Be Very Careful Of the $60-70 Oil “New Normal”

oilldebt3March

By John Richardson

THERE is an argument being made that the recent stability in oil prices will continue as crude enters a “New Normal” of $60-70 a barrel.

This type of thinking seems to have had an effect on petrochemicals markets – for example, in the key China polyethylene (PE) market.

“Our customers in China bought more than we expected before the Lunar New Year because they had expected oil to fall to $30 a barrel, but they instead saw crude recover to $60 a barrel,” said a source with a global PE producer.

I suspect that this must have happened elsewhere in other petrochemicals markets as end-users have bought “ahead of demand”. This has involved them buying their raw materials today instead of tomorrow because they believed that oil prices  had, indeed, stabilised and might creep even higher. More expensive oil translates, of course, into more expensive petrochemicals.

But please be very careful out there, for reasons including the following:

  • Oil traders seized on the headline fall on the rig count number, along with stronger-than-expected demand  because of cold weather in the US, in order to justify their long positions. Their bets paid off as prices surged on the back of this misleading rig count story, despite the continued rise in both production and US oil inventories.
  • Further upward momentum was provided by the launch of the EU’s quantitative easing programme. This has boosted stock markets and helped stabilise crude  prices, according to fellow blogger Paul Hodges.

Up until 20 February, US crude stockpiles had increased by 8.43 million barrels to 434.1 million barrels, the highest since for any week 1982, according to the US Energy Information Administration (EIA).

The nation’s output had also risen to 9.29 million barrels a day for the week ending 20 February, the highest weekly level since 1983, added the EIA.

“A brutal winter in the US northeast has briefly boosted demand,” Bank of America wrote in a research note released yesterday.

But they added that as winter fades, and as real supply levels become more apparent to the market, oil prices could fall to as low as $32 a barrel.

This view is well worth taking into account, as is this argument from the investment analysis service, Seeking Alpha:

  • Even with high inventory levels, robust production from oil and gas companies is likely to continue.
  • The reason is that oil and gas companies with high leverage need to sustain or increase production in order to service debt.

This is line with my argument from last October, when I wrote:

Why shut down when you are still earning some money, even if it isn’t much? You will still have to pay your debt back if you are not running, and, of course, if you are not running, you will have NO revenue.

The above chart, from the same Seeking Alpha article and which is based on Bank for International Settlements data, shows the alarming rise in both oil and gas company debt globally since 2006.

And as I also argued last October, if shale oil or other higher-cost producers do eventually go bust their debts could be written off as they are acquired by private equity companies. In such circumstances, the new owners would then only have to cover variable costs of production.

Crucially, also, demand is the thing as “bad deflation” dominates the global economy. There is no reason, in terms of demand, for oil prices to go any higher this year and every reason to build into your scenario planning the possibility for a significant price decline.

, ,