying for the oil bulls is that the rise in the US$ is also reducing demand in the major Emerging Markets. Oil is priced in US$, and this has risen by 10% or more against many currencies in the past few months. And any recession in 2017, which seems likely based on the chemical industry outlook, will further weaken demand.
But the OPEC meeting did highlight one critical development. For the first time since the 1980s, Saudi Arabia sided with OPEC in terms of agreeing cutbacks. This has only happened twice before in history – during the 1973/4 Arab Oil Boycott, and the 1979/85 Oil Crisis.
Both times, Saudi was worried that its critical Oil-for-Defence deal with the USA might not deliver promised support:
In 1973, President Nixon was facing impeachment over the Watergate scandal, and the Arab world was up in arms over US support for Israel in the Yom Kippur War
In 1979, President Carter was facing defeat in his re-election bid, and the Iran hostage issue meant US support again became unreliable
Today, the 1945 pact between President Roosevelt and King Saud (pictured above) is effectively dead. President-elect Trump no longer sees the USA as the “leader of the free world”, and it is most unlikely that he would send military support to Saudi if it was attacked. The fact that the US is now on the way to becoming energy self-sufficient by 2021 means it has no real need for Saudi oil any more, as I suggested 2 years ago:
”Suddenly the Saudis face a critical question – does the US still need the 1.3 million barrels/day they supplied in 2013?
And if not, will the US still be prepared to defend Saudi from attack, as it did during the first Gulf War in 1990-1991?
This is the question that keeps senior Saudi officials and Ministers awake at nights in Riyadh”
This the New Normal world in action. Old certainties are disappearing, and we do not yet know what will replace them.
Volatility continues to dominate oil markets, as the above chart confirms. Some weeks have seen prices move by over 18%. These are extraordinary moves in a market which is very well supplied, with near-record inventory levels. Some recent daily moves are equally extraordinary, with prices jumping $2.50/bbl on Tuesday.
The volatility highlights the power of the futures market to temporarily overwhelm anyone trading on the basis of physical supply/demand. As I noted last month, futures trading in just the WTI contract has averaged around 10x physical volume. So prices can take wild swings, without anything happening in the “real world” – especially when the automated high frequency traders get involved with their media-led algorithms.
Tuesday’s move, for example, was caused by speculators buying 300 million barrels of oil via call options (betting that the price would be higher in H1 2017) – over 3x daily physical volume. This was why the price soared.
The speculators particularly love “stories”, as these are impossible to prove or disprove. So the story this year about an OPEC/Russia production agreement has been perfect for their purposes. It is the “gift that goes on giving” as one major player told me. But at some point, probably quite soon, the story will run out of road – you can’t keep bouncing prices around forever on speculation, if nothing ever happens.
It therefore seems worth looking at the 3 key questions that will need to be answered by the end of this month, if the promised production agreement is to mean anything tangible. As always, this week’s Monthly Oil Report from the International Energy Agency provides valuable input:
Will there be an OPEC cut? It is very easy to talk about stabilising output at today’s level, given it is currently at record production. The IEA’s view on OPEC output is clear:
“OPEC crude output rose by 230 kb/d to a record 33.83 mb/d in October after production recovered in Nigeria and Libya and flows from Iraq hit an all-time high. Output from the group’s 14 members has climbed for five months running, led by Iraq and Saudi Arabia. In October, OPEC supply stood nearly 1.3 mb/d above a year ago.
“It has only been two months since OPEC last met in Algiers and announced it would examine how to set up a production ceiling of between 32.5 mb/d and 33.0 mb/d. OPEC also said it would seek to bring leading non-OPEC producers into the process. We can’t predict the outcome of the 30 November meeting, but we can see the scale of the task ahead. In this report we estimate that OPEC members pumped 33.8 mb/d in October, well in excess of the high end of the proposed output range. This means that OPEC must agree to significant cuts in Vienna to turn its Algiers commitment into reality.”
Would non-OPEC countries make a cut? Again, the IEA is clear:
“Unfortunately for those seeking higher prices, an analysis of the other components provides little comfort. The world’s biggest crude oil producer Russia will see its output increase by 230 kb/d in 2016, and sustained production at current record levels would result in growth of nearly 200 kb/d next year. With production also expected to grow in Brazil, Canada and Kazakhstan, total non-OPEC output will rise by 0.5 mb/d next year, compared to a fall of 0.9 mb/d in 2016. This means that 2017 could be another year of relentless global supply growth similar to that seen in 2016.”
What would happen if production was cut, and prices then rose to, say $60/bbl? The head of the IEA gave their view in a Reuters interview on Wednesday:
“U.S. shale oil producers will increase their output if oil prices hit $60 a barrel, meaning OPEC will have to walk a fine line if it curtails production to prop up prices. OPEC members are due to meet in Vienna at the end of the month to push through the first output limiting deal since 2008. If this decision pushes the prices up (to) around $60/bbl, we may well see a significant increase from shale oil from the U.S. This level would be enough for many U.S. shale companies to restart stalled production.”
It is therefore clear that OPEC has an uphill battle ahead of it. Of course, it is great fun, and highly profitable, to simply “wave away these facts” if you are a trader trying to profit from the “story”. But this is a zero-sum game: in other words, the trader’s profit is someone else’s loss. They are simply making money for themselves, and leaving the rest of the market to pick up the bill.
Of course, it is possible to believe that that OPEC and Russia will be forced by the downside risk to make real, and major cuts. It is also possible to believe that “this time will be different”, and that most OPEC members won’t immediately cheat on the new quota, if an agreement is reached.
Clearly every business that uses significant quantities of oil needs to prepare a Scenario analysis of the possible outcomes from the OPEC meeting. And this analysis needs to be realistic about the probabilities of success. Does OPEC have a 90% chance of reaching and enforcing an agreement? Is it a 50% chance. Or is the whole story merely wishful thinking, with just a 10% probability of happening? You have to make your own judgement.
Equally important, of course, is that you then spend time thinking about what would happen to your business and investments in each of these Scenarios: if (a) prices rise to $60/bbl (b) stabilise around today’s levels, or (c) collapse below $30/bbl? It is essential that you spend time debating these possible outcomes today, and planning how you would respond to them.
The key issue is that today’s oil market not being run for the benefit of people who actually use or produce oil. The speculators couldn’t care less who does well, or who goes bankrupt, as a result of their activity. They simply want to make the maximum amount of money for themselves, as quickly as possible.
Essentially, therefore, it is best to see today’s market as a very high stakes poker game. And as any good poker player knows, “If you don’t know who is the fool at the table, then its probably you“.