“Within 20 years, we will be an economy or state that doesn’t depend mainly on oil“.
This critical statement from Saudi Arabia’s deputy Crown Prince has been lost in the hype surrounding Q1′s hedge fund-inspired rally in oil, commodities and Emerging Markets. There has seldom been a better example of markets failing to see the bigger picture by remaining focused on day-to-day detail.
But Q2 is likely to see attention return to the fundamentals of oil market supply and demand. This week’s commodities market data showed the hedge funds were already starting to take their bets off the table. This is hardly surprising, with prices having jumped 50% in a matter of weeks:
- Iran is successfully re-entering the market, with its exports to India already up 4-fold since January to 500kbbl/day, and other Asian countries also keen to buy
- US storage operators are resorting to ever-more desperate manoeuvres to stop their tanks from over-flowing
As I warned last month, the rally had nothing to do with a rebalancing of oil markets – either via major cuts in production, or a sudden increase in demand. Instead, it was all about the funds betting, correctly, that further stimulus was on the way from the central banks. As the Financial Times noted:
- By the end of March, the funds had built a record long position of 579m bbls in Brent/WTI
- This was equivalent to almost 6 days of global demand
But last week, they began to take their profits and close their positions. Chemical markets thus face major challenges:
- Prices for the major petrochemicals are highly correlated to crude oil prices – most are more than 95% correlated
- So sales managers are already busy raising their prices to try and maintain their margins
- Purchasing managers are meanwhile building inventory to protect their own margins
And they are not alone. The Q1 rally spread across the commodity sector, and led to major bond and share price rises for commodity exporters and Emerging Markets. But none of the move was real. It was simply the hedge funds spotting a short-term opportunity for profit, based on the realisation that another central bank panic was on the way.
So now, as one would expect, the smart funds are not hanging round to see what happens next. Of course, US oil inventories will reduce as we head into the main driving season. But fundamentals didn’t drive the rally, and the funds know all-too-well that sudden rallies can disappear as quickly as they appeared.
Attention is thus likely to turn to last week’s 5 hour Bloomberg interview with the deputy Crown Prince of Saudi Arabia. It confirmed, as I have argued for the past 18 months, that Saudi is focused on making plans for the post-oil world and highlighted, for example:
“His obsession with moving the Saudi economy away from oil…Aramco’s new strategy will transform it from an oil and gas company to an energy/industrial company”.
Companies and investors have to follow market trends, as they cannot afford to be on the wrong side of 50% rallies. But they also have to recognise that the biggest rallies always occur in bear markets. Oil’s next move may well be another 50% decline, and as I warned last month:
” If prices collapse again as the hedge funds take their profits, companies will face the risk of bankruptcy as we head into Q3. They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory”.
Last year’s ‘Chart of the Year’ was headlined “China’s auto sales bubble begins to burst“. Few would disagree with this view today. Similarly, there is little doubt about 2015′s Chart of the Year. It has been the focus of industry and analyst attention all year:
- Those who believed that argument that the world faces an energy supply glut have used it to argue that WTI oil and US natural gas prices were now realigning again
- Those who decided to invest $150bn of petrochemical industry capital in new gas-based production, or $1.2tn of their investors’ money in new US energy production, have watched with mounting horror
It shows WTI prices divided by 6 (blue line) to equate to oil’s energy equivalent value versus natural gas (red). And it highlights oil’s roller-coaster ride since 2009. Contrary to all logic, oil prices surged from 2009 – 2013, ending far about their relative value versus natgas:
- But since 2009, there has never been any risk of a shortage of oil, despite the constant analyst forecasts that this was “just around the corner”
- The higher prices were instead due to financial players seeking a ‘store of value‘ for US$-based assets, in response to their belief that the US Federal Reserve’s easy money policy would devalue the US$
- Even China’s stimulus policy failed to create shortages, although it supported the wishful thinking that oil demand was set for long-term increase
But then reality began to return, as the Great Unwinding of stimulus policy began to have its effect from August 2014.
