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THE above chart shows the extent to which this year's
oil-price rally has been led by futures markets. What is significant, though,
is that futures activity seems to have plateaued.
Sure,
futures activity could easily go the other way again, driving prices
significantly above the $50/bbl level. But barring a decision by the US Federal
Reserve to once again step away from interest rate rises and China further
loosening the credit tap, it is hard to see why the speculators would want to
go deeper into bull territory. The market remains heavily distorted by the
speculators, and so first and foremost you must analyse futures activity before
you then look at physical supply.
Right
now, I would argue that the Fed looks set on raising interest rates again in
June or July. And in China, credit growth contracted again in April. I believe
this indicates that economic reforms are gathering pace again.
As for
the real supply and demand of oil, you should have been asking yourselves two
questions throughout this rally: Shortages? What Shortages?
I'll deal
with the Fed, China, and today' crude supply position in more detail later on.
First of all, though, here is some historical context behind the role that
financial markets have played in determining the oil price over the last seven
years.
China, Jobs and
Economic Stimulus
I believe
that that the 2009-2014 rally in crude prices was driven by the fall in the
value of the US dollar, thanks to the Fed's ultra-low interest rate policies.
This forced hedge funds and pension funds etc. to seek an alternative 'store of
value'. This store of value was oil and other commodities.
What
seemed to justify this alternative store of value was China's parallel decision
to conduct the biggest economic stimulus programme in global economic history,
which cushioned the country from the impact of the Global Financial Crisis. It
was all about preserving jobs for the Chinese leadership of the time. They
didn't care about anything else, including the long term fundamentals of supply
and demand as overinvestment poured into manufacturing and real estate. To give
you an idea of the scale of what I am talking about, China increased lending by
$10 trillion in 2009, when its nominal GDP was only $5 trillion. Lending was an
astonishing $18 trillion higher by 2013.The long term economic benefits of this
extraordinary rise in credit didn't worry the financial speculators. Of course
not. It is not their job be worried about the long term. But other people who
should have known better, including CEOs of some chemicals companies, who
started talking about a 'new paradigm' of a rising middle class in China who
would very soon be as rich as the middle classes in the West. This not only
justified and underpinned the rallies in oil and commodity prices - but
crucially also added further momentum to the rallies.
As this
paradigm became the new consensus, the shale-oil industry took off in the US -
aided also by the availability of cheap financing thanks to the Fed's
interest-rate policies. Petrochemicals projects in the US, and elsewhere, were
also sanctioned on the theory that China - and emerging markets growth in
general - had entered this new paradigm.
It all
went very badly wrong from September 2014, when it became apparent that Chinese
economic stimulus had, after all, been unsustainable. Crude markets belatedly woke up to the notion
that China's stimulus had left behind vast domestic oversupply in manufacturing
and real, estate, and so a serious bad debt problem. The scale of China's environment crisis, made much worse by this overinvestment, was also
recognised.
What made
people wake up to these long-standing realities was that China's new political
leaders admitted the scale of the problems - and, more importantly, they
reversed course. They started reducing credit growth, and so the Chinese bubble
began to dramatically deflate. Credit growth began to decline from January
2014. And here is another extraordinary number: In 2015, growth in credit was
no less than $4 trillion lower than in 2014.
Back To The Future:
Q1 2016
After the
January 2016 collapse in oil prices and equity markets, the US Federal Reserve
got cold feet. It began to back away from further interest rate rises, on the
belief that weak crude and equities etc. meant that US economy was in too
perilous a condition to take that risk. This was the signal sent to the oil
speculators: The dollar was going to be weaker for longer than they had
expected, and so it was time to get back into crude as an alternative store of
value. This also led to recovery in other commodity markets, including iron ore.
What once
again added further momentum to the rally was China's decision to loosen
credit, which grewby some 58% in Q1
over the first quarter of 2015. The detail didn't matter here. All that
mattered to the crude-market speculators was the wider belief that China had,
somehow, turned the corner. The renewed economic stimulus created the erroneous
idea that China could spend its way out of trouble.
Now,
though, thanks to stronger US GDP growth and continued robust jobs growth, Fed
chairman Janet Yellen has indicated that two to three interest rate rises could,
be on the cards later this year - with the first hike possibly in June or July.
And in
China, credit growth fell in April. Total social financing plunged to 751 billion yuan during
month compared with 2.34 trillion yuan in March.
Any
sensible analyst would have told you that China's Q1 rise in lending was
unsustainable - and that, of course, it was a drop in the ocean compared with
the $4 trillion of credit withdrawn from the economy in 2015.
