Revisiting Crude Oil
Beginning in late August we have frequently discussed the possibility that a significant low in crude oil prices could be imminent in spite of the “obvious” lousy fundamentals. As blind luck would have it, the first of these articles (entitled “Is Crude Oil Close to a Low?”) was posted exactly one trading day before the low to date was actually put in.
Note here that we are not saying it was the low, although this cannot be ruled out either. It seems very likely though that it was at least a low of medium term significance.
From a technical perspective, the action in crude oil since late August is so far consistent with a medium term low. The recent advance looks actually somewhat healthier than the previous one, due to the lengthy consolidation after the initial strong rally leg.
To summarize our train of thought on the topic: We noted for one thing that commodities always bottom out at a point in time when their fundamentals still look atrocious. This is simply due to the fact that prices will at some point have declined sufficiently to discount all the (by then widely known) negative factors.
For another thing, we have pointed out that the prices of commodities are ultimately not only determined by their specific supply-demand characteristics, but also by the money relation. For instance, no-one would seriously expect crude oil prices to revert back to their level of 1933 ($ 0.67 annual average), no matter how bad crude oil’s supply-demand fundamentals become. After all, since May of 1933, the Fed has managed to devalue the US dollar by nearly 95% (based on the government’s own dubious CPI statistics).
Neither should one expect nominal crude oil prices to revert to the level of 1998. The true broad US money supply (the domestic money supply alone – a lot of it has also moved into accounts held abroad and is not part of this statistic) has increased more than four-fold since 1998 (it stood at approx. $2.5 trn. in early 1998 and stands at $11.18 trn. as of August this year).
Based on this fact in combination with the long term technical picture, we have argued that the $35-$40/ bbl. price range of today is the functional equivalent of the $10/ bbl. price level in 1998 (since this particular argument about price ranges is based on empirical data, it is of course open to debate).
Subsequently we have updated this first article on the topic by looking at various other factors, resp. developments, such as e.g. the idea that the term structure of the oil futures market suggested that the supply glut was quite possibly much smaller than was widely believed at the time. As we found out, this opinion was shared by Andy Hall of Astenbeck Capital Management, who is known for being a relatively lone bull on oil.
For readers who have missed them or wish to refresh their memory, these updates and further deliberations on the subject of crude oil can be found in the following posts (in chronological order): More on Crude Oil and Industrial Commodities, A Word on Crude Oil, and Crude Oil – a “Ray of Hope”.
As an aside to all this, our suggestion that the Russian ruble was set to rise considerably if we turned out to be correct about crude oil making a low has turned out to be on the mark as well (not that it was hard to come to that conclusion, but as we have pointed out, this represented a great opportunity for investors to leverage potential gains in oil).
Here is a recent chart of the ruble – after at first advancing slowly from its late August lows (seen as a “high” in this chart, which depicts the number of rubles needed to buy one USD), its rally has recently accelerated quite strongly.The ruble begins to strengthen noticeably – click to enlarge.
The Oil Glut – How Big is it?
Today we want to briefly take up the question of the supply glut again, based on an interesting article we have come across in September (the information is of a general nature, so it is not really “dated”). We were always a bit perplexed by the fact that the oil market had been holding up so well through most of 2011-2014, considering that it was well-known throughout that time period that fracking was continually driving up the amount of crude oil held in storage in the US.
It appears now as though the market may not have been as wrong about interpreting the storage situation as it appeared on a superficial level. As the “The Oklahoman” reported in September, “Some in Oklahoma dispute whether nation has an oil glut”. A few pertinent excerpts:
“The rapid increase in domestic production over the past several years has displaced much of the country’s oil imports and forced changes in many of the ways companies operate throughout the oil patch. Oklahoma City-based Continental Resources Inc. executives say those supply changes also fundamentally affect the way the country’s oil storage levels are measured and understood.
“We’re in a new normal for infrastructure and reserves,” said Kirk Kinnear, Continental’s vice president of crude logistics and hedging. “The industry knows this paradigm shift is real and that they need to take this kind of infrastructure change into account in the new model. Yet the government hasn’t picked it up yet.”
The country’s commercial storage held almost 456 million barrels as of Sept. 11, the U.S. Energy Information Administration said this week. The number is down about 2.1 million barrels over the previous week. The agency has pointed out over the past few months that domestic storage levels now “soar above the five-year seasonal average” and are at 80-year highs.
Analysts have said the storage glut has crated an overhang that has held down prices and promises to keep prices low long after supply and demand return to balance. Kinnear does not dispute the storage numbers, only the interpretation. “It’s an irrelevant comparison, and it leads folks to believe we have a glut of oil when we really don’t,” he said.
