#61. Oil in the doldrums

OIL PRICES – A BRIEF FALSE RALLY

In recent weeks, oil prices have rallied, with Brent crude rising from $47.50/b to $53/b before turning downwards.

Some observers have seen this rally as an indicator of a secular upturn in prices. Others have interpreted it as an essentially seasonal move which can continue through the winter months.

Both are wrong. Whilst the rally is indeed seasonal, it is already over. Always excluding shocks (such as military threats to production), the recent strength in crude markets is over, and is unlikely to return until April 2016 at the earliest.

Though there are a lot of topics on my current agenda – such as rising strains in the financial system, the growing likelihood of global economic “regime-change”, and what I’m coming to call the “medieval-isation” of Britain – I think it’s desirable now to look at the outlook for energy, and for oil in particular.

Let’s deal here with the short-term picture, where we have witnessed a “bull-trap rally” in oil markets that has been predictable for many months (indeed, I predicted it quite some time ago). The explanation for the seemingly-surprising timing of this up-blip – and the timing of its ending – lies in the difference between crude oil and refined products.

Petroleum consumption is subject to seasonality, with peaks in the winter (when heating demand is at its highest) and in the summer (traditionally known as “the driving season”, though better thought-of as “the vacation season”, since it includes increased aviation demand as well). OPEC data shows the highs and lows of consumption for 2015 as the first quarter (a low of 91.9 million barrels per day) and the fourth (a high of 94.0 mmb/d).

This variation becomes more pronounced when we estimate monthly rather than quarterly consumption, where the 2015 low is likely to have been March (about 89.6 mmb/d) and the high may have been either January or December (both about 95 mmb/d).

The crude purchasing pattern, however, is critically different, and it’s this purchasing cycle, and not end-user consumption, which is reflected in crude markets. When we adjust for the time it takes for crude oil to be transported, refined and shipped as product, it becomes apparent that the seasonal timing shifts materially. Any crude purchased after November isn’t going to reach end-users before the winter consumption peak is over – indeed, refiners tend to plan maintenance downtimes for the early months of the year. Likewise, the pre-summer peak in crude purchasing finishes in June, again because refined product isn’t going to reach the customer until summer demand is tailing off.

What this means for oil markets is set out in the first chart. This shows an estimated monthly call on OPEC crude, arrived at by deducting (a) non-OPEC production (and OPEC’s ex-quota liquids) from (b) estimated monthly crude purchasing (which of course excludes the processing gains which contribute to final product supply). The result is shown in red, whilst the faint blue line shows the number you would arrive at if you – mistakenly – made this calculation based on end-user demand, rather than purchasing. Superimposed on the chart is an indicative OPEC crude output level of 31 mmb/d, which is roughly where OPEC is.

Oil supply and demand 10-2015

As the chart reveals, purchaser demand for OPEC crude currently spends most of the year below this indicative OPEC number, meaning that markets are over-supplied – quite how long this is likely to remain the case will considered in a later article.

Such is the extent of structural over-supply that the pre-summer rise in crude purchasing does not move the chart into positive territory. Purchasing does move above the line in October, but not for very long, and not by very much.

This is why the recent rally has been so brief and, in relation to the intrinsic volatility of crude markets, so modest in extent. This analysis indicates not only that the recent rally is over, but also that markets face severe downwards pressure in the coming months.

Of course, crude purchasers – who are perfectly capable of carrying out analyses like this one for themselves – may arbitrage the coming dip, which could put a floor under prices. But there is unlikely to be any upwards pressure in crude markets until late spring at the earliest.

(This analysis does indicate a modest upturn in purchasing at year-end, but this may not happen – it didn’t last year – and isn’t going to take the line into positive territory anyway).

The oil-market timing tool shown on the second chart is something I’ve been calculating for many years, and the basic features have remained largely constant – severe downwards pressures at the beginning of the year, a modest pre-summer upturn, and an equally modest downturn in the summer, ahead of the big autumn upturn.

Oil annotated 10-2015

But the two summer events are pretty marginal affairs at the moment, meaning that the structural turns that do matter occur in autumn (upwards) and the winter months (downwards).

In the near-term, the general pattern remains one of significant over-supply. What we need to consider in a future article are (a) the longer-term picture, and (b) the implications for other commodities and the economy.

14 thoughts on “#61. Oil in the doldrums

  1. How come you have a W pattern for projections for October through January? The 2014 doesn’t show that, it shows it dipping in October to November more or less leveling off until December,dipping hard between December and January, then rising January to February.