In a perfect world, prices would have simply returned very quickly to their natural level in relation to natural gas. But as I warned a year ago, it has been a very bumpy road:
- The problem is that central banks have been destroying markets’ primary role – of price discovery – for 15 years: first with the subprime bubble, and then with Quantitative Easing
- And so anyone who began work within the past 15 years, has only known a world where market forces could be overwhelmed by central bank stimulus.
This is why the chart of WTI prices versus US natgas prices is so important. It reminds us there is is a real world out there, where consumers will not continue to pay more for oil than its relative energy value. And the oil price downturn since August 2014 also reminds us a new era is likely dawning in energy supply itself.
US WTI prices were only decontrolled in 1981 under President Reagan, having previously been set by the Texas Railroad Commission (whose system of “prorating” provided the basis for OPEC’s operation). Now it seems OPEC’s role is following the Railroad Commission into history. Saudi Arabia and the GCC countries have recognised this for some time – and it will likely become more apparent to others in 2016 as we move into the New Normal world.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 65%
Naphtha Europe, down 55%. “OPEC’s new Oil Product Outlook suggests naphtha with be the fastest growing oil product with an average growth of 1.3% per year between 2014 and 2040”
Benzene Europe, down 58%. “The key global development for benzene supply is the new capacity coming online in both India and the Middle East”
PTA China, down 44%. “Chinese demand for polyester end-products and PTA is likely to remain bearish.”
HDPE US export, down 37%. “Ample supplies with little trading activity”
¥:$, down 18%
S&P 500 stock market index, up 5
Did your company or investment manager use $50/bbl as a forecast Scenario price for oil this year? If not, why not? And has this question even been asked, as you finalise forecasts for 2016?
In recent months, many readers have told me despairingly of their efforts to suggest alternative Scenarios to last year’s “consensus” view that prices would always be $100/bbl. They are even more despairing today, when they see the forecast for the next few years – which almost always suggests prices will now rise steadily.
My suggestion is that you ask your company to evaluate the success of its forecasts over the past 5 – 10 years:
- Did it simply adopt the consensus view of $70/bbl in 2007, when budgeting for 2008?
- Did it include a Scenario based on the potential for a major financial crisis in 2008 and a price collapse?
- More recently, did it forecast last year’s collapse from $100/bbl?
- And did it foresee the potential for a major slowdown in China to impact the global economy?
If not, why not? And, even more importantly, what is it doing to improve the track record for the future?
The problem is that very few companies do this type of routine evaluation. Yet engineers routinely monitor whether projects are “on time, on budget”; manufacturing teams monitor product quality and safety records; customer services monitor whether deliveries are “on time, in full”. They know there can be no improvement without measurement.
Obviously, I do have a stake in this debate. As readers will know, I routinely post a review of the previous year’s Budget Outlook before issuing the new one. I also routinely publish the full record of Budget Outlooks since 2007, and the full record of my New Year Outlooks since 2008.
This should be basic practice for everyone. Past performance may not ensure success in the future, but it is the best guide that we have. This discipline was certainly one reason why I was able to successfully forecast here, in the blog:
- 2007-8′s final upward rush and subsequent collapse in oil prices, as well as the potential for a major financial crisis – as highlighted in ICIS Chemical Business in November 2008
- Plus, of course, I have argued since August 2014 that a Great Unwinding of policymaker stimulus is underway due to China’s adoption of its New Normal policies, and that oil prices would collapse to $50/bbl
My point is simply that it is nonsense for others to say “nobody could have forecast these developments”. And the world cannot progress unless we apply the basic principles of measurement to such important areas.
One particular piece of current nonsense is summarised in the above chart. This is the myth that the decline in the number of drilling rigs will have a major impact on US oil production. As we reported in last month’s pH Report:
“The story has everything that is required in the era of Twitter and sound-bites: it sounds logical, is easy to grasp, and needs no follow-up.
