By John Richardson
STILL don’t buy the argument of the role of central bank money in distorting the oil prices, which I made last Friday when I argued that is more of this cheap money that is behind today’s oil price rally?
Then also consider the role of currencies in all of this.
Hedge funds are obviously not interested in the underlying fundamentals of the oil market – why should they be? Their job is just to make money from fluctuations in commodity markets.
What they instead spotted back in January was that the US Federal Reserve was once again trying to push down the value of the US dollar against the Japanese yen and the Euro, just as did when the Global Financial Crisis began in 2008.
They thus rushed back into globally traded commodities, such as oil and iron ore, traded in in US dollars, as these commodities are seen as “stores of value” against a weaker dollar.
The problem is that the Fed isn’t alone in trying to push down the value of its currency. So is the Bank of Japan (BOJ). Abenomics have failed, as they were always going to do.
But instead of admitting this the BOJ is desperate to devalue the yen, which on Friday strengthened to close to an 18-month high against the Greenback.
This desperation to weaken the yen is further good news for the hedge funds, as it indicates that more BOJ stimulus could be just around the corner.
The European Central Bank (ECB) is also desperate to lower the value of the euro, and is now threatening to further reduce interest rates – which are already negative – in order to achieve this. So again, this creates the prospect of even greater quantities of cheap money with which to gamble in commodities.
It is worth noting that the volumes traded in currency and interest rate markets dwarf commodity markets. $5tn is traded every day in currencies. That isn’t a misprint – it is $5 trillion
So it only takes a small proportion needs to leak into commodity markets to destroy genuine price discovery.
What is very worrying is that world’s three major currencies – and with it three of the world’s major economies – appear to be on a collision course. I shall look at the implications of what this collision might mean for the global economy, and so, of course, the underlying demand for oil, in a later post.
More immediately, though, what does this tell you about tomorrow’s oil price?
It tells you this: It could just as easily be close to $100/bbl, as it could be $25/bbl, but it can only get to $100 because of two things – or combination of both of these two things: Geopolitical crises and more central bank stimulus.
Why? We gave gone past Peak Demand Growth for oil. This new era means that the national oil companies will continue to pump hard, rather than risk leaving oil in the ground.
OPEC has lost its ability to control crude prices because of the shift in fundamentals. Production cutbacks would thus only result in loss of market share – i.e. the NOCs would see their fear realised: They would end up being forced to permanently leave oil in the ground – un-extracted for good – because we have beyond Peak Demand Growth.
And I believe that even the listed companies – which, of course, includes the big International Oil Companies – will end up in the same market share battle. Here is why:
- They, too, would not to run the risk of leaving oil in the ground because of the impact on crude demand growth of the climate change consensus. Natural gas is also in vast oversupply, and so to some extent it is replacing oil. But most importantly of all for demand growth is the end of the economic Supercycle.
- Western governments will increasingly want to support their IOCs – and the smaller independent oil companies as well – as Western politicians will also come to realise that production cutbacks are pointless. So expect more financial incentives from Western governments to keep the spigots open as a.) This will, as I said, protect market share and b.) Will be a vital source of maintaining and creating new employment in a job-scarce world.
- No doubt, though, some analysts will pull out their cost curves and say “this doesn’t make sense”. They will also point to project cancellations of, for example, Canadian oil sands projects and deep-sea arctic projects as support for their argument that oil prices will climb back towards $100/bbl. But yesterday’s cost curves were wrong? We discovered that producers were willing to run for covering variable costs only, and that production costs – particularly US shale oil production costs – kept on falling.
- Why, therefore, should today’s conventional cost curves be any better a guide to the future than yesterday’s cost curves? Why shouldn’t acceptable rates of return and production costs continue to fall in today’s deflationary world? And as production costs keep coming down, why shouldn’t output continue to instead rise?
The key here for me is to start with the right framework of thinking. If you start with the wrong framework, you have no chance of building scenarios that help you navigate oil-market volatility.