What told
you it was unsustainable was that this represented another example of a victory
for the short-term thinkers who in China, who prefer to prop-up immediate
growth rather than deal with the longer-term issues. But you also had to bet
that the reformers would reassert control - and, indeed, this has happened. In
this particular instance, local governments temporarily gained the
upper hand because of their struggle to cover their liabilities.
The end
result - and may have already seen early signs of this in the above chart -
could well be speculators switching back to the US dollar, as is strengthens -
away from their alternative stores of value.
Actual Supply And
Demand of Oil Itself
Last is
not meant to be least. Of course, this matters. But in all the noise created by
the speculators, the sound made by the data on physical production, storage and
demand can sometimes be impossible to hear.
Take last
year's oil-price rally as an example. Remember how we kept being told that the
US rig count was falling? This took Brent from $45.19/bbl in mid-January to
$69.63/bbl on 8 May.
Meanwhile,
US shale oil producers continued to push the innovation envelope on cost
reductions. Each rig in operation had also become much more productive. The practice of 'fracklogging' - storing oil in rocks ready to be fracked when
prices recovered - also increased. And thanks to stronger futures prices, the
shale oil industry was able to take out new hedges. This put them in the
position to be able to sell at lower prices in the physical market because they
had locked higher futures returns. Saudi Arabia also stuck with its market
share strategy, whilst the global economy remained weak. This all led to the
fall in oil prices during H2 2015.
The
physical justification for today's rally is on even more shaky ground.
We were
first told that there would be a production freeze agreement at the April Doha
meeting. I never believed that
this on the cards - and, of course, it didn't happen.
We did
then, however, see a dramatic decline in production as a result of wild fires
in Canada, attacks on Nigerian pipelines and more upheavals in Iraq. But I
think that this was seized upon by markets whilst they overlooked some signs of
long supply elsewhere. And, of course, this decline could well prove to be
temporary.
Signs of
long supply elsewhere includes oil in storage. Global oil stockpiles, including
floating storage, have increased for the last ten consecutive quarters,
according to this Hellenic Shipping News article, which adds:
It is estimated that almost 9% of the global VLCC fleet is
currently booked for floating storage, which is a 40% increase in tankers by
number since December. Reuters reported that at least 40 laden VLCCs anchored
off Singapore as floating storage, storing estimated volumes of up to 47.7m
bbl, thought to be the highest level in at least five years.
Crucially,
also the contango is narrowing. Last week, the one-month arbitrage on Brent in
floating storage was -$0.48/bbl, while the 12-month arbitrage was at
-$6.11/bbl, implying there was no profit incentive to store oil on ship.
Storage costs are a minimum of $0.74/bbl, and so there has to be a risk of
destocking.
Iran is
also raising production. By the summer its exports are expected to rise a
further 200,000 bbl/day to reach 2.2m bbl/day the middle of this summer.
And
nobody should be surprised over reports that the US rig count has stopped
declining, with early signs that the rig count may actually increase.The US is
the world's new 'swing producer'. The inventory of drilled but uncompleted US
wells has been building, driven by companies with contracted drilling
services. Ccompanies have merely postponed, rather than cancelled, completion
of wells. This could add 400,000 bbl/day to supply.
Let's not
forget yesterday's OPEC meeting. There was again, of course, no agreement to freeze, never mind cut, production.
As for
demand, the summer lull season in the northern hemisphere, when many people
take their holidays, is set to occur in August and July.
If this
market turns, those who want to short oil have plenty of physical ammunition to
support their positions.
John Richardson from ICIS
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Supply chains are currently in crisis. They have been for a long time now, ever since the start of the Covid-19 pandemic reshaped the way the world works. Stressed shipping networks and operational blockages – coupled with China’s insistence on a Covid-zero policy – means that cargo tanker rates are at an all-time high and that there just aren’t enough of them. McDonalds and KFCs in Asia are running out of French fries to sell, not because there aren’t enough potatoes in Idaho, but because there aren’t enough ships to deliver them to Japan or to Singapore from Los Angeles. The war in Ukraine has placed a particular emphasis on food supply chains by disrupting global wheat and sunflower oil supply chains and kicking off distressingly high levels of food price inflation across North Africa, the Middle East and Asia. It was against this backdrop that Indonesia announced a complete ban on palm oil exports. That nuclear option shocked the markets, set off a potential new supply chain crisis and has particular implications on future of crude oil pricing and biofuels in Asia.
