Crying wolf: For OPEC talk is cheap

When will the oil market crumble?

In the past couple weeks OPEC members, led by Venezuela and Saudi Arabia have attempted to talk back up the price of oil. Besides the obvious why are they doing this?

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The last time OPEC made such an active roile in trying to talk up prices was at the start of 2016 when oil prices fell below $30 per barrel.

“The price itself is irrational if you ask me,” Khalid al-Falih, the chairman of the Saudi state oil company Aramco and one of the Kingdom’s most influential energy figures, said at the World Economic Forum annual meeting in Davos.

“Prices are supposed to be set by the marginal barrel. The marginal barrel is certainly way higher than $30 a barrel.”

Then, in February Saudi Arabia, Qatar, Venezuela and non-OPEC Russia agreed to freeze output at January levels. Buoyed by large unplanned production cuts in OPEC and non-OPEC, the threat of cuts at their June meeting and weakness in the US dollar, oil prices then rebounded to over $50 per barrel by the summer.

And now after oil prices briefly tipped below $40 per barrel Saudi Arabia’s energy minister, Khalid al-Falih, said members of the OPEC cartel and other major producers would “discuss the market situation, including any action that may be required to stabilize prices.”

Despite protestations that cuts to production are on the table, the reality is that OPEC are very unlikely to actually do that which is why they are being so robust in their efforts to talk up the market.

It all comes down to debt.

When oil prices were high oil producers borrowed heavily against the value of that oil. This year OPEC’s net oil export income this year is forecast by the Energy Information Administration to hit its lowest level since 2003 in real terms.

As Bloomberg’s Gadfly notes “suddenly finding yourself saddled with huge debts and savage cuts to your income understandably leaves you feeling depressed. And when oil producers get depressed, they don’t retreat — they pump more oil.”

As Jaime Caruana of the Bank for International Settlements laid out in a speech earlier this year:

Highly leveraged [oil] producers may attempt to maintain, or even increase, output levels even as the oil price falls in order to remain liquid and to meet interest payments and tighter credit conditions. Second, firms with high debt levels face stronger imperatives to hedge their exposure to highly volatile revenues by selling futures or buying put options in derivatives markets, so as to avoid corporate distress or insolvency if the oil price falls further. If financial constraints contribute to keeping production levels high and result in increased hedging of future production, the addition to oil sales would magnify price declines.

There is another weak link in the debt burden, one that if prices fell below a certain level could provoke much sharper falls.

At the start of the year, Sovereign Wealth Funds (SWF) belonging to oil-exporting countries dumped billions in risk assets to help prop up their current account and budget deficits, that due to the sharp drop in the oil price had been been made worse.

However, as JP Morgan calculate if oil prices fell below $40 per barrel on a sustained basis this could provoke SWF into more selling. Indeed, the faster oil prices drop the faster the value of oil and other risk assets will recouple, increasing the risk of a return to the situation at the start of 2016 where pretty much all assets – oil and other commodities see sharp falls.

How long though before the market realises that OPEC can only talk up the market for so long? Oil producers can only cry wolf for so long.

Related article: Oil’s latest bear market – 6 factors to watch

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Oil’s latest bear market – 6 factors to watch

Weaker demand: Concern over an oversupplied crude market has moved on to concerns over an oversupplied product market – particularly gasoline. As refineries have cut back utilisation to protect their margins (in the face of low gasoline prices), refinery demand for crude has fallen.

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Reduced ‘risk premium’: One of the main factors supporting prices earlier in the year was the large supply disruptions – at least 1 million b/d and up to 2 million b/d at its peak. The ‘risk premium’ (estimated at $15 per barrel) has gradually been eroded as output has returned. Nevertheless, its worth looking forward to potential future sources of disruption, and hurricanes in the US Gulf could present the next risk to output. In addition the slow train wreck that is OPEC member Venezuela gradually moves towards complete chaos (lower oil prices will only make it worse). Any disruption here would quickly be felt in oil markets. 2016-08-01_2216

Hedge funds: After amassing a near record long position in crude contracts earlier in the year, short positions (bets on prices falling) in WTI crude have increased at their fastest rate since 2006. As quick as sentiment has switched from bullish to bearish, it can very quickly switch back if prices fall too far too quickly or an adverse market ‘event’ flushes out the short positions.

US production: Rig activity has gradually begun to increase over the past two months in response to $50 per barrel oil, supporting the view of shale oil as a much more price elastic form of supply. At the same time productivity (output per rig/well) continues to rise.

Battle for market share: Over the weekend Saudi Arabia cut the price it sells crude to Asian customers, the sharpest cut since November last year. Competition in Asia is hotting up as Iran, having increased output by 25% in 2016 aims to reach an 8 year high of 4 million b/d by December. Meanwhile, demand from refineries in Asia has stalled.

