Posted on 01/21/2015 9:29:32 AM PST by thackney
Japanese novelist Haruki Murakami was so consumed by running he combined two of his loves to write a book called ‘What I Talk About When I Talk About Running‘. Although an odd concept, it’s actually quite a compelling read. Not only did I think this title was really great (although paraphrased from Raymond Carver), but it also reminded me of my own rather obsessive compulsions. So here are some of the things that I currently think about when I think about crude oil.
–Global economic growth. Crude oil demand growth is highly dependent upon economic growth, and specifically from emerging markets. Hence, a recent downward revision to global economic growth by The World Bank to a mere 3% this year does not bode well. This downbeat view has been endorsed by the IMF, who has revised down its own forecast to 3.5% for this year.
IMF Chief Christine Lagarde said last week that a healthy US economy and falling energy prices “won’t suffice to actually accelerate the growth or the potential for growth in the rest of the world”. While US consumers may see the most benefit from lower oil prices in the form of expendable cash, falling investment in the oil and gas sector will still have repercussions. Both the World Bank and IMF, however, did revise up US economic growth expectations, while lowering it pretty much everywhere else:
–Non-OPEC production growth. It is basically a misnomer, for non-OPEC production growth is essentially North American production growth (with a wee sprinkling of progress from Brazil). Meanwhile, at the other end of the spectrum, we have falling oil production from Mexico (although energy reforms are to buck this trend by the end of the decade), while UK oil production continues to deplete, after already plummeting over 40% since 2010.
But the biggest area of production growth also appears to be coming under the most pressure, based on current headlines of lower drilling activity, job losses and Capex slashing. Although we could see production growth slowing – with a possible drop of 190 kbpd in the 3rd quarter according to the latest EIA Short Term Energy Outlook – there is the potential that material slowing from US and Canadian producers may not come to fruition before the of the year.
Fears of credit concerns appear much less of a threat than first envisioned, as risks are being contained by E&P companies making swift spending cuts to shale budgets, which have greater flexibility than longer-term investments such as offshore projects. As for Canadian oil sands projects, they require a huge initial investment, but low marginal operational costs follow thereafter; projects that are already up and running may well be largely unaffected. The hatches may well be being battened down, but what is unknown is how long they can hold out in this price storm.
–Cushing and Contango. We are already seeing the forward curve adapting to said storm; the near-term weakness is creating opportunities for those who can store oil, as they can sell it forward at a later date at a higher price (exploiting the contango in the market). It is estimated that we could see 55 million barrels of oil stored on tankers (‘floating storage’) by mid-year should the contango in the market persist in widening.
We are already seeing Cushing inventories (in Oklahoma, ‘the pipeline crossroads of the world‘,where WTI crude oil is priced) rapidly increasing, rising from 6-year lows back mid-last year to nearly double to 33.9 million barrels last week. This trend should continue as storing is incentivized, putting further downward pressure on near-term crude prices as the supply glut exacerbates.
–Chinese oil demand. The engine room of global growth (aka China) appears in dire need of a tune-up, with its economy showing its weakest expansion in 24 years. Chinese implied oil demand increased by 3% in 2014, a much slower pace than the rampant expansion since the turn of the century. Granted, data last week showed China imported a record 7 million barrels a day in December, but this signal of demand is somewhat misleading.
China is bargain-hunting and ramping up oil purchases in an effort to fill its strategic petroleum reserve (SPR). It already has over 90 million barrels in storage facilities, close to its capacity of 103 million barrels. A second phase is planned to add a further 170 million barrels by 2020 (to put this in context the US has ~700 million barrels in its SPR). All the while, China is increasingly exporting oil products, another indication of lagging demand.
–Subsidies. Fossil fuel subsidies added up to nearly $550 billion last year, with about half of this spent on oil (think: Venezuela and gasoline prices at 2 cents per liter, Saudi Arabia not far behind). The drop in oil prices is giving governments in countries such as Indonesia, Malaysia and India the opportunity to remove inefficient subsidies that have been in place for many years.
While this is an excellent opportunity for countries to unwind a legacy that has led to wasteful consumption, it does mean that the full benefit of the recent price fall will not be felt in these countries by consumers. (Nonetheless, a global demand response to lower prices should be forthcoming – just on a lagged basis in the second half of the year).
