In the fall of 2017, analysts were talking up the idea of sub-$60 oil through the early 2020s. Then, several weeks ago, market followers suddenly began throwing in the towel following strong 2018 performance and started announcing that oil prices could be reaching *gasp* $100 per barrel as soon as December on supply concerns. Oh, but wait a second- Goldman Sachs later came out and said this almost certainly won’t be the case. After all, supply is adequate for the current demand profile. We won’t even go into the $400 number thrown out this week amid the chaos surrounding the disappearance of a Saudi journalist after visiting the Saudi embassy in Turkey.
As The Ignorant Investor has said before, when multiple contradictory or disparate narratives vie for investor’s – and the general public’s – attention, it’s important to get down to the basics and separate the probable from the fantastical. In this way, the retail investor can form his or her own narrative.
Let us build up our case by looking at the data and then examining both sides of the equation.
Oil Market Fundamentals
Demand and supply hover near historic levels, with both estimated to be slightly above 100 million barrels per day (bpd). This is the result of recently depressed oil prices that followed a huge production boom out of North America (the fracking revolution, if you will).
Recent supply increases from Saudi and Russia ahead of the reintroduction of Iranian oil sanctions has left the world with limited spare supply capacity, which potentially leaves markets vulnerable to supply-side problems.
Additionally, in the more extended term, the theme has been playing out where demand growth for oil and petroleum products in the developing world is exceeding lost demand from the transition to renewables and other types of energy in the developed world.
International Energy Agency (IEA). The IEA reported on October 12th that global oil supply had risen to 100.3M bpd in the third quarter of 2018. This is up about 1.3M bpd from the previous quarter, and up 2.3M bpd from the year ago period. The organization downgraded estimates in demand growth to +1.28M bpd in 2019.
Energy Information Administration (EIA). The United States EIA’s October Outlook estimated global oil supply at 101.3M bpd (up +1.1% from the previous month). Global oil demand fell behind at 100.5M bpd (up +0.20% from the previous month).
This section would also be an appropriate place to delve deep into the bowels of the financial world and examine fund flows and positioning in petroleum futures and options contracts. We could also note such events as the recent decline in NYMEX gasoline crack spreads to help aid in our analysis of near-term oil price movements. That, however, is too complex for a place like this and indeed is beyond the scope of the information The Ignorant Investor is willing to cover here. Instead, let’s examine the medium-term narratives behind the Bulls and the Bears.
Bull’s Case
The world has limited spare oil supply capacity. Saudi and Russia’s decision to help alleviate potential oil supply shortages – and help themselves to Iran’s market share in the process – ahead of Iranian oil sanctions have left the two nations producing at nearly full capacity.
- Seasonal oil demand is fast approaching. Global oil demand historically hits a seasonal peak during wintertime in the Northern hemisphere (ie people use more energy heating their homes).
- OPEC Production at risk in Libya, Venezuela, and Iraq. Libya (1.0M bpd, OPEC) and Venezuela (1.2M bpd) have consistently failed to produce anywhere near their OPEC-imposed limits amid constant infighting within the failed state (Libya) and viritual bankruptcy and civil chaos (Venzuela). Iraq (4.7M bpd) experienced violent protests as recently as last month. Any potential disruption at their oil production facilities could have an outsized effect on output.
- Saudi has limited additional spare capacity. Saudi claimed to have spare production capacity of about 2.0M bpd (this asserted most recently in comments by the Saudi Aramco CEO in India), but analysts suspect this could actually be less. If so, then Saudi is now producing near full capacity.
Oil infrastructure development in North America (fracking regions) is lagging production, resulting in reduced potential for production growth in the near term. Some US companies are struggling to bring their oil to market. Yesterday, the Brent / WTI spread was about $10 per barrel. But do you think NYMEX WTI is cheap here? Think again! Bottlenecks in oil pipeline and transport capacity is creating huge differentials between NYMEX and certain field prices around North America– the spread exceeds $15 per barrel in some major US fracking areas, but in the worst hit Canadian regions the price of crude collapsed this week, falling below $20 per barrel (this is not a typo; we are talking a barrel of crude priced below $20).
Middle East geopolitical risks are rising. This addresses the age-old risk to supply from the Middle East. Conflicts in Yemen and Syria threaten to bring the Sunni – Shiite struggle to the broader region through their respective champions, Saudi Arabia and Iran. Iraq has also recently undergone turmoil with several violent protests taking place last month.
- The Iranian Parade attack. This unusual attack last month may indicate the potential for greater regional instability as Iran continues to agitate behind the scenes with armed groups in Lebanon, Syria, and – most importantly to this article, because of proximity to Saudi – Yemen. Yesterday, Iran claimed to have killed an ISIS commander who was behind this attack.
