About Oil Prices
Academians like Prof. Burton Malkiel have long argued that prices are random; however, as every professional trader knows, they are anything but. For almost 40 years, I argued that prices occurred in trends and cycles based on macroeconomic price drivers such as demand and supply, interest rates, commodity prices and currencies, with the amplitude of price moves stretched naturally by people acting like people. That was true until about eight years ago when an organization some call The One Bank, which I have always called Humongous Bank & Broker (HB&B), took control. Capital market prices today are being roiled to the extreme by their actions designed for self-interested purposes, including central bank policy, political election suasion and generally what I would classify as imperialism. Every industry is affected, including Oil.
As with all prices that are affected by industry reports, I believe by far the most accurate data is published by industry producers of goods and services and not by government or central banks. A case in point; this week, a few days before a crucially important US presidential election in which the lame-duck President is vigorously campaigning for his party’s candidate (Clinton), the one backed by HB&B and the mainstream media, hoping to ensure the status quo of the powerful elite, the government reported the biggest weekly build-up of US oil inventories in history, data that I believe was designed to drive prices down, not only oil prices but most equity prices that go bearish at the hint that the US economy is uncertain. Through the campaign, the media has sold the story that the activist candidate (Trump) is bad for the economy and hence voters. With the help of Wall Street’s elite, prices dropped. A week from now, after the election results are in, I believe this report, which is based on estimates, and was likely the reversal of September’s hurricane-related huge inventory decline, is going to more accurately reflect the facts and the oil price will reverse again.
Having made this point, I will now state that all prices, including the manipulated ones, must have an economic basis of some sort. Oil is no different.
I have a few charts that support my view that oil prices are rising – something OPEC calls rebalancing – and will achieve a level of at least US$80 for both WTI and BRENT within several months.
Let’s first look at the US situation.
Chart 1 shows that US Public and Consumer Debt has soared out of control as interest rates plunged from peak highs in 1981 to historic lows this year, through 35 years of government controlled by both political parties. The one constant through these years has been HB&B and their use of futures to control commodity prices.
While US debt has ballooned some 13 times, the offsetting US GDP has grown just by a factor of two times. So, either massive debt must be written off or assets must be massively increased in price.
Chart 2 shows oil prices from 1950 to the present in 2016 Dollars. The average price has been increasing from US$23 (1950-1973), to an outlier US$68 (1974-1975, including 27 months above $90 during the Iran-Iraq War), to US$33 (1986-1998), to US$62 (1999-2008, including 13 months above $90 during the 2008 global financial crisis) to US$83 (2009-2016, including 48 months above $90 with the Middle East in conflict).
The long-term trend, as it is with most commodity prices, is clearly on the rise, which based on the global asset:debt imbalance is justified. Any further problems in the Middle East between producing states like Saudi Arabia, Iraq and Iran would most likely lead to soaring prices once again. Presently, these nations as well as the large producing non-OPEC Russia, all face political and economic problems caused by the unsustainably low current price. In fact, Saudi Arabia and Russia both have plans to sell stakes in their national oil companies to foreign investors within a year or so, and will not do so unless and until the oil price is higher, giving them full value for these assets. This is the reason Saudi Arabia and Russia are leading the discussions among oil producing nations to, as they call it, a rebalancing of price.
Chart 3 shows the correlation between US inflation-adjusted prices of WTI Oil and GDP. As the US economy expands, the heavier demands on WTI leads to a rising price. Many of you point out that the US is now a globally powerful producer, which is true, but it is also a fact that the US is a major net importer of oil, mostly from Canada and Saudi Arabia. Canada is another oil producing nation that requires higher oil prices to ensure a balanced economic growth outlook.
Chart 4 shows the drop in world crude production from 1979 through 1985 in which OPEC lowered their output by 14 mb/d while non-OPEC increased theirs by +4.5 mb/d. That net supply pull-back led to lower oil prices over the next 15 years, which were the disinflationary years. The inflationary period that followed from 1999 through to the global financial crisis in 2008 helped lift oil prices from a low of around US$20 (in 2014 Dollar terms) to over US$100 at the peak. The point is that OPEC was the agent of global boom times due to their substantial cut-backs. They can, and indications are, they will soon do it again.
