Oil Still Moving Down, But Mid Term Global Supply Looks Uncertain

In the latest edition of the Numbers Report, we'll take a look at some of the most interesting figures put out this week in the energy sector. Each week we'll dig into some data and provide a bit of explanation on what drives the numbers.

Let's take a look.

1. The U.S. dollar is the culprit

- Morgan Stanley says that the collapse of oil prices from $55 to $35 has much more to do with the U.S. dollar than it does with too much supply.
- The Fed raised interest rates for the first time in nearly a decade in December 2014, giving added momentum to a dollar that has been strengthening largely since 2014.
- But there is a reinforcing cycle with dollar appreciation. Dollar strengthens > commodities decline because of their dollar-denominated pricing > commodity-exporting countries see their currencies decline > dollar strengthens relative to other currencies, and then of course > commodity prices decline. The slump in commodity prices could start that cycle on its own as well.
- With cracks in the global economy starting to become visible, the dollar further acts as a safe-haven. That could keep its value high for much of this year, keeping somewhat of a cap on commodity prices at these low levels.

2. Or maybe China is the culprit?

- China has been the darling of commodity producers for much of the 21st century. But the love affair is coming to an end. China's slowdown is one of the principle causes of the collapse in commodity prices.
- China's crude oil demand actually turned negative in November, according to the best data available. Demand declined by 2 percent from a year earlier. Barclays says China may add only 300,000 barrels per day in demand growth in 2016, or a 3 percent expansion. That is down from the 510,000 barrels added in 2015 to total consumption.
- To make matters worse, retail prices are regulated in China. The government recently announced its decision to not adjust diesel or gasoline prices if oil sells for less than $40 per barrel. In other words, consumers won't see lower fuel prices even though global crude is cheap. That could keep a lid on China's demand.
- And even though China's oil imports continue to rise, so do its net exports of refined fuels. 2015 was the first year that China exported more diesel than it imported. High import levels are, thus, a bit misleading.

3. China's stock market meltdown

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- China's economic problems have multiple layers. Too much provincial-level debt, slowing growth, a real estate bubble, and what is increasingly looking like a stock market bubble that has already partially burst.
- The Shanghai Composite, the leading index in China, saw its value double between mid-2014 and mid-2015. Last summer the index partially melted down, losing 40 percent of its value between June and August. The index lost somewhere around $5 trillion worth of value.
- The Composite rebounded slightly through the end of the year but started crashing again at the beginning of 2016.
- The Chinese government has poured billions of dollars into the market to keep it from collapsing, which has helped paper over the problems.
- Market bulls see huge opportunities for bargains. But the slowing economy suggest that the market was way overvalued and detached from underlying fundamentals. Depreciation pressure on the yuan will also weigh on China's performance. While global contagion is not yet being taken seriously, China's downside risk presents some worries to the global economy.

4. $380 billion in oil projects shelved

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- Wood Mackenzie made waves with its headline-grabbing figure: $380 billion in oil and gas projects have been deferred since 2014.
- 68 major projects have been scrapped, which targeted 27 billion barrels of oil. That will lead to 2.9 million barrels per day worth of oil production that won't come online for at least another decade.
- Most of the projects are offshore (see map): Gulf of Mexico, West Africa, North Sea, Australia, and also Canadian oil sands.
- 85 percent of the projects will have an internal rate of return at less than 15 percent. Many won't even earn 10 percent. The industry has essentially put major E&P on ice.

5. Oil is already selling for less than $10

- WTI and Brent briefly dropped below $30 this week. But in Canada, heavy oil sells for less than $10 per barrel. Alberta bitumen hit $8.35 on Tuesday.
- Canada's heavy oil suffers from a painful discount, one that has widened in recent months. The lower price is due to inferior quality, higher transportation costs, and a lack of pipeline capacity.
- Some companies are starting to shut in production. Baytex Energy (NYSE: BTE) and Canadian Natural Resources (NYSE: CNQ) have shut down 35,000 barrels of output per day. Other smaller producers are shutting down as well.
- Larger producers will probably continue to produce - and take a loss on each barrel sold. Shutting down can cause damage to a reservoir, so eating the losses will probably be the course of action for now.

6. Oil traders not closing out short positions yet

- Despite the fact that short positions have hit multiyear highs (and net-long positions are at multiyear lows), traders have not yet started to close out their positions even as oil descends lower.
- In fact, net-long positions for WTI fell by 23,863 contracts to 76,934 contracts for week ending on January 5, or a 24 percent decline. Brent and WTI net-short positions jumped to 363 million barrels last week.
- Net-long positions did rise for Brent by 21,380 contracts to 185,052, the highest level since November 10.
- The overall mood is still one of pessimism, but as we have said multiple times before, short-covering can be sudden and significant.

7. Even as world is awash in oil, spare capacity is really thin

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- With all the bearish news, energy investors are probably feeling pretty depressed. But a few key numbers should provide some comfort.
- The global supply overhang stands at 1 to 1.5 mb/d. This is what weighs on the market for crude. But the excess could soon be erased.
- On the supply side: Production cutbacks from U.S. expected to reach at least 0.6 mb/d. Declines from around the world are not as well understood, but could be significant. Natural depletion can run as high as 5 mb/d, so the industry needs to find at least 5 mb/d of new supply each year just to stay flat.
- On the demand side: global demand expected to grow by 1.2 mb/d.
- Crucially, OPEC spare capacity is at a meager 1.5 mb/d right now, leaving very little margin to cover a supply outage, and there is no shortage of geopolitical threats on the horizon.
- Despite the glut, the world has already planted the seeds for a boom. Oil prices could reach triple digits within a few years.

That's it for this week's Numbers Report. Thanks for reading, and we'll see you next week.