Why Crude Oil Trades So Poorly

Via Global Macro Monitor,

Crude oil is the new widow maker.  It trades heavier than a wet dawg in a New York thunderstorm.    Rallies have no legs and its seems the only bid these days are the shorts with their family jewels caught in a vice grip.

Note the recent lower highs and lower lows and stiff  resistance at the 50 and 200-day moving averages.

Technology Rapidly Changing Oil Industry

Maybe it because of the huge technological progress, which, has, for example,  driven the cost of the breakeven for some deep water drilling projects down 50 percent in the past few years.   Deep water projects, some of which, used to cost north of $100 per bbl elsewhere throughout the world have fallen to around $40–$50 per barrel in the Gulf of Mexico.   Absoulutely stunning!

OPEC is fighting the same forces that did “John Henry, the steel driving man” in.  And, for that matter, the same changes that have wiped out most of the floor traders on the NYSE.  Technology.

We came across this Foreign Affairs piece yesterday that absolutely floored us (be sure to click Foreign Affairs to read full article),

 The technology revolution has transformed one industry after another, from retail to manufacturing to transportation. Its most far-reaching effects, however, may be playing out in the unlikeliest of places: the traditional industries of oil, gas, and electricity.

…These technologies have helped drive oil prices down from an all-time high of $145 per barrel in July 2008 to less than a third of that today, and supply has become much more responsive to market conditions, undercutting the ability of OPEC, a group of the world’s major oil-exporting nations, to influence global oil prices.

…. As the price of oil tumbled from above $100 per barrel in early 2014 to below $50 per barrel in January 2015, many of these projects [deep water] stalled. By early 2016, companies had put on hold an estimated four million barrels per day of new oil output, 40 percent of it from deep-water sources.

…As drilling stalled, oil and gas operators, desperate to cut costs, began to rethink the complex systems they used.

…Today, thanks to these innovations, the average breakeven prices of new deep-water projects have fallen, to just $40–$50 per barrel in the Gulf of Mexico—an important global bellwether because it is one of the most responsive regions in the world to changes in market conditions. Even though oil prices remain low (and many in the industry expect them to stay low), investment is once again growing. Ten deep-water projects were approved for investment in 2016 and the first half of 2017 alone.  – Foreign Affairs

Technology only moves forward unless the Luddites take power, which given recent events can’t be entirely dismissed.   So, our guess is the long-term pressure on crude prices is lower.

The Middle East Mess

Shorter term,  however, we wouldn’t be surprised to see a “wag the dog” event in the Middle East and a price spike as there is currently no geopolitical risk premium in the crude price.  The Saudi-Iran conflict continues to heat up as they fight their  proxy wars across the region from Yemen to Syria.

Just yesterday, for example,  Iran took four Saudi sailors into custody and seized their naval vessel  after they entered Iran’s territorial waters in the Persian Gulf.     One stray missile into the side of an oil tanker in the Straights of Hormuz could send prices up $20 per bbl..  Certain emasculation of the leveraged shorts.   Suppliers would jump on those prices faster than a portfolio manager chasing a 7 percent yield on a 100-year Argentina bond, however.

Being short crude here is therefore not a sleep easy trade.   But, when is it ever an easy trade?

Conclusion

If the above is true, and we could be entirely wrong as articles such as these are not uncommon at bottoms,  the world and geopolitical forces that drive it are in for huge upheaval.

Not only has the supply curve shifted way right it has become flatter or more elastic, that is sensitive to price moves.   The same is true for demand, which has shifted left in the west though it has increased in the emerging markets.   We wouldn’t bet on a huge spike in longer-term demand as technology - as in electric cars (hint Volvo) – continues to evolve at a rapid pace.    “In 2016, approximately 45 percent of the global oil demand was attributable to the road transportation sector.”

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Finally,  it is important not to conflate crude oil’s relative price decline with a generalized global deflation.  It’s kind of frustrating to observe policy makers and market watchers exclude energy prices from the inflation indices when prices are rising and include them when prices are falling.  Easy money bias.

Maybe it’s time to sell those buggy whips.

Largest East Coast Pipeline Reveals Demand For Gasoline Is Crashing

There"s a reason this week"s EIA survey showing gasoline and oil supplies declining has failed to stop RBOB prices from collapsing to 7-month lows: The start of the summer has done nothing to revive sluggish demand. That"s because despite what the EIA survey said, little has been done to reduce record fuel inventories.

The squeeze has gotten so bad, Northeast Colonial Pipeline Co., the operator of the biggest US fuel pipeline system, said that demand to transport gasoline to the country"s populous northeast is the weakest in six years, the latest symptom of a global oil market grappling with oversupply. It’s notable that this peak has arrived despite the advent of the summer driving season, which has seen gasoline demand pull back from last year"s record highs, according to Reuters.