“The only problem is that it ignores the fact that oil rig productivity, like that of gas rigs, doesn’t stand still, as we discussed back in May. The number of gas rigs has fallen from 1600 in 2008 to 200 today according to Baker Hughes (BH) data, yet US Energy Information Administration’s (EIA) data shows total US gas output has risen by a third from 1.8Tcf to 2.5Tcf over the period. Gas rig productivity has thus risen 11-fold, and still seems to be on an upward path. Oil rig productivity appears to be following the same pattern.
“As the chart shows (using BH oil rig count data and EIA oil output data), oil rig productivity has already risen 4-fold over the past 4 years, with no doubt more to come.
“The key is the adoption of new drilling techniques, imported from deep water operations. It would be horrendously expensive to keep drilling new wells in 1000 metres of water. Instead, companies developed the new technique of horizontal drilling which can increase production by up to 20x compared to traditional horizontal drilling. Three quarters of US rigs now drill horizontally, compared to only one quarter in 2007.”
This type of analysis is not rocket science. It only needs access to the internet and a calculator. Yet last Wednesday, a leading hedge fund told Reuters they were mystified by the rise in oil rig production:
“The part of the report that continues to amaze is the domestic production number, which showed a small rise, despite the ever-plunging rig count” .
Please, send a copy of this post to your CEO and senior management, and ask them to review its argument. It is, after all, your salary and career prospects that are affected when myths and opinion are mistaken for analysis.
Simple stories aren’t always true. That’s certainly the case with the fiction that the fall in the number of US oil drilling rigs will soon reduce US oil production.
Exxon Mobil CEO Rex Tillerson recently reminded us of this critical point:
“Clearly a significant decline in rig activity did not diminish the continued growth of natural gas capacity even in a very difficult price environment. Is that analogous to the tight oil? I think that’s what we’re all going to learn.”
Latest data from the US Energy Information Agency confirms his comment, as the chart above shows from the vast Marcellus gas field:
- The number of drilling rigs has almost halved since 2012 to around 80 rigs today (black line)
- Over the same period, actual gas production has nearly trebled to 8.1 tcf/day (blue)
This, of course, is the long-term history of oil and gas production since oil was discovered 150 years ago. Periodically, prices move higher, encouraging capacity expansions – and luring in investors who believe they see an opportunity to earn risk-free profits. But then the new production comes online, flooding the market, and prices collapse again.
We have seen this cycle in action for US natural gas prices over the past few years:
- Lack of drilling activity and Hurricane Katrina caused prices to temporarily spike above $13/MMBtu in 2005
- They then had another jump back to $13/MMBtu in mid-2008, as oil rushed to its $147/bbl peak
- This convinced investors that prices could “never” fall below $8/MMBtu or, at “worst” $6/MMBtu
- Since then, the only direction has been down: gas production has climbed every year since 2011, causing prices to fall today close to $2/MMBtu
And all the time, of course, technological improvement and cost-cutting is further pressuring prices. Current breakeven production prices in parts of the Marcellus field are just $0.38c/MMBtu. Producers in nearly Utica field can even sell at a cash-loss, because of demand for ethane and other natural gas liquids.
Of course, there are powerful forces in the oil trading market that can always take prices higher temporarily. But their actions are eventually self-defeating:
- Today’s higher prices are giving US and other producers the opportunity to hedge their H2 output at highly profitable prices on a cash-cost basis
- At the same time, producers are busy cutting costs as fast as they can – following the example of their colleagues in gas production
In addition, and sometimes forgotten in the shale bubble drama, the US actually has 3-way competition in its energy markets. Coal is also a major supplier. And so natural gas prices need to remain below $3/MMBtu in order to compete with coal supplies.
In turn, therefore, oil prices will soon probably need to trade around their relative energy value to gas, currently $20/bbl, if all the new oil output is to find a home.
