A crude copy: 4 reasons why this could be a false dawn for oil prices

Yesterday Brent crude prices jumped by over 5% to over $40.50 per barrel, the first time the oil price has risen above $40 per barrel since early December and up more than 40% from its January low. But, could this be a false dawn for oil prices just like in 2015?

Loss of confidence in output freeze: Saudi Arabia, Qatar, Venezuela and non-OPEC member Russia agreed last month to freeze output at January levels, but only if others do the same. Russia’s energy minister has indicated that a meeting between OPEC and other leading energy producers could take place between 20th March and 1st April. However, the market could quickly lose confidence in the initiative, even if there is agreement. The key to an agreement taking hold will be Iran’s participation, but it is unlikely to want to cede acquiring market share now that sanctions have been removed. Recent isolated cuts to output (Iraq, Nigeria) were more to do with unrelated geopolitical than an attempt to actually control output.

US shale responds: The decline in US shale output may slow or reverse if operators can take advantage of higher crude prices and hedge near term and future production. A price near $45-$50 per barrel is break-even for many. Although shale is more responsive than conventional production it still operates with a lag. Drilled but uncompleted wells could result in output returning faster than the market thinks.

According to Goldman’s:

“…given the short-cycle nature of shale production and the only nascent non-OPEC supply response to OPEC’s November 2014 decision to maximize longterm revenues. We think it would likely require a period of weak economic and oil demand growth to see a broader agreement to curtail production.”

Related article: Investors long on crude should be wary of shale producer hedges

Oil prices are unlikely to stabilise until inventories stop building: Crude storage tanks aren’t just brimming in the U.S., but across the world. A year ago, the International Energy Agency was sounding this warning:

Barring any unforeseen disruption, OECD stocks may by mid-2015 come close to revisiting the all-time high of 2.83 billion barrels reached in August 1998, shortly before WTI prices sank to an average monthly low of $11.22/bbl.

As it turned out, commercial stocks of oil held in OECD countries had already risen above 2.9 billion barrels by the middle of 2015 — and then kept going.

Demand fails to grow as fast as predicted: Demand for oil is generally forecast to grow slower than in 2015, nevertheless the outlook for oil demand growth is becoming more uncertain. More from Ed Morse:

Not only has the outlook for global GDP growth started to grow dimmer this year, but the relationship between GDP growth and oil demand is starting to diverge in substantial, structural ways. China, which has been the engine to high prices for all commodities and especially energy commodities, is sputtering. Diesel demand in China peaked in 2011 and is looking increasingly unlikely to start growing again any time soon, if ever.

He goes on to say:

Most tellingly, oil has started to lose its one remaining monopoly as a transport fuel as competition from natural gas and electricity appears inexorably on the rise.

Indeed, competition with natural gas implies a much lower oil price. See “Why $20 oil isn’t so fanciful”

There has been a shift in sentiment, but sentiment is just that and can change again. According to Barclays:
“Many of the factors that have supported the recent upward trend in commodities look transient”.
Back in 2015 Brent crude oil prices peaked in early May at $68 per barrel. Watch out for oil to peak around the same period this year, but at a lower level of around $50 per barrel.

Related article: Copper and oil prices: Lower for a bit longer?

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Iran nuclear deal: 4 key implications for commodity markets

1) Lower oil prices

Brent crude prices fell around 2% following the announcement of the deal. However, it may not be until early 2016 until we actually see any additional Iranian crude being exported.

The medium term impact will depend on the when sanctions will be lifted and then how quickly Iran can raise oil production. Sanctions are likely to remain in place until the end of the year when the IAEA published a report on Iran’s compliance with the terms of the deal.

At this point it may be possible for Iran to begin selling the crude it has stockpiled offshore, somewhere between 30 and 50 million barrels. Although this could come to the market very quickly, it wouldn’t be in Iran’s interest to just dump this.

