By John Richardson
THE above chart shows the extent to which this year’s oil-price rally has been led by futures markets. What is significant, though, is that futures activity seems to have plateaued.
Sure, futures activity could easily go the other way again, driving prices significantly above the $50/bbl level. But barring a decision by the US Federal Reserve to once again step away from interest rate rises and China further loosening the credit tap, it is hard to see why the speculators would want to go deeper into bull territory. The market remains heavily distorted by the speculators, and so first and foremost you must analyse futures activity before you then look at physical supply.
Right now, I would argue that the Fed looks set on raising interest rates again in June or July. And in China, credit growth contracted again in April. I believe this indicates that economic reforms are gathering pace again.
As for the real supply and demand of oil, you should have been asking yourselves two questions throughout this rally: Shortages? What Shortages?
I’ll deal with the Fed, China, and today’ crude supply position in more detail later on. First of all, though, here is some historical context behind the role that financial markets have played in determining the oil price over the last seven years.
China, Jobs and Economic Stimulus
I believe that that the 2009-2014 rally in crude prices was driven by the fall in the value of the US dollar, thanks to the Fed’s ultra-low interest rate policies. This forced hedge funds and pension funds etc. to seek an alternative “store of value”. This store of value was oil and other commodities.
What seemed to justify this alternative store of value was China’s parallel decision to conduct the biggest economic stimulus programme in global economic history, which cushioned the country from the impact of the Global Financial Crisis. It was all about preserving jobs for the Chinese leadership of the time. They didn’t care about anything else, including the long term fundamentals of supply and demand as overinvestment poured into manufacturing and real estate. To give you an idea of the scale of what I am talking about, China increased lending by $10 trillion in 2009, when its nominal GDP was only $5 trillion. Lending was an astonishing $18 trillion higher by 2013.
The long term economic benefits of this extraordinary rise in credit didn’t worry the financial speculators. Of course not. It is not their job be worried about the long term. But other people who should have known better, including CEOs of some chemicals companies, who started talking about a “new paradigm” of a rising middle class in China who would very soon be as rich as the middle classes in the West. This not only justified and underpinned the rallies in oil and commodity prices – but crucially also added further momentum to the rallies.
As this paradigm became the new consensus, the shale-oil industry took off in the US – aided also by the availability of cheap financing thanks to the Fed’s interest-rate policies. Petrochemicals projects in the US, and elsewhere, were also sanctioned on the theory that China – and emerging markets growth in general – had entered this new paradigm.
It all went very badly wrong from September 2014, when it became apparent that Chinese economic stimulus had, after all, been unsustainable. Crude markets belatedly woke up to the notion that China’s stimulus had left behind vast domestic oversupply in manufacturing and real, estate, and so a serious bad debt problem. The scale of China’s environment crisis, made much worse by this overinvestment, was also recognised.
What made people wake up to these long-standing realities was that China’s new political leaders admitted the scale of the problems – and, more importantly, they reversed course. They started reducing credit growth, and so the Chinese bubble began to dramatically deflate. Credit growth began to decline from January 2014. And here is another extraordinary number: In 2015, growth in credit was no less than $4 trillion lower than in 2014.
Back To The Future: Q1 2016
After the January 2016 collapse in oil prices and equity markets, the US Federal Reserve got cold feet. It began to back away from further interest rate rises, on the belief that weak crude and equities etc. meant that US economy was in too perilous a condition to take that risk. This was the signal sent to the oil speculators: The dollar was going to be weaker for longer than they had expected, and so it was time to get back into crude as an alternative store of value. This also led to recovery in other commodity markets, including iron ore.
What once again added further momentum to the rally was China’s decision to loosen credit, which grew by some 58% in Q1 over the first quarter of 2015. The detail didn’t matter here. All that mattered to the crude-market speculators was the wider belief that China had, somehow, turned the corner. The renewed economic stimulus created the erroneous idea that China could spend its way out of trouble.