A brief recap. Like most of Asia, Indonesia has been grappling with food price inflation as consequence of Covid-19. Like most of Asia, Indonesia has been attempting to control this through a combination of shielding its most vulnerable citizens through continued subsidies while attempting to optimise supply chains. Like most of Asia, Indonesia hasn’t been to control the market at all, because uncoordinated attempts across a wide spectrum of countries to achieve a similar level of individual protectionism is self-defeating.
Cooking oil is a major product of sensitive importance in Indonesia, and one that it is self-sufficient in as a result of its status as the world’s largest palm oil producer. So large is Indonesia in that regard that its excess palm oil production has been directed to increasingly higher biodiesel mandates, with a B40 mandate – diesel containing 40% of palm material – originally schedule for full implementation this year. But as palm oil prices started rising to all-time highs at the beginning of January, cooking oil started becoming scarcer in Indonesia. The government blamed hoarding and – wary of the Ramadan period and domestic unrest – implemented a Domestic Market Obligation on palm oil refineries, directing them to devote 20% of projected exports for domestic use. Increasingly stricter terms for the DMO continued over February and March, only for an abrupt U-turn in mid-March that removed the DMO completely. But as the war in Ukraine drove prices even further, Indonesia shocked the market by announcing an total ban on palm oil exports in late April. Chaotically, the ban was first clarified to be palm olein only (straight refining cooking oil), but then flip-flopped into a total ban of crude palm oil as well. Markets went haywire, prices jumped to historical highs and Indonesia’s trading partners reacted with alarm.
Joko Widodo has said that the ban will be indefinite until domestic cooking oil prices ‘moderate’. With the global situation as it is, ‘moderate’ is unlikely to be achieved until the end of 2022 at least, if ‘moderate’ is taken to be the previous level of palm oil prices – roughly half of current pricing. Logistically, Indonesia cannot hold out on the ban for more than two months. Only a third of Indonesia’s monthly palm oil production is consumed domestically; the rest is exported. An indefinite ban means that not only fill storage tanks up beyond capacity and estates forced to let fruit rot, but Indonesia will be missing out on crucial revenue from its crude palm oil export tax. Which is used to fund its biodiesel subsidies.
And that’s where the implications on oil come in. Indonesia’s ham-fisted attempt at protectionism has dire implications on biofuels policies in Asia. Palm oil prices within Indonesia might sink as long as surplus volumes can’t make it beyond the borders, but international palm oil prices will remain high as consuming countries pivot to producers like Malaysia, Thailand, Papua New Guinea, West Africa and Latin America. That in turn, threatens the biodiesel mandates in Thailand and Malaysia. The Thai government has already expressed concern over palm-led food price inflation and associated pressure on its (subsidised) biodiesel programme, launching efforts to mitigate the worst effects. Malaysia – which has a more direct approach to subsidised fuels – is also feeling the pinch. Thailand’s move to B10 and Malaysia’s move to B20 is now in jeopardy; in fact, Thailand has regressed its national mandate from B7 to B5. And the reason is that the differential between the bio- and the diesel portion of the biodiesel is now so disparate that subsidy regimes break down. It would be far cheaper – for the government, the tax-payers and consumers – to use straight diesel instead of biodiesel, as evidenced by Thailand’s reversal in mandates.
That, in turn, has implications on crude pricing. While OPEC+ is stubbornly sticking to its gentle approach to managing global crude supply, the stunning rebound in Asian demand has already kept the consumption side tight to match that supply. Crude prices above US$100/b are a recipe for demand destruction, and Asian economies have been preparing for this by looking at alternatives; biofuels for example. In the past four years, Indonesia has converted some of its oil refineries into biodiesel plants; in China, stricter crude import quotas are paving the way for China to clamp down on its status of a fuels exporter in favour of self-sustainability. But what happens when crude prices are high, but the prices of alternatives are higher? That is the case for palm oil now, where the gasoil-palm spread is now triple the previous average.
Part of this situation is due to market dynamics. Part of it is due to geopolitical effects. But part of it is also due to Indonesia’s knee-jerk reaction. Supply disruption at the level of a blanket ban is always seismic and kicks off a chain of unintended consequences; see the OPEC oil shocks of the 70s. Indonesia’s palm oil export ban is almost at that level. ‘Indefinite’ is a vague term and offers no consolation to markets looking for direction. Damage will be done, even if the ban lasts a month. But the longer it lasts – Indonesian general elections are due in February 2024 – the more serious the consequences could be. And the more the oil and refining industry in Asia will have to think about their preconceived notions of the future of oil in the region.
End of Article
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