Because of the oversupply in the northeast, “line space”… the cost of renting “space” on the pipeline to assure one’s ability to get supplies of gasoline when necessary… has gone negative, according to Reuters. What can be more exemplary of excess inventories and of reduced demand for gasoline than this?

Refiners are in part to blame for the problem - they have continued to pump motor fuel at record levels for the second year in a row, worsening the oversupply problem, for fear of losing access to pipeline capacity. 

More broadly, attempts by large producers to reduce global supplies have failed to meaningfully raise the price of oil.  And with good reason: Traders have been skeptical of an agreement between OPEC and non-OPEC producers, including Russia, to extend last year"s supply cut, and already they"re concerns are being validated: Iraq has said it plans to increase production later this year despite the agreement.

The existence of negative capacity is a reversal of the typical dynamic, where refiners are forced to supplement their deliveries with tanker shipments or imports.

"The only reason [the pipelines] wouldn"t be full is clearly that inventory levels are high enough that there is no incentive to move product to New York," said Sandy Fielder, director of oil and products research, Morningstar in Austin, Texas.

"The situation is quite unusual," he said.

Even when high inventories make it unprofitable to do so, refiners typically keep pumping full volumes just to ensure they keep their rights to the line space, said Fielden.

But it appears as if refiners have finally reached the point where the financial pain outweighs the necessity of keepig their lease on some pipeline space - after all, Colonial has capacity to spare right now.

"It"s purely economic - why ship into a negative arb(itrage) for that long," one trader said.

Colonial connects Gulf Coast refineries with markets across the southern and eastern United States through more than 5,500 miles (8,850 km) of pipelines, delivering gasoline, diesel, jet fuel and other refined products. Colonial indicated it did not expect demand to exceed capacity for the next five-day cycle through the line, and informed shippers it would therefore not follow the typical process for rationing space.

Oil traders who insist on staying long can hold out hope that production shutdowns related to Tropical Storm Cindy could lift the price of oil for a short period. It"s also worth noting that  Dennis Gartman, who recently said oil wouldn"t rise above $44 a barrel again in his lifetime, just turned bullish folllowing a wave of downgrades from energy analyst. That could be good news...or maybe not.

While the cause of the supply is obvious, whatever has caused demand to fall off is less clear. Barclays has suggested that President Donald Trump"s immigrant crackdown has made millions of illegal immigrants living in the US afraid to get behind the wheel for fear of being detained and deported. If this is true, that means Trump is to thank for gasoline prices falling to their lowest levels since February, despite the start of the summer driving season?

Are Banks About To Derail The New U.S. Shale Boom?

Authored by Irinia Slav via OIlPrice.com,

Just when international oil benchmarks are sliding down, banks are preparing to review the credit lines of U.S. E&Ps. Starting in April, lenders will reassess companies’ creditworthiness on the basis of reserves, production trends, current prices, and future prospects for the industry, among others. Should anything spark worry, banks will be quick to start reducing their exposure, cutting credit lines and arresting producers’ recovery at a crucial point.

This year, U.S. E&Ps have announced an overall spending increase of $25 billion from 2016, an 11-percent rise, as a clear sign of continuing optimism after the November OPEC-non-OPEC deal that aimed to shave 1.8 million barrels of crude off daily global supply.

Besides boosting spending plans, producers have been adding rigs at a respectable pace: at the end of last week, active oil and gas rigs in the United States totaled 789, an increase of 313 over a year ago. They are also investing in more efficient drilling technologies, aiming for ever lower production prices in the aftermath of the oil price crash.

The banks could put a stop to all this if they deem the outlook for oil prices or any other element of their assessment methodology unfavorable. For oil prices, more bad news seems to be on the way if we are to trust Goldman Sachs.

The investment bank said in a note yesterday that record-high investments in 2011-2013 could start bearing fruit this year and the next two, adding around a million barrels of crude to global daily production on an annual basis in the period 2017-2019. That will only happen if the mega projects that swallowed the huge investments deliver as expected, which is by no means certain.

This message contrasts with an earlier one, contained in another note to investors, which saw global oil supply tightening thanks to the OPEC deal. In fact, at the time – a month ago – Goldman was of the opinion that the draw in global stockpiles would completely offset the rise in U.S. shale output.

But for now, Brent crude is now trading below $51 and WTI has dropped below $48 a barrel. Investors are watching OPEC again for a possible extension of the production cut deal, but it’s still uncertain if it will happen, and even if it does, no one knows what the effect of an extension would be.