The Great Unwinding of the central banks stimulus policies is underway, as discussed last week. Oil markets have been one of the first to feel the change, as the chart shows, with prices finally falling out of the ‘triangle’ shape built up since 2008. The value of the US$, interest rates and the S&P 500 will also be impacted as the Unwinding continues.
The ‘triangle shape’ is one of the most interesting ’technical’ shapes. It monitors the balance of power between the bulls (seeking to push prices higher) and the bears (trying to take them lower). And the oil triangle since 2008 has been particularly interesting as in reality it has monitored the balance between:
- The financial players, trading electronically on the futures markets second by second
- The physical players, actually using the product for transport, heating and other ‘real’ purposes
Essentially what has happened is that the market long-ago stopped being based on supply/demand fundamentals. Instead it became driven by financial players. In hindsight, we can see there were two stages to this development:
Stage 1, 2005 – 2008
- Investment banks had made easy gains from 2005 onwards, by buying large volumes of futures contracts
- Prices then collapsed back to the historical $30/bbl level at the end of 2008
Stage 2, 2009 – 2014
One set of statistics highlights the change that took place (data from ThomsonReuters):
- 2005: Just 920,636 contracts were traded in the US WTI futures market
- 2008: There were 21,485,557 contracts traded
- 2011: There were 41,943,006 contracts traded
Futures markets had originally been created to allow producers and consumers to hedge positions. The blog helped to develop the contract in its early days when working for ICI in Houston, Texas. It still believe they have a valid purpose.
But as the blog noted as long ago as July 2010, the financial players’ strategy have reversed the normal working of the markets. They have created a contango structure, where prices for future delivery are higher than today’s.
This is the opposite of the traditional role, where producers hedge their positions and create backwardation – making today’s price higher than tomorrow’s.
FINANCIAL PLAYERS CAME TO DOMINATE OIL MARKETS
Thus oil markets have thus lost their price discovery role since 2005, and have instead been swamped by financial players.
- In 2005, world oil production was 82 million bbls/day of crude: WTI hedging was less than 1 million bbls/day
- By 2011, world oil production was still only 84 million bbls/day: but WTI hedging was now half of the total
History shows that the global economy cannot support oil prices being more than 2.5% of GDP. But since 2009 they have taken 5% of GDP, due to the actions of the financial players. The gap has been bridged by the central banks, creating $35tn (50% of global GDP) of new money on a low-cost basis over the period.
Naturally, prices soared as all this new financial demand appeared. The reason is simple: it takes only a microsecond to create a trade on a futures market, but it takes at least 5 – 10 years to find new oilfields and bring them into production.
Speculators thus began to dominate the market, creating a completely artificial balance between supply and demand – based on financial flows instead of product flows.
THE GREAT UNWINDING OF STIMULUS IS NOW UNDERWAY
But now the central banks are starting to pull back. Logic says you can’t go on printing money forever – in the end, you have to start paying it back, or defaulting.
China was the first to do this last year under the new leadership. Thus Reuters reports its implied oil demand was down 6% in July. Now, the International Energy Agency has reported in its latest Report that:
“Oil supplies were ample, and the Atlantic market was even reported to be facing a glut”
Thus the oil price is finally starting to fall out of its triangle:
- 10 years of historically high prices has led to major new investment, which is finally starting to come online – not only in oil, but also in gas and other energy sources
- At the same time, central bank lending is finally starting to reduce in China and the US
- 10 years of high prices have also led to demand destruction via greater efficiency and conservation efforts
- The result, as the IEA note, is that we suddenly find we face a supply glut as
So the chart is telling us that the financial players are now retreating from the market. In turn, this means physical supply/demand levels will come to drive the process of price discovery once again.
