Beware Of Oil-Price Rally: Nothing To Do With Fundamentals

Economics, Europe, Naphtha & other feedstocks, Oil & Gas, US

USoilinventorylevels

By John Richardson

PEOPLE are once again at risk of dangerously over-exposing themselves to a further collapse in oil prices following yesterday’s increase to the highest levels since November 2015. The obvious risk  is that there will be stock building up and down all the petrochemicals values chains, only for oil to once again decline in Q3 or the underlying fundamentals.

Here are a few critical points that you must take into account in your scenario planning.

One of the increasingly widely-held assumptions is that the producers’ meeting in Doha on Sunday about a possible production freeze could be the prelude to an eventual production cut. That is at least an admission that a freeze by itself won’t be enough, given current record-high levels of output.

We have to consider how likely it is that a cut will occur.  I for one  don’t see it happening..

Why? Because Iran is easing itself back into the global market in a much bigger way and its long term aim is to win back market share to make up for the economic ground lost as a result of sanctions.

We should also listen to Daniel Yergin, author of course of The Prize, the book that everyone with an interest in oil and energy should read.

Yergin told the FT:

The era of Opec as a decisive force in the world economy is over. It is clearly a very divided organisation.

I remember when the operating code was: save the oil for our grandchildren. Now the grandchildren are in charge and they are looking at it in a very different way.

They are not looking at it as precious resource . . . but rather asking how do you monetise it?

Hear, hear. One of the underlying messages of Yergin’s book is that it is not only the cost of production that ultimately counts in oil markets, but it is the social and political factors that drive the industry.

So I remain convinced that Saudi Arabia -, as of course the world’s biggest producer – doesn’t want to risk leaving its most valuable asset in the ground because we have gone beyond the point of peak oil demand growth.

A fascinating Bloomberg interview with Saudi Deputy Crown Prince Mohammed bin Salman is further essential reading on this point. Prince Mohammed talks extensively about adding greater downstream value as the Kingdom attempts to move into a post-oil economy.

The approach is thus to pump as much oil as possible in the short term, in order to, as I said, not leave this vital assets in the ground, whilst using today’s low prices as a means of pushing the Kingdom more aggressively away from overdependence on crude exports.

Back in October 2014, I also made the point that US shale oil producers, if they went bust, would not stop operating. This Reuters article confirms what I suspected – that producers in chapter 11 have every motive to carry on pumping crude.

I have also flagged up the steep fall in shale-oil production costs, which Reuters again underlines when it writes in the same article on chapter 11:

With operating expenses for existing US shale wells between $17 and $23 per barrel, most companies can keep pumping unless oil falls below $20 per barrel, says David Zusman, chief investment officer of Talara Capital Management.

And again you have to consider the social and political factors here. Following the lifting of the US ban on exporting crude, the US has a great opportunity to take more advantage of one of the few genuine bright spots in its economy. This will very likely involve maximising these exports to create jobs.

Sure, today’s rally might have more legs, but please be aware of all the above important context and accept this:

That this rally is not about fundamentals, but is instead another great example of “after the fact” story telling. Prices have gone up mainly because hedge funds have gone long, rather than short, in oil. And they have gone long because they expect oceans of more cheap money with which to gamble in equities, oil and commodities in general.

These extra oceans are expected to be available due to more European Central Bank and Bank of Japan economic stimulus and the indications that the US Federal Reserve has become lukewarm on further interest rate rises. People have, after the event, sought a rational in physical markets for what is mainly a rally built on the behaviour of financial markets.

The risk is therefore of another sudden retreat in crude that takes the petrochemicals business off guard. Possible triggers for this?

  • Well, first of all, just look at US crude inventory levels in my above chart. They remain at their highest levels since 1982. When people start staring at these types of charts again, this could severely dent today’s positive sentiment.
  • A disappointing Doha meeting this Sunday.
  • The end of the US driving season after the 4  July holiday.
  • Q3 demand is always seasonally weak before it picks up again for restocking ahead of winter.

So please, please: Be very careful out there.

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