CONFUSED? You will remain confused by oil markets as long as you continue to only look at physical supply and demand.
Here is my long, but I think essential, historical explanation about why I think this is the root of today’s forecasting problems. And I also make no apologies for going over all ground because I worry that my arguments are not sinking in, as far too many analysts are still firmly welded to the idea that staring at spreadsheets of physical supply and demand estimates will provide all the answers.
From late 2008 until the second half of last year, the price of oil was mainly in the region of $100 a barrel only because it was in the interests of the banks, other speculators and the pension funds to keep it there. The banks and the other speculators pushed the “commodities supercyle” myth very hard because, thanks to the Fed, they had huge amounts of cheap capital that encouraged them to go almost constantly long in crude. Meanwhile, the pension funds simply had to jump on the bandwagon because the low interest rates made the yield on other investments far-too low.
They were, of course, occasional dips in the market, but as Fed liquidity had remained ample since 2008, with the constant promise of more money printing if the real economy showed further weakness, it always made sense to buy on these dips. And as a result of this flood of speculative investment in oil markets, the dips and the rises nearly always occurred around the $100 a barrel mark.
But from September 2014, it became apparent to everyone that too much supply was chasing too little demand, largely as a result of the belated recognition that China was slowing down. Supply had become very long because of again all that cheap Fed money pouring into overinvestment in US shale oil. Next came the Saudi Arabian decision to chase market share rather than cut production to bolster prices. So we ended up with a collapse in pricing.
This was followed by the early February until late June recovery. This was again based on speculators going long. On this occasion, though, the commodities supercycle myth had bitten the dust. So the financial world needed new bogus stories to justify the rally. One argument was that US shale oil production would soon collapse. We were also told that the Saudis would also soon scrap their market share approach because they were running out of money. This would result in a big cut in OPEC production.
Prices then collapsed again when it became obvious to everyone that a.) US production was a lot more resilient than had been thought, b.) Global inventory levels remained at record highs, c.) China’s economy was rapidly deteriorating and d.) Saudi Arabia would not change policy, as it simply could not afford to do so. Another bearish factor was the prospect of new Iranian supply hitting the market from early next year.
Just as was the case in H2 last year, the evidence of oversupply was so overwhelming that the financial world was unable to drown out all this bearish news; and, anyway, they had no motive to do so because it looked as if the Fed might raise interest rates in September. This would have heralded the start of the end of the era of incredibly cheap and ample financing.
Back to the future: Over the last few weeks we have seen prices rally again, which has been justified by very selective analysis of US production data. In reality, though, global inventory levels have remained at record highs.
But this renewed rally was first of all driven by the Fed’s decision not to raise rates in September. Since then the notion has grown that the Fed will delay its rate rise until next year. There are also constant whispers of a fourth round of quantitative easing (QE4), which would of course mean lots more cheap credit.
The irony here is that the potential delay in a US rate rise, and hopes for QE4, are because the real economy has worsened again – meaning lower demand growth for crude oil. For example, there is talk that the Fed might have to push its rate hike into 2016 because of the disappointing latest US jobs report.
But real supply and demand once again reasserted itself yesterday after OPEC announced that its September production was at its highest level for more than three years. So prices have retreated again.
Still confused? The only way to sort out this muddle is if you accept the role of financial markets in crude-oil prices, both in the short and long term, which is why these three scenarios for oil prices still make perfect sense:
- No more major Western central bank stimulus and you are looking at prices returning to their long term average of around $30 a barrel.
- More major Fed etc. stimulus and we could be back to $100 a barrel.
- Or around $50 a barrel in a world of perhaps some stimulus, but still weak underlying demand.
However painful in the short term, my preferred scenario is No1 as this would avoid a further build- up in global bad debts, overcapacity in general across all industries, and so deflationary pressure. The longer we delay the reckoning, the more difficult the eventual reckoning.