The latest catch phrase to enter the lexicon of the oilpatch is “lower for longer.” One assumes it simply means oil prices are down and will stay that way for a long time. The difference between a catch phrase and an essay is the detail for purposes of definition. “Lower” must be oil prices below what they used be, although in fact they are not lower than they have ever been. “Longer” refers to an extended period of time, clearly undefined. “Longer” after the oil price collapse of 1985 was over 15 years.
Oil is often treated as something a bit more special than a typical commodity because it is so essential to modern life. But let’s take a simple definition for “commodity”, such as, “any useful or valuable thing…something that is bought and sold”, and when the price of this thing falls to the point that it is available at lower prices from multiple sources. Crude oil very much fits that definition.
So while people inside the oil industry often neglect what happens in other resource-based industries, the discussion often misses the fact that there are much bigger forces at play today with crude oil. What doesn’t get enough attention is how global commodities from metal to potash to rubber are caught in a sectoral downdraft resulting in the lowest prices in over a decade. Crude oil is one of them, and is clearly not immune. The following chart illustrates the five-year performance of eight commodities including benchmark West Texas Intermediate crude oil (WTI), Australian thermal coal, iron ore, copper, potash, nickel, rubber and aluminum. Can’t live without any of them. More importantly, except for potash they are all, to one degree or another, inputs in the development of the next barrel of oil. Directly or indirectly, oil and gas developers consume them all but one. Related: “Walking” Oil Rigs Can Make Drilling Faster, Cheaper, Safer
Source: Indexmundi commodities, MNP LLP
The chart tracks the August 2015 price of each commodity as a percentage of its five-year high. Seven of the eight commodities reached their highest price in early 2011 and have been falling since. As a group, these eight commodities traded at an average of 42 percent of their five-year high in August. WTI was at 39 percent, lower than the average but better than rubber, iron ore or nickel.
As the new industry mantra becomes “lower for longer”, the chart shows WTI in fact traded “higher for longer” than any of the other seven commodities. As everything else tanked, crude held on to 80 percent of its peak value until September of 2014. What is noteworthy about the other seven commodities is low prices have not resulted in sufficient shortages to change the supply/demand curve and cause prices to rise. All these other industries remain amply supplied. Related: Can The Saudi Economy Resist ‘Much Lower For Much Longer’?
This is not to say it hasn’t been painful, because it has. Australia enjoyed a massive mining boom supplying iron ore and thermal coal to the Chinese. This is now over because of lower prices. The potash business in Saskatchewan isn’t what it was a few years ago. Mining for metals like copper, nickel and aluminum is a tough and highly cyclical business. But like oil, market forces worked perfectly. When prices remained high, demand shrank and new supplies were developed. The supply/demand curves crossed and prices tanked.
Those who trade commodities and knew oil was due for a massive correction have been making big money. A Bloomberg article on September 18 reported eight of the ten best performing of 1,600 exchange traded funds (ETFs) over the past 12 months succeeded because they benefited from raw material price declines. Five more than doubled their money. One trader who bet the price of heating oil, natural gas and crude would decline said, “…it’s been good because we’ve been short all year. Commodity markets have been trending pretty consistently. They have this downward momentum”. Meanwhile, betting that crude would rise has cost investors a lot of money.
At an oil industry conference in Lake Louise on September 16, Goldman Sachs Group commodity research lead Jeffrey Currie told the crowd he thought oil prices would be weak for 15 years, possibly falling as low as $20 in the short term. He blames this on a 30 year commodity cycle that has moved from an investment phase to an exploitation phase. One of the factors that will help keep crude prices low is major input costs such as iron ore, coal (to make steel), copper and other inputs, such as those in the above chart, will allow oil to be developed more cheaply.
What commodity markets are experiencing is what some think is the end of a commodity “super cycle”, a term coined last decade when commodity prices – including oil – skyrocketed. The commodities boom of the early 2000s, or “super cycle,” was largely due to the rising demand from emerging markets like the BRIC countries (Brazil, Russia, India, and China) and concerns over long-term supply. This is when the theory of “peak oil” emerged. While this phenomenon was being hotly debated, WTI hit an all-time record high of $US145.16 on July 14, 2008. The fact oil prices went in only one direction for most of the previous five-years helped a lot of traders make one-sided and lucrative investment decisions.
However, the massive commodities correction this past August caused analysts to observe that, despite continued vacillations in the price, the “super cycle” was over, a process that was “long, slow and painful.” British bank Barclays Co. wrote in mid-August, “It is an old saying in commodities that the best cure for low prices is low prices.” But this market is clearly different, causing the bank to write, “Almost all the gains associated with the so-called ‘commodity super cycle’ have been eroded, and the index is back at levels not seen since 2002.” The main factors cited are that the rapidly growing consumer nation China “is broken”; there is “just too much” of almost everything; and the U.S. dollar will continue to rise. Of course, the dollar is the currency in which most commodities are priced.
Another article in the Financial Times on August 31 was titled, “Why the commodities super cycle was a myth.” It noted that historically, the price of virtually every commodity has declined in real terms over time. “The past five years have nevertheless dealt a fatal blow to the popularized version of the super cycle story: that inexorably rising demand in emerging economies and constrained supplies of many commodities would inevitably put prices on a rising trend. With China apparently facing a future of slower growth than in the past two decades…the assumptions of strong long term demand have been called into question”.
Think about it. How many times in the past fifteen years have we in the Canadian oilpatch repeated the story about how much oil China will need if only (pick a number: 10%, 20%, 30%, 40%) of the Chinese people buy their first car. We weren’t in the commodity business. We were on a date with destiny. Related: Is This The Bottom For Oil Prices?
This is not to say the situation is hopeless, because it isn’t. At the same conference where Goldman Sachs opined about low prices for the foreseeable future, respected Citi Research global commodities leader Ed Morse predicted a recovery beginning later next year or in 2017 once uneconomic production was “weeded out.” But even his definition of improvement doesn’t include $100 a barrel.
In the Financial Post on September 17 Claudia Cattaneo quoted Morse as saying, “The age of abundance of supply is here, even as the world is moving away from fossil fuel, and makes it highly unlikely that we will see $100 oil again.” Morse called Goldman’s 15-year glut “ridiculous” saying, “If we look at the oil markets, US$40 to US$45 is not sustainable. It will rebalance, not just on a loss of production in the U.S. and Canada, but negative production in Mexico, Oman, China, eventually in Russia”.
While Morse concurred the commodity super cycle is over, he said some of the growth in U.S. shale oil production was due to a lack of financial discipline because ultimately it wasn’t economic at anything but the highest prices. If then. That means less growth and less oil, part of the “weeding out” that will eventually yield higher prices.
What does “lower for longer” really mean? It means if oil is just a commodity like so many others, the price won’t outperform other commodities or the world’s economy, barring a massive physical supply disruption.
By David Yager for Oilprice.com
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