Macro concerns: The US dollar strengthened on a trade weighted basis between May and July, as speculation mounted that the Federal Reserve would increase interest rates following better than expected economic data. A stronger US dollar tends to result in weaker crude prices. Meanwhile, uncertainty at least partly Brexit induced, has hit prospects for global economic growth and so for oil demand (oil prices closed at $51 per barrel on the day of the EU referendum).

However, the weaker economic outlook now means that the chances of higher interest rates have diminished. Indeed, recent data out of the US points to a slowdown in growth. Meanwhile, the likelihood of policy divergences between the US, Europe and Japan appear much more limited (note Japan’s pullback from ‘helicopter money’). All of which implies that a weaker US dollar in coming months could be supportive of higher oil prices.

Related article: Life after 50? Shale oil’s true test as a swing producer awaits

Related article: How big is the oil price ‘risk premium’?

Related article: Hurricane season: La Nina could lead to late summer oil price spike

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Trumponomics: What would a Trump presidency mean for commodity prices?

With so much uncertainty over Donald Trump’s economic policies it is very difficult to say what the impact on commodity prices will be. In the short-medium term the biggest positive impact is likely to be for precious metals, reflecting the uncertainty and the heightened geopolitical risk. Further ahead a Trump presidency could lead to lower energy prices as his insular agenda leads to support for domestic growth in energy supplies. Meanwhile, labour intensive agricultural supplies (that really excludes corn, wheat etc.) may be hit if anti-immigration policies lead to the loss of workers resulting in higher prices in the US.

At the time of writing the implied probability from betting odds of the Republicans winning the Presidential election stand at just under 35%. Since Trump was nominated at the Republican convention his chances have improved markedly. Indeed recent polls carried out since the nomination suggest that the chances of Trump winning in November should be significantly higher, although perhaps not quite yet the favourite.

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Of course it isn’t just about Trump winning the Presidency. For him to have greater influence then it helps if the Republicans are in a majority in the House of Representatives and the Senate. And here the chances of Republicans being in control currently stand at 98% and 78% respectively (source: Pivit).

That’s the probabilities dealt with (disclaimer: remember how bad prediction markets got the Brexit vote), now what does a Trump victory mean?

Well, lets start with the US economy. This is where Trump in particular has been vague in terms of actual policies so the degree of uncertainty is high. Having said that he has been vocal in rejecting trade deals and has promised to take a more aggressive approach against China and Mexico. Tough trade deals are only likely to lead to lower US export growth as countries on the other side retaliate.

US dollar: With political uncertainty likely to be much higher under Trump the probability of US interest rate hikes will diminish. All in all this should lead to a weaker US dollar. By itself a weaker US dollar would be supportive of stronger commodity prices. However, concerns over the strength of the US economy and commodity specific factors may play a larger role.

Energy: Trump is serious about oil’s significance to the U.S. economy and wants the country to be energy independent. Indeed, Oklahoma oil and gas mogul Harold Hamm is thought to be in pole position to be energy secretary if Trump wins. A reduced regulatory environment under a Republican administration could increase new pipeline construction and drilling, potentially increasing supply and keeping pressure on oil, gas and coal prices.

Industrial metals: Slower growth in the US will be negative for industrial metals like copper and aluminium as demand from construction and automotive sectors slows. However, calls for more infrastructure spending (and here both parties are on similar ground, except for the ‘wall’) could be a boon for metal demand as the country’s aging infrastructure is updated.

Trump has surrounded himself with advocates for traditional energy sources and climate change skeptics. This may lead to reduced investment in renewable energy sources in the US and electric cars. Together this may reduce demand growth for ‘energy’ metals such as lithium, cobalt etc.

Precious metals: According to ABN Ambro uncertainty over Trump’s policies could result in higher precious metal prices.

If Trump were to become President (low probability in our view), gold prices will likely perform well, because we expect that his policies will be inward looking and will weaken the fundamentals of the US economy. In addition, his rhetoric and possibly policy actions could create domestic and international uncertainty at beast, and upheaval at worst.

However, given the scale of the increase in prices seen so far in 2016, and the likelihood that prices may rise further prior to November – if a Trump victory is seen as more likely – then there may be limited scope for gains should he actually win. Under this scenario the ‘beta’ precious metals such as silver, platinum and palladium may see much sharper price increases.

Agriculture: According to the US Farm Burea more than half of US farm workers are illegal immigrants. While crops such as soybeans and corn are largely harvested by machinery and would be largely unaffected by Trump’s anti-immigration policies, others such as vegetables, nuts and fruit are mainly picked by hand.

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