Oil supply glut demand desert

Monday, March 11, 2013

THE HIGHGROUND VIEW

Understanding why oil markets are "sticky for prices" needs a look at the basics. Oil markets are among the most liquid, most traded and most sought after - not only by investors, traders and hedgers, but also by economic and monetary policy makers of the world, due to the geopolitical sentiment that runs alongside oil. This highground can, and often does shade the basic supply-demand energy role of oil to an also-ran, but this has limits.

What we know for sure is oil's role in world energy has declined - not crashed but declined - on a constant long-run basis, almost unrelated to annual or multi-annual average prices. In 1973 oil supplied about 53% of world energy, but today it provides about 32%. By 2020, it may supply only 27%. This, for starters, should take the crisis-word out of oil analysis.

When we look at who are the suppliers, the classic approach splits suppliers into OPEC and Non-OPEC (or NOPEC) countries, the same way that classic analysis divides global demand into OECD (developed world) and Non-OECD (emerging and developing world) countries. This again creates problems, today, due a large number of factors, ranging from resource and technology issues, to market and trading issues.

The supply-demand driven market theory would deliver predictable price change, that is if demand > supply, prices go up, and if there is slack demand and supply builds a glut, prices come down. This is already glaringly different from the "sticky market" which characterizes what we have.

Basic economic principles do operate, but with huge distortions - and this also is one key reason why oil's share in world energy has been declining, now, for 40 years. Since at latest the 1980s, oil is a heavily traded commodity with volatile, rapidly changing, often distorted prices, more often than not. It can also become an "asset bubble", with its price almost unrelated to supply-demand fundamentals, the most recently in 2005-2008, and arguably since 2011.

SUPPLY-DEMAND AND SLOW ECONOMIC GROWTH

Oil was for decades "the swing fuel" whose demand was a bellwether for the economy. If the GDP number rose by 4%, oil demand would automatically rise by 3%. But if the GDP number does not rise at all, or stumbles forward at anemic rates below 2% a year (with outright contraction in Europe), oil demand growth is almost impossible to envisage. Oil demand will contract faster than GDP.

Making this even more sure and certain, we have had decades of "anti-oil" energy policy, recently joined by "carbon consciousness" in the OECD group, and increasingly in Emerging and developing countries. One example is the oil share of electric power generation: in most OECD countries, today, this weighs in at around 1%. In some lower-income developing countries however, it can still take 33% - 50% of power generation: reducing this share is a recognized major economic opportunity.

On the supply side, Non-OPEC countries heavily dominant world roduction but not traded supplies. OPEC countries are the reverse of this paradigm: they produce less of world oil, but supply more of the oil that is traded and crosses at least one national boundary. OPEC's share of global traded oil is a prized metric for oil price analysts and forecasters, to be sure, but this metric is distanced by the pace of world crude-versus-refined oil market operations. One example is the USA's ever growing refined products exports (now about 2.6 million barrels/day). Another concerns the huge overhang of European oil refining capacity: one result of this might be unexpected, a softening of refined product prices, a compression of light-heavy crude price spreads, migrating upstream to soften crude oil prices.

OPEC's quota system, also, is a prized metric for price forecasting, but here again the mix and mingle of technology, industrial, market and political issues and factors make this a cloudy gauge. The biggest supply-side reason is the exclusion of Iraq from any quota limitation, and Iraq's oil production capacity which is growing rapidly. Quota system, to be sure, also means quota cheating and this translates "on the ground" to havily volatile production runs and net export capacities, or "offer", from the majority of OPEC member states. Basic logic, however, tells us that in a global environment of very slow oil demand growth - current IEA forecasts are around 0.8% for 2013 - quota discipline will tend to erode, and when market prices also erode, the process can self-reinforce for some while.

OIL STOCKS AND PRICES

The key metric, managed by the IEA is days-of-average-demand oil volumes stored in the OECD group, broken down to US/Europe/Asia-Pacific. This metric, however, rarely changes significantly, for reasons which include the simple physical capacity of storage, as well as its opportunity cost. The metric is often given high-profile treatment, to be sure, within market trading strategies, for example if most recent stock data shows OECD stored oil shrank from say 57 days, to 56 days demand coverage.

Particularly for the US and the world's biggest oil market, the Nymex, reported volumes at the Cushing (Oklahoma) oil basing point for physical traded oil, is a key oil storage metric. Here again however, big things are happening, including rapidly rising output of US shale oil, and increasing supply of Canadian tarsand oil - both of them to the North. US north-south pipeline debates, and rail transport of oil, are major ongoing themes in the US, with a constant ability to influence daily prices.

What we can call "static stocks" of the Cushing type ignore the oil-in-transit "stock", by pipeline, rail, barge and tanker shipping: this is a very big number! Bringing both parts of the stocks picture together produces not the impression, but the reality of serious oversupply pressures operating across the oil sector, today. How long this takes to "percolate" into the investment decisions and positions of Hedgers and Speculators, is a complex subject - but here again the answer is sometime, and not never.

The double-headed role of Hedgers on one side, Speculators on the other, is itelf unstable and volatile making it always possible for markets to stumble into a "flash crash" as of May 2011, driving a price drop of over 9% in one day. The post-facto explanation from trade pundits was that extra long positions suddenly lost their attractiveness, on the back of a weaker US economic data, and caused the crash. We can be sure that in coming weeks that net long positions in Brent and WTI will decline, but the exact forecasting of this needs a lot more than Fibonacci chart-gazing!

Contribution by
from AMK CONSULT

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser. More

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