  2. Hi Tim

    if you have not read the work of Art Berman I think you should at least take a look at these two articles..

    http://www.artberman.com/wp-content/uploads/NTGS-Presentation-15-Oct-2015.pdf

    http://www.artberman.com/rig-productivity-is-a-red-herring/

    As far as I can see a lot more oil companies are going to go to the wall than many people think. In the last week of October and first week of November – Oil Companies will be announcing big losses in unison as it will be the first quarter that they will have not have had hedged production to ameliorate their situation. They already had a lot of distressed debt and I believe the capital markets will desert the industry en-mass from this point on. With a market collapse in sentiment for the oil industry, they will not be able to get new money via equity placings, junk bond issuance or from banks.

    Quite how bad this situation is going to be is very much dependent upon how honest the US shale producers have been about their production costs. Actually that probably applies across the industry in general. From my reading I have read of lot of misleading RNS and statements out of oil companies regarding production and costs which border upon fraud. If this is as bad as I think, then its going to have a significant knock on effect in markets in general.

    Regards

    Simon

    • Simon

      I’m sure you’re right here. On the subject of misleading reports, that is particularly interesting to me because I’m working on “the breakdown of trust” as an economic factor, significant but under-rated, in the situation that we’re in. We know that the “neo-liberal” or “Anglo-American” deregulated model has resulted in excessive debt, but have we failed to notice the breakdown of trust? An efficient market is impossible in the absence of trust.

      I’m sure you will have seen, too, the article on oil by BP’s (and formerly the BoE’s) chief economist. One of his arguments is that shale enables the industry to switch on/off production much more quickly than in a past dominated by multi-year megaprojects. He cites shale decline rates i.e. first-year declines in output per well, at 75-80%, far higher than the industry itself has ever admitted to before. I think he may be over-estimating future potential, i.e. the hot-spots (best drilling locations) have naturally been tapped first.

      A lot of the cost of shale production is energy, so the fall in energy prices must itself have contributed to cost reduction – this may be a factor here. My focus has always been not on opcosts but on decline rates, with their implications for a “drilling treadmill” and thus for capex. If I’m right about this – as I think I am – then the loss of access to capital is going to have implications that are far more serious for shalecos than investors perhaps appreciate – at 75-80% per year decline rates, their production could drop off a cliff in the absence of funding for new wells. I’m not seeing this in anyone’s projected aggregate outputs yet.

    • Thanks Tim

      Depletion has always been an issue. I’m sure you have read the reports from the post carbon institute’s David Hughes who has done the most comprehensive analysis of depletion.

      Personally I think its a mistake to concentrate on any of the issues in isolation and that we need to consider them as structurally connected in a global world of problems.

      You have already extensively covered China recently but I also think it is important to look at how the banking system is to deal with this and how it will effect credit markets in general as per the two recent articles below.

      http://www.zerohedge.com/news/2015-10-18/bankers-have-gone-through-they-know-how-it-ends-and-it%E2%80%99s-not-pretty

      http://www.zerohedge.com/news/2015-10-18/world-hits-its-credit-limit-are-debt-market-starting-realize

      Distress in capital markets as discussed by Wolf Richter in the linkks below

      http://wolfstreet.com/2015/10/16/moodys-recession-warning-jarring-drop-in-payrolls/

      http://wolfstreet.com/2015/10/12/junk-bond-issuance-collapses-distress-ratio-spikes/

      And also from Wolf Richter worrying issues with financial engineering. This is not just the oil industry it is Wall Mart, Dell computers and god knows how many other companies who will be running out of financing options.

      http://wolfstreet.com/2015/10/13/junk-rated-money-losing-revenue-challenged-dell-tries-to-pull-off-largest-tech-emc-buyout-ever/

      http://wolfstreet.com/2015/10/14/have-share-buybacks-suddenly-lost-their-magic-wal-mart-financial-engineering/

      http://wolfstreet.com/2015/10/15/wrath-of-financial-engineering-eating-earnings-record-corporate-debt/

      And lastly it appears that Saudi Arabia is in dire financial situation and is deplaying payment to contractors.

      It this is true then one must also take into account that SA owns vasts amounts of all sort of assets in the US, the UK, Europe etc.

      If things get worse for SA what happens so prices in all those different asset classes when the Saudis start liquidating them.

      When one takes all of this into consideration then a collapse in market sentiment for oil companies will be a big enough catalyst to set off a chain reaction in all these interrelated, troubled and distressed markets.

      Regards

      Simon

  3. Simon

    You have given me and other readers a whole lot to think about here, especially as I’m working on finance issues at the moment. My focus is that two long-established “verities” are at last coming under intellectual challenge – one line of new thinking is that a big financial sector might not be a good thing after all (!), and the second is that capital inflows may not to be a good thing either (!!).

