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Oil Prices Start To Catch Up With Supply And Demand Realities

Business, China, Company Strategy, Economics, Oil & Gas, US
By John Richardson on 10-Mar-2017


By John Richardson

I HATE to say “I told you so,”, but I have been telling you that this would happen. Oil prices on Thursday fell below $50, and were at their lowest levels since December as the realities of supply and demand caught up with the market

In summary, I have been arguing the following since January:

  • US shale oil production would continue to rise, which would be reflected in constantly higher US inventory levels.
  • The bulk of the burden of production cutbacks had fallen on Saudi Arabia, and so if they blinked and changed tack, OPEC and non-OPEC producers would quickly be back in the market-share game.
  • The constantly rising number of long positions in futures markets could start to unwind. It was these long positions that had led to crude at more than $50/bbl. This speculation had little to do with the real, underlying fundamentals of supply and demand.

And sure enough, on Tuesday of this week the EIA revised-up its estimate of US oil production to 9.53m bbld/day by December 2017. Last March, it had expected US output to only reach 8.26m bbl/day by December of this year.

A day later it reported an 8.2m bbl climb in domestic crude supplies, which lifted total commercial inventories to a record weekly level of 528.4m bbl. The weekly climb was the ninth in a row.

This reflects the new realities of US oil production. Production costs will keep falling as innovation continues. Plus, of course, the future seems even brighter for the US industry now that Mr Trump is in the White House. He has promised to unwind regulations that restrict production.

And every time the oil price rallies and the market goes into contango, US producers can lock-in profits through hedging in the futures markets. So if today’s physical prices go down, these locked-in profits combine with ever-lower production costs to help them pump more and more oil.

Saudi Arabia’s Words of Warning and Futures Markets

On Tuesday, Saudi Oil Minister Khalid al-Falih said at the CERAWeek conference: “In the past, non-OPEC producers have simply reaped the benefits of OPEC supply reductions. But this time around, we made it clear that we will not bear the burden of ‘free rides’.  My optimism should not tip investors into irrational exuberance or wishful thinking that OPEC or the Kingdom will underwrite the investments of others at our own expense.”

This was interpreted as being very bearish for crude prices, as the oil minister’s comments were viewed as reflecting concerns over the rise in US production.

His words were also interpreted as a warning to some OPEC members who have a past track record of not adhering to quotas. As Tom Kloza, global head of energy analysis at Oil Price Information Service, said: “The Saudis almost explicitly warned that if we don’t get cooperation or we see cheating we’re not going to be someone’s patsy forever.”

On the constant setting of new record-high long positions in crude futures markets, I warned in early February:

Hundreds of millions of dollars can be moved in and out of oil and other commodity markets in a fraction of a second, based on nothing more than the number of re-Tweets of a story on Twitter. These algorithms are not designed to assess whether a story is true or not because they are built for speed and momentum trading

There are now early signs that some of these long positions are being unwound. But we potentially haven’t seen anything yet. Downward momentum could build as investors cut their losses and move into short positions.

What’s Going to Happen Next

By the time I have finished the blog post, oil markets might of course have bounced back. But this won’t change the fundamentals for either crude or other commodities including iron ore, which has also retreated this week.

In addition to constantly rising US  crude output, a potential unwinding of the OPEC production deal and panic by speculators as they quit long positions, here are three other factors to consider:

  1. There could be as many as three US interest-rate hikes this year as the Fed looks to normalise economic policy. Analysts see an 86% chance of a rate hike in March. Higher interest rates could well strengthen the dollar – and a stronger dollar means cheaper crude  and other commodities.
  2. China’s economy is likely to slow down in 2017. It is not going to collapse, just slow down, as President Xi Jinping re-accelerates economic reforms. But growth doesn’t have to collapse for oil and other commodity markets to see major declines, as last year commodity pricres were artificially inflated by a re-inflation of the credit bubble.
  3. President Trump will very probably not be able to get his tax cut and infrastructure-spending plans through Congress. Equity and commodity markets have already priced-in implementation of these two policy initiatives in 2017.  If it becomes clear to the majority of people that Mr Trump’s agenda has been stalled, equities and commodities will come under further downward pressure.

What this Means for Petrochemicals

I have had numerous calls with petrochemicals sales managers over the last few weeks, nearly all of whom talked about oil being “range bound” in the $50/bbl region for the rest of this year.

This is, I am afraid, another example of harmful consensus thinking. Nothing about the real supply and demand fundamental, in my view, point towards long-term price stability at around $50/bbl.

As I said, a rebound back to $50/bbl or above is perfectly possible over the coming days. But Thursday’s 5% collapse tells us that we are in a world of great political, economic and social uncertainty that will be reflected in the oil price.

Crude could just as easily be back at $35/bbl by the end of 2017 on weak supply and demand fundamentals – or at around $90/bbl on the same weak fundamentals combined with geopolitical-driven supply disruptions.

You need scenarios that take this into account, with these scenarios reflecting the range of effects on petrochemical buying patterns.