Chart 5 shows the return today to the so-called peak production level of 1970. As production fell during the 1970-1977 years, US imports increased by 5 times. Because the US today is a major importer of oil, the nation will be at the mercy of higher prices should the coalition of producers led by Saudi Arabia and Russia be successful in their agreements to have cuts in world supply. A ten percent cut in supply would be certainly more than made up by a price increase greater than ten percent.
While the US is the major consumer of oil, there are many dynamics underway that serve to boost demand in other major markets like China and India. Independent and objectively-minded investors are well served to review the monthly report from OPEC, which addresses the worldwide market.
From September-October OPEC Monthly Oil Market Reports (MOMR), I have extracted some oil market highlights that may give clarity to the situation.
Crude Oil Price Movements
In September, ICE Brent ended up 8¢ at $47.24/b and NYMEX WTI increased 43¢ to $45.23/b. Crude oil prices were supported by efforts to address excess global supplies and consecutive draws in US crude stockpiles. The recent price rise was due to signs of an improving supply/demand balance and US dollar weakness, although a surprise build in US crude stocks, increasing supplies and worries about Chinese demand also pressured prices. The Brent-WTI spread narrowed to $2.01/b, down from $2.36/b in August.
The Oil Futures Market
Both oil futures (BRENT and WTI) edged up in September, being greatly pushed up by a late-month rally in the oil complex. Oil futures had been caught in one of their most volatile couple of weeks in months amid uncertainty regarding the pace of rebalancing of fundamentals. Toward the end of the month, with the announcement by OPEC that it aimed for a production target with a view to rebalancing the market next year, prices took a considerable amount of support with ICE Brent nearing the $50/b level. The development was seen as the first step of a process, with concrete action being discussed further over the next two months, potentially also including a contribution from non-OPEC producers, particularly Russia. Oil prices were also supported after US government data showed a surprise drop in domestic crude stockpiles for four weeks in a row. The month-long drawdown in crude stocks was a surprise after a massive 14-mb storm-related drop in inventories at the beginning of September. Inventories were expected to rebound after the big drop.
World Economy
World economic growth remains unchanged at 2.9% for 2016 and 3.1% for 2017. The OECD growth forecast remains at 1.6% and 1.7% for 2016 and 2017, respectively. Weak 1H16 growth caused a downward revision to the US growth forecast for 2016 to 1.5%, while the 2017 forecast remains at 2.1%. Growth in Japan was also revised down to 0.7% given weak 1H16 growth. Euro-zone growth remains unchanged at 1.5% for this year and 1.2% for 2017. Forecasts for China and India are also unchanged at 6.5% and 7.5% for 2016 and 6.1% and 7.2% for 2017. Brazil and Russia are forecast to grow by 0.4% and 0.7% in 2017, following contractions of 3.4% and 0.6% this year.
World Oil Demand
World oil demand in 2016in October is seen increasing by 1.24 mb/d to average 94.40 mb/d, after a marginal upward revision of around 10 tb/d from September. Positive revisions were primarily a result of higher-than-expected demand in the Other Asia region, while downward revisions were a result of lower-than-expected performance from OECD America. In 2017, world oil demand is anticipated to rise by 1.15 mb/d, unchanged from the September MOMR, to average 95.56 mb/d.
World Oil Supply
Total crude production is now estimated at 96.36 mb/d. Non-OPEC oil supply in 2016 is expected to contract by 0.68 mb/d. In 2017, non-OPEC supply was revised up slightly by 40 tb/d to show growth of 0.24 mb/d to average 56.54 mb/d, mainly due to new projects coming on stream in Russia. OPEC NGLs are expected to average 6.43 mb/d in 2017, an increase of 0.15 mb/d over the current year, while OPEC crude production, per secondary sources, now average 33.39 mb/d for 2017. The total production then is roughly 96.36 mb/d, marginally higher than anticipated demand.
