Oil heads to $30/bbl as Great Unwinding reaches 1st anniversary

Global markets are becoming ever more complex as the Great Unwinding of stimulus policies continues.  This means that each blog post is now taking much longer to write.  It therefore seems sensible to focus on writing 3 posts each week – on Monday, Wednesday and Friday – in order to continue to provide the highest possible quality of analysis. 

GU 15Aug15
It is exactly a year since I forecast that the Great Unwinding of stimulus policies was about to begin:

  • Brent oil prices were then at $104/bbl and had been above $100/bbl level for over 3 years
  • The US$ index against the world’s major currencies was at 81, continuing its 30-year downtrend since 1985

Last Friday, as the chart shows, Brent oil prices were 54% lower at $49/bbl, and the US$ Index was 19% higher at 96.

These are massive moves over such a short space of time.  Most worryingly, it seems that most commentators never even dreamt that they could take place.  Thus it is only very recently that the consensus has begun to accept that oil prices might stay “lower for longer”.  Even China’s devaluation last week appeared to come as a complete shock to most experts.  This highlights the problems caused by policymakers’ refusal to accept that demographic change is creating a New Normal world.

Global debt has risen by $57tn since 2007 to $199tn, as they tried to restore growth to the SuperCycle levels seen when the BabyBoomers were in their peak income and spending period.  In the process, they destroyed the price discovery mechanism in most major financial markets.  In turn, of course, this means that most people under the age of 40 have never known a world where markets fulfilled their fundamental role of balancing supply and demand.

Over the past year, however, markets have begun to rediscover their role.  Oil prices have therefore been falling, and the US$ has been rising.   And this process will likely continue.  As the International Energy Agency reported last week, “global supply continues to grow at a breakneck pace“.  As a result, it suggests that “2H15 sees supply exceeding demand by 1.4 mb/d, testing storage limits worldwide”.

US markets are already waking up to reality, with storage tanks at the key Cushing terminal expected to overflow within 2 months.  And already the force majeure at BP’s Whiting refinery has caused Western Canada Select crude to trade at just $22.75/bbl on Friday.  Brent prices are also weakening, of course, as Iraq production hits record levels and Iran prepares to return to the market – at a time when Chinese and Asian demand is slowing fast.

I therefore doubt that it will be too long before Brent prices hit my forecast level of $30/bbl.  And they will quite possibly go much lower, due to the long-term surpluses that have now developed in all major energy sources – coal, gas and oil.  This will create great opportunities for those who are light on their feet.  But it will also create major challenges for those who cling to the idea that policymakers and the consensus know best.

My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Brent crude oil, down 52%
Naphtha Europe, down 51%. “Asian arbitrage window closed because of high freight rates”
Benzene Europe, down 48%. “Supply is expected to lengthen into September, with improved cracker operating rates and lower downstream production”
PTA China, down 41%. “The traditional pick-up in demand between August and September had also not been seen so far”
HDPE US export, down 27%. “Domestic export prices dropped during the week as suppliers and producers lowered prices to keep their ties open to international markets.”
¥:$, down 21%
S&P 500 stock market index, up 7%

Cracks appear in crude oil pricing

Brent etc Jan13.pngCrude oil and the major commodity markets have been a “fool’s paradise” in the past 4 years, created by the arrival of the central banks’ massive liquidity programmes. Pension funds rushed to buy, in the belief they would be a “store of value”. Hedge funds followed them as a momentum play, encouraged by analyst reports of supply shortages and soaring demand in emerging markets.

But nothing lasts forever. Financial players have sustained oil prices at record levels for the past 2 years. But high prices destroy demand, and so buyers of futures contracts have largely lost money over the past 18 months. Plus, of course, there have never been any real shortages in the market to justify today’s high prices. So finally, they are leaving the markets to the physical players once more.

Repricing is therefore becoming almost inevitable as we move through 2013. The reason is that since 2009 the speculators have taken over the markets, and have no longer just provided liquidity. So no single financial market has really known what it was meant to be pricing. But now, signs of strain in oil markets are becoming very visible.

Saudi Arabia has already had to cut production by 1 million bpd due to lack of demand. But others do not have this luxury, and instead have to sell in order to pay their bills. So a downward spiral seems to be developing:

• US natural gas prices (purple) have dropped to the equivalent of $30/bbl
• Power stations thus continue to prioritise gas over fuel oil
• This puts pressure on WTI (green), which remains $20/bbl below Brent
• In turn, Western Canada Select (blue), is under real pressure at $60/bbl

And all the time, supply is rising under the influence of sustained high prices. US output is now at 7mbd, the highest level since 1993.

Only Brent (red) is now uniquely strong at $110/bbl, due to its key role in Russian finances as the price-setting mechanism for European gas and oil markets. Pre-2009, it would have been $1/bbl below WTI. With the US now in surplus, and the European economy in recession, Brent should now be trading well below WTI.

Of course, some naive analysts now argue that high capital investment costs have to be repaid, and will keep prices high. But anyone with manufacturing industry experience knows that once the capital is spent, the only cost that matters is the variable cost of production. And even that can be irrelevant if the producer needs to pay a major bill – then, the field will simply run for cash flow.

Repricing is thus now a real risk in the market. And once Brent prices begin to crack, then buyers will disappear. In turn, all the owners of oil and oil products currently being hoarded in Rotterdam and elsewhere will become distressed sellers. Already, for example, Europe is 600kt long on naphtha according to ICIS pricing reports.

There is a lot of product sitting in tanks around the world that will have to be sold in a hurry, if a panic starts. Anyone without a contingency plan to handle this scenario, now needs to develop one with extreme urgency.