That said, as the chart at right from The Economist so starkly highlights, the removal of these subsidies should hopefully lead to a reallocation of funds to other causes such as education – something which currently takes a backseat to fuel subsidies.
–Volatility. The sell-off in the latter part of last year brought heightened volatility for oil prices. This is something that will likely persist through the first half of this year, as the market tries to preempt where the bottom of this market is, and when a potential price turnaround will occur.
–US dollar strength. While the euro continues to weaken in the face of impending quantitative easing in the Eurozone, and as the yen sings from the same hymn-sheet, weakness across the world’s currencies make the US dollar a relatively attractive destination – even if interest rate hikes do not manifest themselves this year (um, I bet they won’t). From the euro to the yen, from the polish zloty to the pound, from the Russian ruble to the Nigerian naira, abounding weakness means a stronger dollar, and ergo, ongoing downward pressure for crude given its inverse relationship:
I have more things I’m thinking about writing about crude, but it is probably best that I end this rant here. Looping back to where we started, I leave you with a quote from Mr. Murakami’s book: “What the world needs is a set villain that people can point at and say, “It’s all your fault!”. And while it would appear that OPEC fills this role in the current oil market, there is always much more at play than meets the eye.
Excellent read.
The links are worthwhile reading as well:
For example:
http://www.reuters.com/article/2015/01/20/oil-economy-investment-kemp-idUSL6N0UZ41G20150120
...The same dynamics are being played out on a global scale. High-paying jobs and capital investment are being lost in the oil and gas sector faster than they are being added in the other industries that will eventually replace them.
The global oil and gas sector has been a massive engine of global growth over the last five years and is now coming to an abrupt halt.
The speed and magnitude of price changes matter: the 60 percent reduction in oil prices in just seven months counts as a price shock of the first magnitude.
Rapid price changes (positive or negative) in key raw materials (and none is more vital than oil) always produce some economic dislocation.
Prices change faster than consumers and businesses can adapt to them, causing some loss of potential output and employment.
Lower energy prices will, eventually, be an unambiguous net benefit for the United States, and for much of the rest of the world economy. But the process of adjustment itself could be painful.
If I remember right, you play in the energy industry. I used to (in my misspent youth!).
Has a drop like this happened before? I remember other booms/busts, but the speed and depth of this one is different.
The 2008~9 drop was faster, farther. But that was from a rather sharp spike up first.
By percentage The 1999 drop was larger, also the 1990.
http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rclc1&f=w
Lower energy prices will, eventually, be an unambiguous net benefit for the United States, and for much of the rest of the world economy. But the process of adjustment itself could be painful.
No one can argue with that. It's incredibly disruptive, but will be a net plus, eventually.
His other points about the difficulty of moving white collar skill sets from exploration to other industries is well taken. Again, the joke during a previous bust: How do you call a petroleum Engineer? "Waiter!"
I think most of the blue collar skills will translate well to other industry. Welders, for example, are still in great demand.
This downside for employment as an industry slows (example: the auto industry seven years ago) happens regardless of the industry. I believe the upside of low energy prices is more powerful, because energy factors into every kind of commerce. Consumers use a lot of energy.
A point to remember, part of the cause of oil price drop is a slowing global economy. The price of oil drop did not happen without other factors. It is the reason you also see copper near a 5 year low as well as iron, lumber future prices trading low, etc.
If only the oil price was dropping, growth would be more evident in other sectors. But that is not the case.
The next financial collapse, already on our radar screen, will not come from hedge funds or home mortgages. It will come from junk bonds, especially energy-related and emerging-market corporate debt. The Financial Times recently estimated that the total amount of energy-related corporate debt issued from 2009-2014 for exploration and development is over $5 trillion. Meanwhile, the Bank for International Settlements recently estimated that the total amount of emerging-market dollar-denominated corporate debt is over $9 trillion.
http://www.freerepublic.com/focus/f-bloggers/3249214/posts
Some investors will undoubtedly take a haircut, some more than others.
I've not followed investment trends for a few years, but for awhile mutual funds were pretty heavily invested in third world stocks. As far as junk debt...that's hedge fund territory, as is exploration and development.
Who knows how many local banks are lending in that area?
It will be as big a problem as we decide to make it. The underlying assets are sound.
No doubt some stronger financial companies will get to buy them on the discount.
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