Product Markets and Refining Operations
Product markets in the Atlantic Basin experienced a mixed performance as margins fell in the US, hit by a seasonal slowing in gasoline demand in the US as the driving season ended. In Europe, margins were supported by higher export opportunities along with slowing inflows, which eased the gasoil oversupply in the region. Meanwhile, Asian margins strengthened on the back of stronger regional demand amid the onset of the autumn refinery maintenance season.
Stock Movements
OECD total commercial stocks fell in August to stand at 3,094 mb, some 322 mb above the latest five-year average. Crude and product inventories showed surpluses of 191 mb and 131 mb, respectively. In days of forward cover, OECD commercial stocks in August stood at 66.7 days, some 6.7 days higher than the seasonal average.
Balance of Supply and Demand
Demand for OPEC crude in 2016 is estimated to stand at 31.8 mb/d, an increase of 1.8 mb/d over 2015. In 2017, demand for OPEC crude is forecast at 32.6 mb/d, a rise of 0.8 mb/d over the current year. Yet, OPEC is believed to soon agree to a supply cut.
The product market outlook ahead of winter
Oil product markets in the major consuming regions have performed relatively well over the recent driving season. In the Atlantic Basin, product markets received support from the positive performance at the top of the barrel, with stronger US gasoline demand hitting record levels amid higher export opportunities from Europe, which, along with some refineries outages, lent further support to refinery margins. Meanwhile, margins in Asia have seen a slight recovery in recent weeks on the back of firm demand ahead of autumn maintenance.
Since the start of 2014, the trend in gasoline and gasoil consumption has diverged. Gasoline demand has grown strongly worldwide, increasing by almost 700 tb/d in 2015, allowing the motor fuel to remain the driver of the product market even over the winter season (Graph 1). Meanwhile, gasoil has seen weaker global growth of around 350 tb/d, resulting in a more unbalanced market, as the drop seen in demand growth in the US and China has outweighed the recovery seen in Europe and India, (Graph 2), while supply has continued to increase.
During the last months, gasoil demand growth in India recorded a significant rise on the back of a general improvement in economic activities, especially manufacturing. Year-to-date, gasoil consumption in India has increased by 125 tb/d over the same period last year to reach 1.65 mb/d. At the same time, the US manufacturing sector showed only slight growth in September, while 3Q16 figures showed a continued weakness in industrial production, the mining sector in particular, which is mainly energy related. Despite recent reports indicating a recovery in the transportation sector since 2Q16, particularly for trucks and trains, gasoil demand in the US shows a year-to-date decline of around 250 tb/d from the same period last year to average 3.8 mb/d.
Europe is the global benchmark for diesel pricing as the region receives large import volumes of diesel from several refinery hubs to meet its demand. New refineries in the Middle East and Asia, as well as increasing US diesel exports in recent years, have led to a sharp increase in global diesel supplies, much of which is consumed and/or stored in Europe. Looking ahead to the coming quarters, oil product markets are typically supported by heating fuel in the winter season. However, according to the preliminary forecast by the US weather service, a colder winter so far seems unlikely. In addition, inventories stand near all-time highs worldwide, although in recent weeks, these high levels have been slightly drawn down, due to some refinery and pipeline outages and bad weather conditions lowering global production. With the end of the autumn refinery maintenance season, gasoil production will be on the rise and refiners will most likely shift yields to meet middle distillate demand, supporting crude intake over the winter season.
Conclusion
As readers know, prices are materially affected by media headlines and inferences nuanced in the content by parties who seek to confuse investors, if not mislead them. In the days and weeks leading up to the most contentious presidential election in memory, these headlines and stories have had a huge impact. But, in a few days, the game starts anew. What will not change is the intent of the largest producing nations in the world to force a rebalancing of crude oil prices. At this point, that is the only important dynamic. All others, like alt energy, natural gas, episodic strength and weakness in the US economy, weather, and so forth, are bit players in the main drama. Production will get capped. Demand and prices will increase. I anticipate a recovery from the US$43.50-$44 level to a break-through of the US$52 level soon after the next Oil producers coalition meeting, followed by a run-up to US$60. That level will not break the US economy or any other major economy, but will, I believe, lead to spin-off economic benefits. Ultimately I believe the rebalanced price in 2017 will be around US$80 for both WTI and BRENT benchmark prices.
