Oil markets can’t quite make up their mind as to what they want to do, as the chart confirms. The are trapped in a major ‘flag shape’.
Every time they want to move sharply lower, the bulls jump in to buy on hopes of a major US-China trade deal and a strong economy. But when they want to make new highs, the bears start selling again.
Its been a long journey for the flag, stretching back to the pre-Crisis peaks at nearly $150/bbl in the summer of 2008. And the bottom of the flag was made back in 2016, after the last collapse from 2014 $115/bbl peak.
Recent weeks have seen the bulls jump back in, when prices again threatened to break the flag’s floor below $60/bbl. And, of course, OPEC keeps making noises about further output cuts in an effort to talk prices higher.
But as the charts from the International Energy Agency’s latest monthly report confirm:
“The OPEC+ countries face a major challenge in 2020 as demand for their crude is expected to fall sharply.”
This is OPEC’s problem when it aims for higher prices than the market will bear. Other producers, inside and outside OPEC, always take advantage of the opportunity to sell more volume. And once they have spent the capital on drilling new wells, the only factor holding them back is the actual production cost.
Capital-intensive industries like oil have always had this problem. They raise capital from investors when prices are high – but high prices naturally choke off demand growth, and so the new wells come on stream just when the market is falling. Next year the IEA suggests will see 2.3mbd of new volume come on stream from the US, Canada, Brazil, Norway and Guyana as a result.
OPEC’s high prices have already impacted demand, as the IEA notes:
“Sluggish refinery activity in the first three quarters has caused crude oil demand to fall in 2019 for the first time since 2009.”
OPEC has had a bit of a free pass until recently, though, in respect of the new volumes from the USA. As the chart shows, the shale drilling programme led to a major volume of “drilled but uncompleted wells”. In other words, producers drilled lots of wells, but the pipelines weren’t in place to then take the new oil to potential markets.
But now the situation is changing, particularly in the prolific Permian basin region, as Argus report:
“The Permian basin has been a juggernaut for US producers, with output quadrupling from under 1mbd in 2010 to more than 4.5mbd in October. US midstream developers have responded with a wave of new long-haul pipelines to shuttle the torrent of supply to Houston, Corpus Christi and beyond.
“The 670kbd Cactus 2 and the 400kbd Epic line went into service in August moving Permian crude to the Corpus Christi area. Phillips 66’s 900kbd Gray Oak pipeline is expected to enter service this month, moving Permian basin crude to Corpus Christi, Texas, for export.”
As a result, some of that oil trapped in drilled but uncompleted wells is starting to come to market. So if OPEC wants to keep prices high, it will either have to cut output further, or hope that the world economy starts to pick up.
But the news on the economic front is not good, as everyone outside the financial world knows. Central banks are still busy pumping out $bns to keep stock markets moving higher. But in the real world outside Wall Street, high oil prices, trade wars, Brexit uncertainty and many other factors are making recession almost a certainty.
As the chart shows, there is a high correlation between the level of oil prices and global GDP growth. Once oil takes ~3% of GDP, consumers start to cut back on other purchases. They have to drive to work and keep their homes warm in winter. And with inflation weak, their incomes aren’t rising to pay the extra costs.
The US sums up the general weakness. The impact of President Trump’s tax cuts has long disappeared. And now concerns are refocusing on the debt that it has left behind. As the function of debt is to bring forward demand from the future, growth must now reduce. US GDP growth was just 1.9% in Q3, and the latest Q4 forecast from the Atlanta Fed is just 0.3% .
Its still too early to forecast which way prices will go, when they finally break out of the flag shape. But their failure to break upwards in the summer, when the bulls were confidently forecasting war with Iran, suggests the balance of risks is now tilting to the downside.
Back in 2015, veteran Saudi Oil Minister Ali Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:
“Saudi Arabia cut output in 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. We learned from that mistake.”
As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4. But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand. And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:
“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”
Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.
Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:
- Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
- But its short-term need is to support prices by cutting production, in order to fund its spending priorities
The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past. It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.
The reason is that high oil prices reduce discretionary spending. Consumers have to drive to work and keep their homes warm (and cool in the summer). So if oil prices are high, they have to cut back in other areas, slowing the economy.
CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014
There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.
They were creating tens of $tns of free cash to support consumer spending. But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report. It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:
“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.”
SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS
Oil prices are therefore now on a roller-coaster ride:
- Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
- The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December
Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd). But as always, its “allies” have let it down. So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.
Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:
Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds. As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.
But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.
Companies and investors therefore need to be very cautious. Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.
Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.
*Total cost is number of barrels used multiplied by their cost
We are living in a strange world. As in 2007 – 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.
It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.
Last year, for example, it was reasonable to use $50/bbl as a Base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:
- On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid up-front, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018
- On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have over-extended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl
Unfortunately, oil price volatility is not the only risk facing us in 2018. As the chart shows, the potential for a debt crisis triggered by rising interest rates cannot be ignored, given that the current $34tn total of central bank debt is approaching half of global GDP. Most media attention has been on the US Federal Reserve, which is finally moving to raise rates and “normalise” monetary policy. But the real action has been taking place in the emerging markets. 10-year benchmark bond rates have risen by a third in China over the past year to 4%, whilst rates are now at 6% in India, 7.5% in Russia and 10% in Brazil.
An “inflation surprise” could well prove the catalyst for such a reappraisal of market fundamentals. In the past, I have argued that deflation is the likely default outcome for the global economy, given its long-term demographic and demand deficits. But markets tend not to move in straight lines, and 2018 may well bring a temporary inflation spike, as China’s President Xi has clearly decided to tackle the country’s endemic pollution early in his second term. He has already shutdown thousands of polluting companies in many key industries such as steel, metal smelting, cement and coke.
His roadmap is the landmark ‘China 2030’ joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition: “From policies that served it so well in the past to ones that address the very different challenges of a very different future”.
But, of course, transitions can be a dangerous time, as China’s central bank chief, Zhou Xiaochuan, highlighted at the 5-yearly Party Congress in October, when warning that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008 in the west.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t face a need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. Nobody wanted to be focusing on contingency plans when everybody else seemed to be laughing all the way to the bank.
I discuss these issues in more detail in my annual Outlook for 2018. Please click here to download this, and click here to watch the video interview with ICB deputy editor, Will Beacham.
The post The return of volatility is the key market risk for 2018 appeared first on Chemicals & The Economy.
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.
“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.
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.