Oil Price Recovery: Please Remember 2015

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By John Richardson

EVEN if oil prices should go down right now, based on supply and demand fundamentals, the financial players will not let that happen.

This is the view of several analysts who point to the closure of numerous short positions, in favour of opening long positions, over the last few weeks. In time-honoured tradition, some people in the financial world are thus busy via numerous news websites, newspapers and on Twitter etc. in pushing the perception that the market has finally bottomed out.

To what extent will this deafening noise prevent sensible judgement? To a large extent, of course, as has so often been the case in the past. Remember 2008 until 2014 when we were told that the natural price for oil was $100/bbl? Just think of the economic damage left over from that period and that should help you make some sound judgements over the next few weeks and months.

Sure, the independent and so very reliable International Energy Agency has said that prices might have bottomed out on reduced non-OPEC output, particularly as a result of US shale oil cutbacks. And it has added that to date, Iranian production increases are less than had been expected.

But over the longer term, nothing has really changed on the supply side.

US shale oil production will rebound if prices rise much further, thanks to technology and so production cost improvements. The rise in futures prices has also enabled US producers to lock-in profits by hedging at $45/bbl, and so, of course, if actual prices fall below these levels later this year, they can carry on pumping.

And I remain convinced that shale oil and shale gas are two of the few bright spots for the US economy. Increasing quantities of energy could be produced both for local needs, and exported, in order to generate good-quality jobs – not part time, low paid jobs in fast-food restaurants. The US government might end up offering more financial incentives to energy producers.

Saudi Arabia and Russia reaching a deal on cutting oil output, as opposed to just freezing output? This seems a great stretch to me, following recent comments by Saudi Oil Minister Ali Ibrahim Al-Naimi.

And Iranian production increases were never likely to be smooth, given the length of time that Iran has been subject to economic sanctions. But nothing has again changed here. Iran’s economic motive to pump and sell as much as oil as possible remains the same as two months ago – when the consensus was that $25/bbl or even lower might be the bottom of the market.

What also continues to worry me is that far too little attention is paid to the demand side of the story. Denial is still a problem, in the face of all the evidence confirming the end of the economic Supercycle.

But even if you buy into the Supercycle argument, you might have been temporarily deafened by another very loud noise at the moment. This is the noise being made by all the commentators who claim that China is backtracking on reforms, through renewed economic stimulus and a failure to adequately deal with corporate debt.

From this you can reach the conclusion that China’s oil demand growth will return to “Old Normal” levels over the next few months – perhaps for an even longer period- as the day of eventual economic reckoning is delayed by Beijing.

I don’t buy this because, as I argued last Friday, temporary “sticking plaster” measures that attempt to ease the pain of reform should not be confused with a change in overall direction.

Equally, look at the data that continues to emerge from China. Take as an important example Sunday’s announcement that the country’s industrial production in January and February had grown at its slowest pace since December 2008, when the Global Financial Crisis was in full swing. This type of data point tells us two things.

Firstly, it tells us that the Chinese economy is still in “post stimulus”.  By this phrase, I mean that the availability of new credit  is nowhere close to the levels of 2008-2013 – and this remains the most important measure. An investment bubble can only be prevented from bursting if you pump ever-more quantities of air into the bubble.

And secondly, the fall in China’s industrial production underlines the reality of the end of the economic Supercycle. China is of course a major exporter, and so lower production points to lower export sales – as was obviously also the case with the 25% fall in China’scFebruary exports.

Just about everyone will keep telling you that “forecasting oil prices is a mug’s game”, which is sometimes quite a handy excuse when you have given some very misleading advice over the last few years.

There is, though, some wisdom in this phrase. But there is no wisdom in a “one track” approach, where you build your one and only businesses plan around a conviction that oil prices have indeed reached their long term bottom.

Instead, you must consider that this year might see a repeat of 2015. Remember how from February of last year onwards, we were told how prices could only go higher, only for the opposite to happen in Q4? (See the chart at the beginning of this post).

In this world of great volatility in energy prices, where all the old assumptions no longer apply, here are our three scenarios:

$25/bbl oil = Collapsing demand. Emerging markets submerge, and developed markets slow dramatically as stimulus-created debt has to be repaid.

•$50/bbl oil = Comfortable middle. Stimulus policies prove to have worked, demand recovers, project cancellations and revived growth prospects create a balanced market.

•$100/bbl oil = Continuing tension. Further central bank stimulus takes place as economic recovery stalls, and geopolitical risks rise, along with the potential for supply disruptions.

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