By John Richardson
THE illusion of a strong global economy has been created by central bank stimulus – via the Fed and, much more importantly, via China.
And the illusion of a strong global economy was accompanied by the “illusion of scarcity” in crude oil, when, in fact, inventories have been high for years as new supply has been added. New supply has been brought on-stream because of the illusion of a strong global economy.
Both these illusions have been exposed by the retreat in oil prices since June.
Here is why prices have fallen.
- The correlation trade between the US dollar, the S&P 500 and oil prices has begun to unwind as the Fed ends its stimulus programme.
- A third illusion has now almost vanished – that China will “blink” by launching a huge new, old style economic stimulus package. But we worry that chemicals companies have lost valuable time in planning for a new China. This third illusion has disappeared far too late.
Signs of distress in oil are everywhere. For example:
- Crude held in storage by speculators has risen to between 25 million to 50 million barrels from virtually zero in April. The reason is that markets have been in contango for the longest sustained period since April 2009, when oil in storage rose to 70 million barrels. But on this occasion, as we said, the Fed and, most importantly, China, have changed direction.
- High quality Russian crude cargoes are being turned away from China, and are instead finding their way to California. This is the first time this has happened since the onset of the Global Financial Crisis.
As for the supply side of the equation, oil markets suffered a shock last week when Saudi Aramco cut its November Arab light selling price to Asia by $1 a barrel and 40 cents a barrel to the US and Europe.
Why the shock? Because some crude analysts had instead expected that Saudi Arabia, rather than cutting prices, would signal a firm intention to announce a production cutback at the next OPEC meeting, which takes place in November.
Here is, instead, what might really be happening:
- For Saudi Arabia, this is a geopolitical rather than an economic issue.
- They really need to close down higher cost US shale-based output and thus restore their export position to the US.
- If they remain excluded from the US market in the long term, who will look after their global political and military security?
- The Saudis have depended on the US for this security ever since the pivotal meeting between Ibn Saud and Franklin Delano Roosevelt in February 1945.
- At that meeting, the US promised long term political and military support in return for Saudi crude.
- But the shale revolution, of course, means that the US no longer needs Saudi crude – as long its higher-cost producers remain in business. Net oil imports to the US have fallen since 2007 by 8.7 million barrels a day, “roughly equivalent to total Saudi and Nigerian exports,” according to a recent Citigroup report.
- It is often argued that Saudi Arabia needs crude to be at around $90 barrels a day to meet the cost of its social programmes.
- But perhaps Saudi Arabia knows that it cannot repeat the 1981-1985 mistake of trying to stabilise the market by cutting production from 10 million barrels a day to 2 million barrels a day. All that happened was that they lost market share to their fellow OPEC members.
- And so, with vastly lower production costs than anywhere else in the world, they could continue to pump as much oil as today for market share reasons.
Even if all the above adds up, many people will argue that deep production cutbacks amongst all the higher cost producers will swiftly put a floor beneath prices.
But what if enough of these producers run harder than many people think? Isn’t it better to recover a few cents on each dollar of investment than no cents at all?
And even if this theory is wrong, surely the role of Saudi Arabia is still more important here, as it remains the world’s biggest “swing producer”?
It would be very easy to take be complacent here and stick to the “accepted wisdom” on supply.
But if recent history has taught us anything, it is that the accepted wisdom has been wrong – and that all sorts of complex social and political, as well as economic, factors have shaped the demand side of the equation.
Why not the same for supply?
We could be wrong on supply, of course, – but our essential point is this: Build one scenario for 2015 where supply remains longer than most people think.