OPEC Praises Production Cuts, Reveals No Penalties For Violators As Deal Skepticism Rises

After Sunday"s latest meeting between OPEC and non-OPEC countries in Vienna, energy ministers struck an optimistic note regarding the recent agreement to cut oil output as a committee set to monitor compliance with the deal meets for the first time. Oil producers said they are in "total agreement" on the mechanism for monitoring pledged output cuts, Kuwait Oil Minister Essam Al-Marzouk told reporters after the committee ended its meeting in Vienna.

"I am satisfied, I am optimistic and, as I said, the markets are on their way to rebalance and it"s happening," Saudi energy minister Khalid al-Falih said. He added that compliance with the agreement, which calls for cuts to begin this month, had been "fantastic", he said adding that "based on everything I know, I think it’s been one of the best agreements we’ve had for a long time.” The issue, however, is that what everyone else knows is largely sourced from word of mouth statements, at least until the first official reports of monthly production emerge, validating his optimism.

As a reminder, under the Vienna deal struck last December between OPEC and non-OPEC nations, producers agreed to lower production by nearly 1.8 million barrels per day (bpd) aiming to ease a global glut that has weighed on oil prices for more than two years.

Following Falih"s claim last week that 1.5 million bpd in production had already been taken out of the market, on Sunday the Saudi energy minister added that "usually non-OPEC would raise their production to compensate for voluntary cuts by OPEC. Now, we are seeing voluntary cuts by both sides."  Saudi Arabia, has already exceeded its target with an output reduction of more than 500,000 barrels a day, Al-Falih said, while Algeria and Kuwait have also cut to levels beyond their targets, according to ministers from those nations. Other OPEC members such as Iraq and Venezuela have not yet reached their quotas but say they are more than half-way there.

Al-Falih then predicted that "the other 300,000 bpd, for all I know, is still happening," and hoped for 100 percent compliance in February. Full compliance could take global oil inventories back close to their five-year average by mid-2017, lowering oil in storage by around 300 million barrels, Falih said.

Still, despite the elated promises of cooperation, it still remains unclear just how monitoring of compliance would take place. According to Reuters, Kuwaiti oil minister Essam Al-Marzouq, who chairs the five-member compliance committee, said it would examine how to best monitor compliance and what level of compliance would be acceptable.  The other members of the committee represent Algeria, Venezuela, Russia and Oman.

In other words, faith in "compliance" still remains largely a function of trust that OPEC is telling the truth, which in light of historic precedent, when numerous OPEC members complied with initial cut agreements only to defect shortly thereafter, can be a major leap of faith. Indeed, as Bloomberg notes, OPEC has often flouted its own target as member nations quietly tried to gain market share at their peers" expense.

Venezuela"s new oil minister, Nelson Martinez said his country has achieved more than half of its planned 95,000 bpd cut, although again there was no way to verify. 

"[There are] no surprises so far in terms of demand or supply from other sources so there is no reason for us to suddenly come in January and say we need a bigger reduction or a longer period," he said.

The biggest wildcard remains Russia. It Energy Minister Alexander Novak on Sunday said he was satisfied with the level of compliance shown. Russia has cut its oil output by around 100,000 bpd, Novak told Russia"s TASS news agency. Novak added Russian oil production has averaged around 11.15 million bpd this month. In his opening speech to the Vienna meeting, Novak said many countries had lowered their oil output by more than they had agreed to and added that Russia was lowering its production ahead of schedule.

He told reporters that oil output cuts had been positive for markets, adding it was too early to talk about extending the output-reduction deal beyond the planned six months but that remained an option. "Every one sees that the agreements on oil production cuts have already have a positive effect on oil markets. The market has become more stable and predictable."

“We are starting to see a shift in the momentum and the emergence of more bullish sentiment on the market,” Kuwait’s Oil Minister Essam Al-Marzouk said at the start of the monitoring committee’s first official meeting. “These are all encouraging signs that we are on the right track.”

Meanwhile, Saudi Arabia is reportedly producing slightly below 10 million bpd and has informed buyers of Saudi crude of substantial cuts scheduled for next month, he said.

How (non) compliance will be evaluated?

With January not yet complete, Bloomberg reports that the committee will focus mostly on how to assess compliance rather than produce any new data, said one person. As outlined in OPEC’s initial agreement, monthly production data known as “secondary sources” compiled by analysts in the group’s secretariat will be the principal tool for judging whether members are complying with the deal, said three people. Those figures don’t cover non-members such as Russia.

The committee currently has no plans to use external agencies, such as consultants that track oil exports by monitoring tanker movements, to verify that countries are implementing the pledged supply curbs, said three people familiar with the matter. It will meet every month, the Kuwaiti oil minister said. Additionally, the OPEC committee said it would not need export data, and will instead only focus on output data.

