Since making a low in July last year, West Texas Intermediate Crude (WTI) has risen by 38.5% and is now approaching the $75 highs achieved at the end of June this year. In the same period, the US Dollar Index has fallen just 2%, suggesting that oil prices, long negatively correlated with the US currency have “de-coupled”, with a new pricing dynamic coming to the fore. Last week saw another crude drawdown (in stockpiles), pushing both WTI and Brent Crude still higher, with the latter reaching $80. In February 2016, WTI was trading at $26 a barrel.
We can see any number of geopolitical factors that are conspiring to raise prices; the on-going trade “war” between the US and China, the sanctions imposed on the export of Iranian crude, the interminable proxy war in Syria which gives plenty of ammunition for the Oil bulls. One analyst thinks oil could rise to $250 per barrel should the Iranians decide to block the Strait of Hormuz (which is a MAJOR oil shipment route).
Investment management firm Sanford Bernstein believes that years of returning cash to shareholders at the expense of Capital Investment could lead to an underinvestment crisis, causing Oil reaching $150. The analyst wrote “Any shortfall in supply will result in a super-spike in prices, potentially much larger than the $150 a barrel spike witnessed in 2008.” Others, such as Morgan Stanley, believe $85 oil is the target. Most other Investment banks see oil around current levels for now, but are careful to hedge their bets with the appropriate caveats regarding politics etc.
A more interesting theory concerns the effect of IMO (International Maritime Organisation) regulations, due to take effect in 2020, regarding sulphur emissions. They want the maximum content of sulphur in shipping oil to drop from 3.5% now to just 0.5%. The result would be a global shortage of compliant fuel types, while relatively few refineries have the ability (let alone the capacity) to ramp up production to the levels required to meet that demand. If supply cannot rise to meet demand, the latter will have to fall (i.e. demand sapping price rises). In the interim, oil prices could rise (it is said), to $150+.
Before we all rush out to chop down whatever plantation exists in our gardens for fuel, one must remember that there is an alternative view (which of course is what makes a market).
One Oil market truism is that “the best cure for high oil prices is high oil prices”, which is another way of saying that high prices sows the seeds of its own demise. As prices rise, demand inevitably falls (or the demand for other things fall, as most have only a finite amount of available cash to pay for “stuff”). The latest oil market reports (cited above) showed that demand for Gasoline and Diesel actually fell by 1 million barrels per day, which is an indication that higher prices are starting to hurt drivers at least.
The latest OPEC monthly report (for August) shows that the cartel is expecting supply to remain broadly stable, but that global demand has been revised down (by c.20,000 barrels per day (b/d) for 2018- compared to its forecast of the previous month- and 2019 demand has been revised down by a similar amount). The big concern appears to be Chinese growth, which is (unsurprisingly), likely to be subdued by the on-going trade dispute between the US and China, with the latter’s crude oil imports falling by 70,000 b/d in July, which OPEC expects to continue (and possibly intensify).
The Russian Finance Ministry (Russia are not an OPEC member), are also warning of a fall to sub $50 dollars per barrel, as they believe prices are above “long-term equilibrium” levels; there is also the potential for another Donald Trump “tweet fest”- last week he warned OPEC again, (and not very cryptically), about the issue, saying “We protect the countries of the Middle East, they would not be safe for very long without us, and yet they continue to push for higher and higher oil prices! We will remember. The OPEC monopoly must get prices down now!”. Should this fail, he could easily release oil stockpiles from the nation’s Strategic Petroleum Reserve- up to 30 million barrels (out of a total reserve of 660 million barrels), would certainly have a major effect on prices, and conveniently, could occur just in time for the US mid-term elections in November.
The final factor in lower oil is the US drillers themselves; this year, the US became the world’s largest oil producer, according to the US EIA’s estimates, surpassing both Russia and Saudi Arabia. North Dakota alone is now pumping as much oil as Venezuela, Many US shales drillers have been hedging the oil price they receive, (by selling futures oil production); at c.$55 per barrel, well below current levels. This is a prudent risk management strategy, designed to protect future cash flow and with oil price forecasts for 2019 ranging from $45, (Citibank) to around $80 (Goldman Sachs)- i.e. all over the place- it seems eminently sensible to do so. But it is very likely that more hedging will occur as prices rise, as many firms do not have the luxury of being able to withstand another decline in oil prices. So, the higher prices go, the more hedging will be completed putting downward pressure on prices
All of this implies a degree of uncertainty regarding oil prices that is unusual even in a market where 2% + daily swings are not uncommon. Current Oil futures market annualised volatility is 26.15%, which translates into an expected daily range of 1.73%, so trying to guess the direction is a bit of a fool’s errand. The ultimate pathway for prices could have major consequences for World Growth, (and thus for stock markets), so needs to be watched carefully. But to be on the safe side, maybe I need to sharpen my axe…
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.