As Brent oil touched $86 a barrel, there was no shortage of oil pundits and sell-side analysts calling for $90/bbl, or even $100, quoting Iran sanctions, lack of Saudi Arabia spare capacity and any geopolitical headline to support their thesis. It is easy to follow a trend but not understand what is driving that trend -- and what can change it. Why do we even bother reading sell-side, IEA, and EIA commentary as other than an excellent substitute for night-table stands? I am not entirely sure the point of reading "what is" as opposed to "what can be."
Oil is a seasonal commodity. It trades from summer gasoline demand season to winter heating oil season. Oil is the input that goes into making various products, from Jet Fuel to Distillate and other fuels, whose market economics actually drive the demand for oil. Less than 10% of the people trading oil can probably spell or quote the cracks that drive these products, yet most run outright naked future positions in them following media articles and stories. An old lesson I learnt while on the trading floor, "Once something is printed, it's not news anymore," still holds true to today.
Since the summer, there has been a collapse in emerging market demand, given the rising dollar -- as evident by the economic data prints from various economies -- including Argentina, South Korea, Turkey, India and all the way to China. If consumers of oil were showing weak growth, how can analysts assume the same demand rate as earlier this year? Astonishing! Once the U.S. summer gasoline season ended in September and hurricane damage to oil infrastructure was contained, oil inventories started accumulating as refineries needed less oil to process it into products.
The nail in the coffin was the increased supply from Russia and U.S. shale at a time when demand was softening. U.S. crude oil production is rising at the fastest rate on record, as the higher prices have boosted drilling and completion activity. Crude oil production hit a record of 11.35 million barrels per day (mbpd) in August, up from 10.93 mbpd in July, according to U.S. Energy Information Administration (EIA). Crude output has increased by more than 2 mbpd over the past year -- an unparalleled rate. Most of the increase is coming from onshore shale fields, where output has risen by more than 1.9 mbpd over the past year.
During the summer, the market was worried about the impact of Iran oil sanctions. There were analysts talking about loss of the entire 2.5 mbpd of oil exports. Despite Trump's bullying tactics, most of the larger traders of Iranian Crude, like Europe, China, Turkey and India, said they would still do business with them. Ironically enough, as sanctions take effect today, it was announced that most of Iran's clients have been exempt from the sanctions. Yawn! Why bother with all this noise when really nothing has changed in the physical market?
Russia and Saudi Arabia have increased production, as well. The former's production averaged 11.412 mbpd last month -- a post-soviet record and not far off the highest-ever output. Who can blame them, given these mouth-watering prices of $85/bbl., when the fair value of oil is somewhere closer to $70/bbl., barring a global recession.
Now that prices are back down, President Trump will be happy to quote "victory" at getting prices down, as voters head to the polls on Tuesday to vote for the House and Senate leaders. Amazing how he takes credit for everything positive, but blames China or the Fed when things do not go to plan.
The oil market is in a shoulder period for now. We need to wait till winter heating season starts to see how demand is shaping up going into the fourth quarter. Given the global macro slowdown seen across the board and U.S. data being impacted by the president's Trade War games and the Fed not holding off on raising rates, U.S. financial conditions are not getting any easier. The implications for oil price are negative at a time when demand is coming off and supply is picking up as producers scramble to monetize on these juicy price levels.
Even the major oil companies, despite their huge cash generation over the past few quarters, are down 10%-15% over the past month. Investors forget yield makes no difference whatsoever if their top-line driver (oil price) is going in the opposite direction. Time to take profits on being short oil majors -- but for now, oil and oil stocks will be a source of funds, as there is much better value in the commodity complex, namely base metals like copper, iron-ore and steel. We just need to get the yuan and U.S./China trade war noise out of the way, then we can go back to the physical market dynamics.