MAJOR OIL PRICE VOLATILITY IS NOW LIKELY
How low will prices go? We can have no idea, as prices have never been this high for so long. Nor can we rule out a further massive stimulus effort by the central banks at some point. But ‘technical trading’ logic would suggest they will fall to at least the 200-day exponential moving average, currently around $70/bbl, and probably lower (red line).
Equally, if price discovery does start to become based on real supply/demand balances again, we will have to watch out for geopolitical issues.
Ironically, there was never a single moment when supplies were interupted whilst prices were high. It was all hype, as the blog described at the time. But today there are real concerns developing on the supply side.
Will Russia cut Europe’s gas supply through the Ukraine in the winter, for example? That could easily push oil prices much higher, as users panicked and tried to substitute oil for gas.
Companies need to urgently prepare for major and unprecedented volatility in energy markets, as the Great Unwinding continues.
Slowly but surely the myths over supposed supply shortages in the crude oil market are being exposed. As leading US investment magazine Barron’s wrote this week:
“In May, U.S. production hit its highest monthly average level since 1988 and is projected to keep rising. Domestic supplies have piled up in storage, especially on the Gulf Coast, and market watchers think supplies could get perilously high this fall when refineries traditionally shut down units for seasonal maintenance….
“A pipeline linking Cushing to Gulf Coast refineries has relieved a glut of oil at the hub, shrinking stockpiles there to the lowest level in six years, but analysts say supplies could start building again this fall. New pipelines bringing oil from Canada and the Northern U.S. to Cushing are expected to open in late summer or early fall.”
Supplies “perilously high”. “A glut of oil”. This is the reality after 3 years of record high annual oil prices.
It is also the background to last week’s decision by the US Administration to approve condensate exports. In turn, this is a likely game-changer for global oil markets and long-suffering petchem producers. They probably mark the first step in a return to a more normal relationship between oil and gas prices:
- Oil has 6x the energy content of natural gas, and its logistics are more flexible
- So it has normally sold for around 9 times natural gas levels, as the chart shows
- Currently it sells at a massive premium to this of around 25 times gas prices
- This is only due to the influence of pension funds and hedge funds, who bid up prices in response to the Fed’s money-printing, as they raced to find a ‘store of value’
But there has never been any reason for this premium in terms of supply/demand balances. Quite the opposite, in fact. Not only have there been no supply disruptions in the past 5 years to justify the premium. But supply has grown to such an extent in the US that it is close to running out of storage.
Thus we may well be getting close to the end-game of this particular story.
2 events suggest that the world may be about to return to a more normal relationship between oil and gas. The first is that oil trading has slowed almost to a stop:
- Oil traders have made desperate efforts to push up oil prices in response to the terrible events in Iraq
- They have been in danger of losing their bonuses, as volatility has almost disappeared
- Early in June, a whole week passed with just a 30c/bbl range in daily closing prices
- But now their push to the upside appears to have failed, as Iraq’s exports are clearly not reduced by the fighting
- As a result, we can expect their next push to be downwards, to pressure prices as summer driving season ends
The second event is the US decision to allow exports of condensate (a light form of naphtha) in order to keep supplies under control:
The key issue is that US demand is not recovering, as the blog has noted with shale gas developments. So the US administration had to allow condensate exports to take place, as there will soon be nowhere to store all the new oil production. As Reuters noted at the weekend:
“The U.S. oil boom has created a glut of light oil and condensate that Gulf Coast refineries, largely built to run heavy crudes, have been unable to fully absorb.”
The world “glut” is important. US propane is already heading in increasing quantities to China and elsewhere to boost propylene production. Now large quantities of US condensate will be also heading into export markets. This is very good news for those European and Asian crackers that have been under pressure from low-cost US ethane. They will soon have US condensate suppliers lining up to supply them with cheaper product.
In turn, this will likely prove the first step towards returning oil prices to their normal relationship to natural gas. Unless geo-political events intervene, today’s weakening demand growth combined with growing energy surpluses in the US and elsewhere can lead to only one possible outcome.