February 01, 2016
It says something about the current oil market that the conflagration between Saudi Arabia and Iran at the beginning of the year generated little more than a slight upward blip in prices. Ditto the muted market reaction to an apparent Hydrogen Bomb test carried out by North Korea. As recently as 2013, these kind of events would have sent prices sky-rocketing. But such is the current level of over-supply in the oil markets that prices only momentarily headed up, before continuing their relentless drive downwards. The only clear conclusion can be that – however bad things are in the world - geo-political concerns are very much playing second fiddle to the basic dynamics of supply and demand.
The current over supply situation has been well documented; fracked oil flooding US markets, OPEC refusing to cut production in an attempt to maintain market share and now, Iran’s bounteous harvest of oil (4th largest producer in the world) ready to overwhelm the market even further. But, at the same time, we now have a concurrent narrative around slackening demand. In the past, Portland has taken a fairly sanguine view of this supposed reduction in global oil demand - preferring to call it a slow-down in demand growth rather than an actual reduction in consumption. But now with China’s economy potentially going into (minor?) meltdown, can we be so confident that demand will hold up? The markets would seem to suggest not, with each new month heralding another unceremonious breach of a previously “agreed” minimum price for oil.
$50…$40….$30…Each price “floor” has been swept aside and we are now getting to the point where we might have to accept Goldman Sachs’ $20 per barrel prediction after all. In fact, the odds on even more outlandish predictions ($10 from Standard Chartered) are shortening by the day. Maybe we are heading back to the 1990’s, when crude prices largely stayed below $20 and dropped as low as $7 in 1997!
Well, probably not actually, because 2016 is certainly not 1997. Not least, the world has 1.5bn more people (!) to feed, heat and transport. And if demand is looking a little more patchy, it is still growing – and most definitely growing in China. OK, the Chinese Stock Market seems to be collapsing under the weight of its own unsustainable expectations (and may well be a harbinger of future economic problems), but this seems unlikely to affect current oil consumption. As evidence of this, January 2016 saw a record amount of oil imported into Chinese ports.
Plus 6% GDP growth in China means that they will “only” create an economy the size of Poland over the next 12 months! Then there are the actions of China’s Oil Stocking Agency to take into consideration. This Government body is busily seizing the moment and buying as much low-priced oil as possible and has already acknowledged its desire to increase the national stock holding to 90 days of reserves (in line with countries in the EU and IEA = International Energy Agency). Although accurate data is difficult to come by, most estimates put current Chinese stock reserves at between 20 and 30 days, which leaves 65 “days” of oil to purchase. Based on a daily consumption of circa 1.5bn litres, that’s 100bn litres of incremental demand making its way to China.
There is also a credible supply related argument against prices hitting $20 (or if they do, not staying there for very long) and this concerns the nature of crude oil pricing. When we talk about “crude” being at $20 a barrel, what we are really referring to is the benchmark crudes of Brent and WTI (West Texas Intermediate). But these marker grades make up only a small percentage of the oil sold around the world, with the vast majority of crude being sold at a discount to these two grades. So for example, “$20 a barrel” would in fact mean around $15 (ie, a $5 per barrel discount) for oil from fracking wells - such is the tricky, truck-based logistics required to deliver that type of land-locked oil to US refineries. And Heaven forbid you are producing sour crudes from Alberta, where the quality give-away is huge (lower quality crude means refineries have to work harder to process it into cleaner, refined products). Forget Goldman Sachs and $20 - some of the heavier, bitumen based Canadian crudes are already discounting at up to $18, which means the actual price is already below $10 per barrel…ouch!
Such rock bottom prices are of course not sustainable and the sands of time must be running out for oil producers at these low value levels. Put simply, something has to give. Whether it will be OPEC introducing strict production quotas or perhaps independent oil producers being able to hang on no longer. Or maybe oil buyers will conclude that demand is not so weak after all. One way or another, these super low oil prices will not last and a level around the $40-$50 mark seems likely by the end of this year, so we suggest you stock up on heating oil today.
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