By John Richardson
THE new consensus view on oil prices, based on my discussions with many delegate on the side lines of this year’s Asia Petrochemical Industry Conference (APIC) in Seoul, South Korea, seems to run roughly as follows:
- OK, most of us completely missed the H2 2014 collapse of crude, but never mind, we now know the future and the future is this: Stability of pricing in the region of $60-80 a barrel until the end of the year.
- Why? Because finally there are signs that US crude production is being cut back on lower production. An indication of this was the latest US Energy Information Administration figures on inventory levels in the States. Last week, stocks fell by 3.9 million barrels, the first decline in four months.
- Yes, global demand is clearly not there to support $100 a barrel crude anymore, but higher cost supply is, as we said, finally responding to the recent collapse in pricing. This is why we are entering a New Normal of $60-80 a barrel.
But I do worry that this involves a great deal of wishful thinking. It would be nice to believe that the turbulence of the last eight months is behind us, and that we have entered a New Normal of $60-75 a barrel, but this theory does not stand up to the kind of broader-based analysis that I think is now vital to understanding how crude markets are behaving.
To follow my argument, you have to start from understanding why oil collapsed in the first place
Far too little discussion during APIC has so far taken place about the role that the US Fed played in last year’s decline in oil. Instead, people have mainly talked about supply and demand fundamentals, with insufficient attention paid to how Fed policy has influenced financial markets.
For me, these were the major events of last year that led to the collapse in oil prices.
In chronological order, there was the growing expectation amongst paper-market speculators that US monetary policy would soon be tightened. The Fed said that quantitative easing was drawing to closer, and that interest rates would be raised sooner rather than later.This led to a strengthening of the US dollar and so a withdrawal of lots of speculative money from oil and commodity markets in general. A stronger dollar means cheaper crude.
The flight back to the dollar was then followed by the belated acceptance that China’s economy was undergoing a major, long term slow down. This was followed by a realisation that shale-oil capacity had been added in the US that was well in excess of global demand – as, of course, China drives global oil demand.
And finally came Saudi Arabia’s decision to maintain rather than cut production because of the bitter lesson that it learnt in the 1980s. Back then, it was the first of the OPEC producers to cut its output in an attempt to shore-up prices. But other members of OPEC kept pumping big volumes of oil and prices still collapsed, resulting in Saudi Arabia losing market share.
So why have prices rebounded since around mid-February?
I think this is primarily because of once again the role of speculators. Data shows that hedge funds have placed huge bets on higher Brent prices by taking out futures options worth 265 million barrels of oil – an all-time high.
What if these bets don’t pay off? I think it is essential to repeat six of the reasons I gave last week about why the hedge funds might have got the market wrong:
1. Oil producers have hedged more than 500 million barrels of Brent in order to protect against further price declines. Their ability to so do might well have been helped by the extra liquidity in futures markets provided by the hedge funds. So this means that the producers can now afford to stomach much-lower H2 prices in physical markets because they have locked-in higher prices on futures markets. This could result in oil production remaining high in the second half of this year, even if physical prices do suffer another sharp downward correction.
2. The view of the oil producers is opposite to that of the hedge funds. ExxonMobil CEO Rex Tillerson, for example, said last month there would be no quick rebound to higher prices. Exxon is the largest shale producer in the US.
3. US shale producers are expected to see their costs fall by 45% this year, and by up to 70% by the end of next year, according to the UK’s Daily Telegraph. Hess, for example, has announced it has already “driven down drilling costs by 50%, and we can see another 30% ahead.” This underlines my point that the US has huge incentives, both economic and political, to continue working very hard to reduce shale-oil production costs.
4. Oil companies in general, not just shale oil companies, are treating lower prices as an opportunity to trim costs – and thus lower their production costs. They are finding these savings in rig rates, the cost of equipment, well completions and other oil services.
5. Almost all countries can still economically produce oil at $15 a barrel, according to a new IMF and Rystard Energy Study. Only Canada/Australia with costs of $20 a barrel, Brazil at $30 a barrel and the UK at $40 a barrel needed higher prices, added the study.
6. Saudi Arabia is playing the long game in order to try and win back market share, and so is unlikely to cut production. There used to be a lot of talk of Saudi Arabia needing oil at around $90 a barrel to balance its budget. But this overlooked the fact that Saudi Arabia has plenty of foreign reserves to enable to withstand prices at much-lower levels for several years.
And I would add that you have understand the nature of shale oil technology. You can quickly turn on production as quickly as you can turn off production.So the oil that is, effect, held in storage in un-fracked rock – i.e. the “fracklog that I first discussed in March – can be quickly be brought back into production in the event of higher prices (see the above chart from this Bloomberg story). The US has thus become the world’s new “swing producer”, perhaps replacing the Saudis in this role. They will swing back into higher production as soon as prices show a significant recovery.
And further, what is done is done. Because of the low interest rates resulting from Fed monetary policy, $1.2 trillion has been invested in US shale oil and gas over the last five years alone. This debt isn’t going to go away in a hurry and so it is better for US oil producers to run hard, no matter how low crude prices fall, as a few dollars return on investment to pay back their debts are better than dollars at all.
And, anyway, as I said, shale oil is rapidly moving up the “experience curve” and so production costs will continue to fall.
In all the talk of a New Normal of prices remaining in the $60-75 a barrel range for the rest of this year, here are some other factors to consider:
- Although oil futures markets are buoyant, physical markets are much weaker and oversupplied.
- Traders see a disconnect in markets, with tens of millions of West African and North Sea barrels struggling to find buyers.
And what happens if Iran and the West complete their nuclear deal by the 30 June deadline? Even physical supply from Iran doesn’t immediately increase, what about the impact on sentiment?
There is also the Fed. Ironically, the worse growth becomes in the US, which of course impacts the demand for oil, the later the likely rise in interest rates. Disappointing Q1 growth has led to expectations that the cost of borrowing in the States might now not be increased until 2016. But eventually, unless the Fed goes for bust with a third quantitative easing programme, and thus loses all credibility, rates will have to rise. When financial markets once again become convinced that a rate rise is imminent, a resulting stronger dollar will, of course, weaken crude. So if second quarter growth in the US improves, this becomes a risk.
The bottom line for me in this highly complex, but vital-to-follow story, is this: The Fed, and also China through its stimulus programme, badly distorted oil-price discovery from 2009 until the second half of last year. But now true price discovery is returning to the market, and so the downside risks to pricing are very significant in H2.