    You’ve also given me a list of links to read or re-read (I follow zerohedge and wolfstreet). Another point that you might consider is that 2015 will be the first time in 30+ years that there have been net capital OUTflows from emerging markets.

    I must apologise for being somewhat busy with other things just at the moment – which might make this a good time to ask if you’d be interested in writing the first ever “guest post” on this site?

    • Thanks Tim

      If you have a direct email link I can email you some pieces I have written but never published which would compliment most of your articles. Also within a few days I hope to produce the results of some critical discourse analysis of RNS from a particular oil company that I have been writing which shows the methodologies by which companies are deceiving and misleading investors and general manipulating investors by use of a large variety of media from the MSM to RNS to twitter to investor presentations to shareholder bulletin boards such as the LSE.

      I have already contacted the serious fraud office about a certain UK company and I will be submitting my findings to them. I first contacted them last week and the companies shares have already collapsed more than 50% since I expressed concerns.

      If you have my email address please email me directly.

      Regards

      Simon

  4. Tim – slightly off topic, but your article reminds me of a conversation many years ago with a senior Admiral. In order to maintain the proportion of budget allocation to the RN within MOD financing, a variety of tactics were deployed towards year end to demonstrate in-year budgets and targets were met. One being to top up the RN’s world-wide oil bunkers in February/March. Although this wouldn’t pass scrutineering these days, it provides an example of how each Service would spend unallocated in-year budget to ensure continued funding in following years. I’ve heard of various other similar tactics within Local Government – using unallocated budget for more road signage or IT projects towards year end etc.

    The fact that Central and Local Government in-year budgeting has been known to drive these behaviours is relatively well known. However, are they significant enough to produce an anomaly in overall economic analysis and is it possible to produce a data set to smooth such an effect? If so, it might be useful evidence to provide HMT or Cabinet Office to the absurdities of in-year budgeting. Just a thought!

  5. I’m little interested in market fluctuations as markers of permanent or decisive change, it’s mostly just noise. But your comment on Trust is very interesting. We all should be aware that a nation’s only backing of it’s currency today is the “Full Faith and Credit” it keeps. So any hiccup in that can have big consequences. Zimbabwe is a classic example and hyperinflation is always consequential to the loss of confidence, rather than debt.
    It doesn’t seem to be a problem for most countries today, but possibly the Euro, being so flawed and distorted by Neo-liberal political interference, might, IMO, be threatened.
    I’ll look forward to your thoughts there, Tim.

  6. Dear Tim Morgan
    You mentioned the prospect of medievalisation of the UK. I have come across the idea of medievalisation of currently industrialised societies elsewhere on the web, but yours is the first I have found with reference to the UK. Most popular for near term medievalisation is Japan, with its huge government debt, stagnant growth, aging population, and dependence on imports for most of it’s energy and for raw materials for industry. The others talked about are the Euro PIIGS of southern Europe for much the same reasons. The most popular trigger for medievalisation is financial collapse, throwing countries back onto their internal resources only. The character of medievalisation envisioned is a peasant economy of small farms and artisan industry. The Euro PIIGS and Japan could all succeed at Medievalisation as they still have many peasant small holdings and Italy and Japan have large artisan production sectors. Not so the UK, though some facets of artisan production are increasing in the food sector. For the UK I think your diagnosis of corporatism will deepen as a response to crisis, with further centralisation of control as in WW1 and WW2, driven by the meme that big is efficient. The collapse of the Soviet Union failed to dent that meme. The response of countries directly affected by the Soviet collapse is informative for the prospects of Medievalisation. In Eastern Europe a peasant economy was tolerated under communism, and can be said to have cushioned the collapse for many people, though the EU CAP is rapidly eliminating it. In Russia all vestiges of the peasant economy had been eliminated except for Dacha gardens which were very significant in feeding the people during the collapse. However a medieval economy did not evolve due to the still plentiful natural resources available, principally oil and gas, which funded the return to an industrial economy. Of North Korea little is known for sure, but they have stuck doggedly to Soviet forms of organisation and suffered famines that have killed millions i.e. no Medievalisation here. The only country that responded to the Soviet collapse with Medievalisation as envisioned above, is Cuba, with a huge expansion in small farmers, and market gardeners. Yes, this was done in a socialist way, but it worked in feeding the country. Though it may only have worked because in Cuba’s case, it was only its economy that collapse, and not both its economic and political systems. Cuba did not revive artisan production though.
    What do you think are the UK’s prospects for successful Medievalisation of its economy?
    Regards
    Philip Hardy

    • Thanks Philip, you make some very interesting points here.

      I must admit that I was was using “medievalisation” in a less technical and more pejorative sense in my aside here. I was referring to some retrograde tendencies that I observe in the UK.

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