When oil is imported to the United States, the oil is not counted in domestic inventory numbers until it clears customs and is poured into U.S. pipes and storage tanks. For the 50 days the oil is on a tanker from the Persian Gulf or the 15 days it takes to ship from the west coast of Africa, the oil is not included in U.S. inventory data. Domestic production, however, is counted essentially from the wellhead. Inventory numbers count the oil while it is moving through gathering systems and interstate pipelines and on trains, barges and trucks.
“Because these (domestic) barrels are replacing barrels that previously were delivered from other countries on tankers, the working inventory that refiners require to operate efficiently is now onshore and is being counted by inventory reports,” Kinnear said. “Previously, the working inventory was not counted because it was on tankers.”
Over the past seven years, domestic production has grown rapidly while oil imports have dropped. Accounting for that displacement and the time it takes for the oil to reach the refinery, Continental found a minimum of about 103 million barrels of oil inventories are needed to make up for the displaced imports.
“This is the absolute minimum because it’s assuming just-in-time inventory,” Kinnear said. “In reality, refiners have to have more inventory because that is not the way the world works. A refinery might have 1.25 or 1.5 times the oil they need in case there is a disruption in the supply chain.”
Over the past five years, companies have built more than 150 million barrels worth of oil storage.“You’re building tanks. You need them because of the supply chain change, yet the analysts are ignoring it,” Kinnear said. “They’re calling it record high stocks when in reality they’re normal working inventory levels.”
It seems obvious to us that these are facts that anyone not directly involved in the downstream oil industry would quite easily miss. If one looks at the raw inventory data, one sees a glut – but in reality, over 100 million barrels were previously simply not counted due to the time difference in adding imported and domestically produced oil to inventory numbers. What has mainly changed is where the oil is coming from.
We are of course not trying to deny that oil’s supply-demand fundamentals have indeed deteriorated quite a bit. The slowdown in China’s economic growth, the additions to global oil supply from fracking and OPEC’s frantic rush to balance the loss of revenues by means of over-producing (quite possibly combined with strategic designs on the part of Saudi Arabia aiming to put some of the upstart fracking competition out of business) all have contributed to a significant supply-demand imbalance on a global level. Since prices are determined at the margin, even a slight imbalance can have a very outsized effect on the price of an industrial commodity.
However, as we have pointed out in the first article mentioned above, the very same thing could be, and indeed has been, said at the lows of 1998/1999. It increasingly appears to us that both then and now the significance of the oversupply was generally overestimated.
While we cannot pinpoint precisely what the error in reasoning consisted of back in the late 1990s, we now at least have a hint as to what errors are probably committed today. The character of the physical market has changed, and consequently US onshore storage data have to be interpreted differently from before. There may well be a glut of sorts anyway, but it is evidently far smaller than is widely believed.
One thing we are quite confident about is that monetary debasement will continue apace. Commodity prices in the aggregate (i.e., as measured by popular indexes such as the CRB Index) have returned to levels last seen in the late 1990s. However, not one cent of the money that has been created since then has disappeared (in spite of all the angst about “deflation”). One should therefore expect that there is a limit to how low prices can go, regardless of commodity-specific supply-demand issues.
As to the near term prospects, WTI crude is now approaching its still declining 200-day moving average, which we would expect to offer resistance to the rally. Many trading strategies use such widely followed moving averages as buy/sell points, so crude should struggle with that level for a while. Nevertheless, it appears to us that pullbacks will probably continue to represent buying opportunities for the time being.
We certainly don’t expect any miracles in terms of the remaining upside. However, even if prices merely manage to eventually work their way back to the low 60s – a level seen in May/June of this year already – this would still represent an excellent opportunity in various investment vehicles tied to oil. Needless to say, these vehicles have to be assessed on a case-by-case basis, not least because many high cost producers whose hedges are about to run off are likely to get into trouble even if oil prices recover to the extent mooted here.
The same holds for the ruble and by extension Russian stocks and bonds – not only is the ruble still cheap, but the Russian stock market remains the cheapest in the world and Russian bonds are still sporting fat yields. In a general emerging markets recovery, Russia’s market can be expected to outperform greatly, especially in dollar and euro terms. However, one has to carefully assess Russian oil producers in terms of the maturity structure of their often large debt and the free cash flows needed to support it (some sort of index product, ETF or investment fund may be a good way of getting around having to work these things out). The usual caveats apply.