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.
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.
Development is clearly hotting up in the industrial biotech area. The key is the increasing demand by consumers for sustainable methods of production. As Antonello Ciotto, commercial director of Equipolymers, told our Conference in Brussels this week, the major brand owners are forcing the pace on this issue:
Coca-Cola: “We are working to completely eliminate the use of non-renewable fossil fuels in our plastic bottles, while maintaining quality and reliability”
Nestle. “Leading in the development and use of packaging materials made from sustainably managed renewable resources such as bioplastics”
Toyota. “Green. That’s how we’d like the world to be. As an environmental leader, we do more than meet industry standards – we seek to raise them”
Individual companies such as Equipolymers and Novozymes are clearly already moving in the same direction.
Now Scotland has become the first country to develop a national strategy for the area. As Caroline Strain, head of chemical sciences at Scottish Enterprise has noted:
“The rise in global population, rapid depletion of resources, increasing environmental pressures and climate change are each driving the need to develop more sustainable manufacturing processes. Investing in industrial biotechnology (IB) can help us achieve that. Supporting more companies, both at home and overseas, to invest in IB technology in Scotland is a priority for us. Building on our existing strengths in this area, we aim to position Scotland as an international hub for IB excellence.”
The key is to look forward, not back. As Sandy Dobbie of Chemical Sciences Scotland added, “in 20 years time, the chemicals industry will be transformed by the increasing use of renewable feedstocks and bio-processing steps”.
Chemicals used to be made from coal, but then transitioned to oil and gas-based feedstocks. Today, most are made from these fossil fuels. But the world does not stand still, and industrial biotech is becoming a super-critical area. The blog congratulates the Scottish team on their forward-thinking, which is vital to building the chemical industry of the future.
ExxonMobil’s annual energy review is always a fascinating read. This year’s issue looks out to 2040 for the first time. It thus forecasts the relative share of the major fuels over the next 30 years.
Interestingly, it also shares the blog’s belief, as set out in our ‘Boom, Gloom and the New Normal‘ eBook, that demographics will play a critical role in changing demand patterns over this period, noting that:
• “Demographics and economic expansion drive energy demand”
• “Population growth is slowing. In some places – many OECD countries plus China – populations will change little by 2040”
• China will see “a steep drop in its working age group”
• “India and Africa become some of the strongest areas of GDP growth”
EM also provide the above historical chart showing how fuel use has changed over the past 300 years.
Biomass, mainly wood (brown), was the main fuel from 1800. It began to be replaced by coal (light brown) from 1850. Then oil (green) began its reign from 1900. More recently, gas (red) has begun its rise. EM expect a 60% growth in its use by 2040. Hydro (light blue), nuclear (dark blue) and other renewables (yellow) are at an early stage of growth.
EM make the useful point that the variability of wind and solar power can be balanced by ‘on-demand’ sources. This will add to gas’s more obvious advantages such as its relative abundance and low price.