Now, though, thanks to stronger US GDP growth and continued robust jobs growth, Fed chairman Janet Yellen has indicated that two to three interest rate rises could, be on the cards later this year – with the first hike possibly in June or July.
And in China, credit growth fell in April. Total social financing plunged to 751 billion yuan during month compared with 2.34 trillion yuan in March.
Any sensible analyst would have told you that China’s Q1 rise in lending was unsustainable – and that, of course, it was a drop in the ocean compared with the $4 trillion of credit withdrawn from the economy in 2015.
What told you it was unsustainable was that this represented another example of a victory for the short-term thinkers who in China, who prefer to prop-up immediate growth rather than deal with the longer-term issues. But you also had to bet that the reformers would reassert control – and, indeed, this has happened. In this particular instance, local governments temporarily gained the upper hand because of their struggle to cover their liabilities.
The end result – and may have already seen early signs of this in the above chart – could well be speculators switching back to the US dollar, as is strengthens – away from their alternative stores of value.
Actual Supply And Demand of Oil Itself
Last is not meant to be least. Of course, this matters. But in all the noise created by the speculators, the sound made by the data on physical production, storage and demand can sometimes be impossible to hear.
Take last year’s oil-price rally as an example. Remember how we kept being told that the US rig count was falling? This took Brent from $45.19/bbl in mid-January to $69.63/bbl on 8 May.
Meanwhile, US shale oil producers continued to push the innovation envelope on cost reductions. Each rig in operation had also become much more productive. The practice of “fracklogging” – storing oil in rocks ready to be fracked when prices recovered – also increased. And thanks to stronger futures prices, the shale oil industry was able to take out new hedges. This put them in the position to be able to sell at lower prices in the physical market because they had locked higher futures returns. Saudi Arabia also stuck with its market share strategy, whilst the global economy remained weak. This all led to the fall in oil prices during H2 2015.
The physical justification for today’s rally is on even more shaky ground.
We were first told that there would be a production freeze agreement at the April Doha meeting. I never believed that this on the cards – and, of course, it didn’t happen.
We did then, however, see a dramatic decline in production as a result of wild fires in Canada, attacks on Nigerian pipelines and more upheavals in Iraq. But I think that this was seized upon by markets whilst they overlooked some signs of long supply elsewhere. And, of course, this decline could well prove to be temporary.
Signs of long supply elsewhere includes oil in storage. Global oil stockpiles, including floating storage, have increased for the last ten consecutive quarters, according to this Hellenic Shipping News article, which adds:
It is estimated that almost 9% of the global VLCC fleet is currently booked for floating storage, which is a 40% increase in tankers by number since December. Reuters reported that at least 40 laden VLCCs anchored off Singapore as floating storage, storing estimated volumes of up to 47.7m bbl, thought to be the highest level in at least five years.
Crucially, also the contango is narrowing. Last week, the one-month arbitrage on Brent in floating storage was -$0.48/bbl, while the 12-month arbitrage was at -$6.11/bbl, implying there was no profit incentive to store oil on ship. Storage costs are a minimum of $0.74/bbl, and so there has to be a risk of destocking.
Iran is also raising production. By the summer its exports are expected to rise a further 200,000 bbl/day to reach 2.2m bbl/day the middle of this summer.
And nobody should be surprised over reports that the US rig count has stopped declining, with early signs that the rig count may actually increase.The US is the world’s new “swing producer”. The inventory of drilled but uncompleted US wells has been building, driven by companies with contracted drilling services. Ccompanies have merely postponed, rather than cancelled, completion of wells. This could add 400,000 bbl/day to supply.
Let’s not forget yesterday’s OPEC meeting. There was again, of course, no agreement to freeze, never mind cut, production.
As for demand, the summer lull season in the northern hemisphere, when many people take their holidays, is set to occur in August and July.
If this market turns, those who want to short oil have plenty of physical ammunition to support their positions.