According to Goldman Sachs it could then take another six months or so to revive aging oil wells, potentially adding 0.5 million b/d (vs current output of 2.8 million b/d).

The longer term impact will depend on Iran’s ability to attract foreign investment and then for that to bring additional production to market. Estimates from Wood Mackenzie point to output potentially rising as high as 4.4 million b/d by 2025.

2) More pain for higher cost producers

With all OPEC members free to produce what they wish, extra output from Iran will help assist Saudi Arabia’s strategy of pressuring those higher cost producers.

More downward pressure on the futures curve, not just near term prices but 12-18 months out as investor’s price in the return of Iranian barrels will make it harder for US shale oil producers to hedge their crude production.

Many of the weaker shale producers have relied on hedging to preserve their profit margins and to maintain credit lines with the banks. If hedging becomes less financially beneficial then it will act as a brake on future drilling activity, particularly for those financially weaker operators.

3) Complications for OPEC?

Pressure from those OPEC producer’s outside of the Middle East for output to be cut to help support prices is likely to intensify as Iran increases oil production.

The return of Iranian crude is an issue for Saudi Arabia too, it being chemically similar to Saudi crude as well as from Kuwait and Iraq. More Iranian crude will mean more competition in those markets that these OPEC producers sell into.

Yet, any change in Saudi strategy just gives a free pass to those higher cost producers (see point 2).

Expect more details on how Saudi Arabia could respond at the next OPEC meeting, scheduled for 4th December.

4) It’s not just about oil

Iran has the second largest gas reserves in the world, yet its market share of the global gas trade is less than 1%. The potential for growth here is thought to be more longer term though.

Meanwhile, although Iran ranks as the world’s seventh largest oil producer, it vies with the US as the biggest grower of pistachios. Although China, India and Turkey remain large buyers, current restrictions on banking and shipping are limiting Iran’s ability to export the cocktail nibble into Europe.

Pistachio prices have risen 40% over the past five years due to shortages. The removal of sanctions could see supply increase, putting downward pressure on prices.

More broadly though, the Iranian nuclear deal adds to the bearish sentiment for commodities. Recently investors have focused on fears over Greece and China as potential brakes on economic growth and hence commodity demand.

Although there are big uncertainties about timing, the direction of travel is a lot clearer with Iranian supply to add to downward pressure on oil and other commodities.

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What do relative energy values say about future oil and natural gas prices?

Oil and natural gas prices in the US have historically tracked each other on the basis of relative energy values (oil has around 6 times the energy value of gas). Up until around 2008 any difference in relative values has been rapidly arbitraged away over a period of a few years or so. However, since 2008 the difference in relative values blew out to enormous proportions. While the collapse in oil prices since mid-2014 has brought energy markets more into line there is more to do which could have implications for both crude (WTI) and natural gas prices.

2015-02-07_0639

Between 1990 and 2008 the average energy value of natural gas versus crude was 72% (the grey line in the chart). Now although there was volatility around this level the market arbitraged away the difference in price over a period of a few years or so. Since 2008 things changed. The ratio of gas to WTI over the past six years has averaged 29%.

While the fracking boom in the US impacted both gas and oil production the impact on the oil market was hidden by large unplanned problems in other key producers (think Iraq, Libya, Iran etc). Large manufacturing companies in the US (e.g. chemical producers and the like) saw low gas prices and thinking that high oil prices were here to stay invested accordingly, in the case of chemical companies placing large investments in ethylene capacity. To an extent this is what the market should be doing, arbitraging away the differences in price (as a side note the question for some is whether they have now over invested?).

So does the sharp drop in the oil price mean that the market has finished its work? Well even at current oil prices the ratio between gas and WTI is still only 33%. Remember the average pre-2008 was 72%. To get back to this ratio clearly WTI has to fall, natural gas prices have to rise or a combination of the two. At current market prices if oil shouldered all the responsibility WTI prices would need to fall to $22 per barrel!

Related article: Oil prices: History does not repeat itself, but it often rhymes

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