“Evaluation of conformity to the respective country production adjustment will be based on production data only,” according to OPEC statement on group’s website.  OPEC will present a report with monthly production data to Joint OPEC-Non-OPEC Ministerial Monitoring Committee, known as JMMC, on 17th of each month; report also to include non-OPEC producers’ oil liquid output. Furthermore, the monitoring committee would meet next on March 17, then for 3rd time in May before OPEC gathers that month; with the March meeting said to be in Kuwait.

Each of the 5 member countries comprising JMMC to nominate one technical contact person to form Joint Technical Committee (JTC), which will also include OPEC presidency.

These export obfuscations - the real variable in OPEC compliance - suggests that beneath the thin veneer of deal "compliance", the underlying production dynamics may end up being far different from the promised 1.8mm, if not greater, reduction.

But the clearest indication that non-compliance will be a major hurdle was a statement by the Russian energy minister Alexander Novak who told reporters that violators to the output cut agreement will not be penalized. Which means that without negative reinforcement, compliance may work as long as prices are rising offsetting volume losses, but the moments prices slip expect the agreement to be quickly violated by one or all member states.

“We started to trust each other better, which is just as important as the market re-balancing,” Russia’s Novak said. “One year ago not many believed in the success of this initiative.”

That said, when we check back one year from today, the skepticism of the "many" will be justified. Here"s why.

Why Only A Six Month Deal?

As OPEC has claimed before, there’s no indication that the cuts will need to be extended beyond the initial six-month term, Algerian Energy Minister Noureddine Boutarfa said in an interview, echoing comments from his Saudi counterpart earlier this week. “If we really comply by 80 to 90 percent, it may not be necessary to continue,” Boutarfa said. “We aren’t excluding it, but signals are positive.”

But why just six months? As Bloomberg"s Julian Lee writes overnight, "that seems a very quick and painless solution to an oversupply problem that has bedeviled the oil market for the past two years, brought several producers to the brink of collapse and tipped others over it."

We now may have the answer.  As Lee adds, "the latest numbers from the Joint Organisations Data Initiative offer a different, and compelling, narrative" from the widely accepted one, namely that "brimming supply had created financial difficulties for the kingdom, and also complicated the forthcoming IPO of a small part of Saudi Aramco."

This is what happened:

It turns out that, as the deal was being thrashed out, Saudi Arabia was enjoying a 35-year high in total oil exports. One big factor was a huge drop in the amount of oil the country needs to burn to generate electricity. The punishing Saudi summers boost demand for electricity -- mostly to run air-conditioners -- to a level that previously required vast amounts of oil-fired generating capacity to be brought into use. The direct burning of crude oil in power stations would roughly double to about 900,000 barrels a day at the height of the season.

Saudi oil usage has dropped as natural gas replaces around a third of what it uses for power generation.

But that changed last year. The start-up of the Wasit gas plant allowed the kingdom to slash the use of crude in power generation by as much as a third -- freeing that oil up for export. In addition, the kingdom cut fuel subsidies, pushing down oil consumption by 2 percent year-on-year in the first eleven months of 2016. That"s the first dip since at least 2003, when JODI records begin.

As a result, Saudi Arabia was left with "an embarrassment of riches as the OPEC negotiations were underway last year." So, unless it cut output, it would start flooding the market during the first half of 2017. Conveniently, t he stars were aligned for it to solve the problem by persuading others to share the burden in a way that has not been seen since the financial crisis of 2008, while at the same time restoring its credentials as a team player within OPEC.

"This new read on the Saudis" motivations for agreeing to the deal has the benefit of explaining why Al-Falih is looking for a six-month time line and why the kingdom has been prepared to make such a deep cut in its production. Its surplus will have disappeared by that time, at which point it can start to boost production again in order to get exports back to the level it wants to maintain."

Lee"s conclusion: "Such a move could easily be the catalyst for the whole deal to fall apart by June." Which, in turn, would explain why OPEC is repeatedly pointing out the "6 month" bogey as a successful deal deadline, after which OPEC members wil go their separate ways once again, pumping to the max. However, there"s no way the global backlog of inventory will be dealt with at that time.

Ultimately, "this seems a situation designed to antagonize the rest of the group and create a raft of bad feeling. If maintaining exports is more important to Saudi Arabia than balancing the market, then so is a willingness to back out on a hard-won deal that took the kingdom and its partners a lot of political capital to achieve."

In short, enjoy the OPEC "deal", with minimum surveillance, virtually no compliance markers and zero penalties for violators: the production cut "deal" relying entirely on "trust" between OPEC members, is anything but.

For now, however, oil will trade with each and every optimistic headline out of OPEC, likely pushing the price to a level where the recent surge in US shale production becomes a flood - recall on Friday Baker Hughes reported that the US oil rig count soared by 29, the most since April 2013...

... and threatens to cut deeply into OPEC"s own production levels, guaranteeing that the collapse of the OPEC "deal" is just a matter of time.