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 below 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.
By Matt Smith
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