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.
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.
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.
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.
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.“
Financial players have become convinced in recent months that the oil price will rise. And so far, this has been a self-fulfilling prophecy. Their buying has led to oil being stored all over the world – in tankers floating at sea and in shale oil wells, as well as in storage tanks.
Unsurprisingly, prices have rallied as all this product was being taken off the market. But whilst it easy to buy oil in an over-supplied market, the buyers now face the more difficult task of trying to resell it at a profit as we move into the seasonally weaker months of Q3.
The chart above from the Wall Street Journal shows how the volume of oil in floating storage more than trebled between January – May, and is still more than twice the earlier level. The volume comes from traders taking advantage of the difference between current and future prices (the contango) to buy today and sell to hedge funds and other financial buyers at a guaranteed profit in the future.
But Iran has also been storing oil on ships, to release on world markets if sanctions are lifted following a deal on the nuclear issue, perhaps in the next few weeks
In addition, of course, there is the record volume of oil inventory in the US, as I discussed last week. Plus US shale producers have drilled 3000 wells in preparation to pump up to 1.3mbbls/day of oil once prices have moved higher.
And in Europe, as the second WSJ chart shows, oil storage has hit a record level of 61mbbls.
And finally, recent months have seen strong buying by China to fill its strategic petroleum reserve. It had decided to raise the reserve to 100 days of normal demand. But as a Sinopec executive told Reuters back in March this programme will soon be complete.
It clearly makes no sense for prices to rise on such artificial/temporary types of demand, when the International Energy Agency suggests surplus production is currently running at 2mb/day.
The problem is the record amounts of money that have gone into commodity hedge funds. This has fallen slightly from the $80bn peak seen in 2013, but still stands at $69bn today. And, of course, $69bn buys a lot more oil today than it did when prices were at $100/bbl in 2013.
These mounting surpluses are making life more and more difficult for producers in Europe and W Africa. As I noted last year, Nigeria has lost its entire export market to the US, worth 1.3mb/day, and is instead having to send its oil all the way to Asia. Now N Sea producers are facing the same problem, with tankers carrying the equivalent of a week’s consumption by the UK now heading to Asia instead.
Of course, as the saying goes, “money talks”. So as long as financial players keep buying in financial markets, oil supplies will keep increasing. But unused oil can’t keep being held in storage forever. Eventually the fundamentals of supply/demand balances will cause prices to fall back to historical levels of $30/bbl or lower.
We cannot know what might be the catalyst for this development. Perhaps it will be a panic over Greece, or an Iranian agreement, or something else entirely. But barring geopolitical upset, it is not a question of “if”, but of “when”.