OilVoice Magazine - Edition 52 - July 2016

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Oil Prices: Beware Return Of The Financial Bears - Brexit and the energy equation - North Sea Oil and Gas - an industry averse to change

Text of OilVoice Magazine - Edition 52 - July 2016

  • Edition Fifty Two July 2016

    Oil Prices: Beware Return Of The Financial Bears

    Brexit and the energy equation

    North Sea Oil and Gas - an industry averse to change

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  • 1

    Oil Prices: Beware

    Return Of The

    Financial Bears

    Written by John Richardson from ICIS

    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.

  • 2

    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

  • 3

    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 ofChina'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.

  • 4

    What once again added further momentum to the rally was China's decision to

    loosen credit, which grew by 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.

  • 5

    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.

    Thepractice 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