- The Khashoggi situation. Saudi Arabia came under intense international criticism after journalist Jamal Khashoggi disappeared two weeks ago after visiting the Saudi Arabian Embassy in Turkey. Saudi responded by threatening strong retaliation against any country that sanctioned it in response to Jamal’s disappearance. Several commentaries suggested the country could weaponize its oil production (raising the specter of the 1973 Oil Embargo, although The Ignorant Investor discounts this possibility as basically zero; weaponizing oil would be a Pyrrhic victory for Saudi, hastening the demise of OPEC’s influence on global energy markets by accelerating oil infrastructure development across North America).
Oil prices may be held lower until after the United State’s November 6th elections. Following the US election, Saudi and Russia may be comfortable with somewhat higher oil prices. On top of this, the US government will be able to take a harder line on Iranian oil waivers after political uncertainty is removed.
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Background: Both Saudi Arabia and Russia have demonstrated satisfaction with President Donald Trump leading the US government (China less so, but that’s only relevant to Iranian sanctions compliance for this story). In September, Saudi and Russia secretly agreed to raise oil output, privately informing the USA of their plan amid Trump’s vocal denunciation of high oil prices. The remainder of OPEC was left in the dark regarding these developments.
Grey Swan events could create demand supply imbalance. This would encompass the possible unknown, including geopolitical or natural events in the Middle East and other oil production regions or mechanical failures at oil production/transport facilities.
- Infrastructure problems occur on a semi-regular basis. Canada’s extended Syncrude outage in June and the North Sea pipeline outage in December 2017 are several recent examples.
Bear’s Case
OPEC and Russia wish to avoid a sequel to the oil crash that last began in late 2014. This right here is the million-dollar talking point. OPEC and Russia remember what caused the initial fracking boom – high oil prices coupled with new fracking technology in North America (as well as easy access to capital to power CAPEX through the US Fed’s great money printing experiment), resulting in unchecked enthusiasm among exploration and production companies in the USA and Canada. If oil prices move above a certain target range, the balance may begin to slip towards too much supply once again. As primarily energy producing nations, Saudi and Russia plan to avoid this occurrence at any cost.
- Saudi Arabia and Russia have argued ahead of the last several OPEC meetings to raise production quotas, indicating they are comfortable with current prices
- Saudi and Russia secretly agreed to raise production in September and have promised net importers like India to make up for any shortfall that occurs as a result of Iranian sanctions (and, as mentioned before, take market share as part of the process). Iran complained about this situation just last month.
US-Trade tensions may hinder demand growth. If the US and China miscalculate or misplay their hands, China’s economy – which is showing some signs of weakness – could potentially take a turn for the worse. The global economy and/or secondary nations could also be affected by a downturn in US-China trade relations. Yesterday, Commerce Secretary Ross said US and China trade discussions are on “hiatus.”
Higher oil prices and a stronger dollar may cause demand growth to deteriorate. As oil prices move higher, some demand destruction will be seen in energy importers like India and further across the developing world (areas that are helping drive current demand growth). Additionally, the dollar has been strengthening in sympathy with the US Fed raising interest rates in the face of rising inflation. This has negatively affected some emerging market economies by making dollars, and hence, oil, more expensive relative to local currencies (the Indian Rupee-US Dollar pair is a good example of this).
US commercial oil inventory data is showing signs that market is relatively balanced. However, the weekly inventory data is less clear. US oil inventories (excluding the SPR) have expanded by 14.5M barrels in the past two weeks according to EIA data, reversing a recent trend of stockpile draws and shifting back above the five-year moving average (prior to this, inventory data had fallen to about 5% below). Here we must also note that while refinery usage rates are down from the summer highs, gasoline stockpiles have only experience small draws for the same period.
President Trump is willing to use the Strategic Petroleum Reserve (SPR) to cool prices. The US President authorized the release of sour crude from the Strategic Petroleum Reserve in August and may be willing to authorize the release of more supplies in the future. He basically made way for this by stating that current rate of US oil production, which was estimated by the EIA as 10.9M bpd last week, has made the US energy independent, and hence the SPR obsolete (see a chart of US oil production on the EIA’s website here).
The Verdict
The bullish case for higher oil prices rests almost entirely on the fact that oil production must operate at near perfection (for the near term) to continue to meet strong demand. Any material threat to this supply has the potential to cause prices to rise sharply from current levels after the US reintroduces Iranian sanctions on November 4th. Should US sanctions prove more effective than planned, a demand supply imbalance may quickly occur. In summary, the Bull’s case is very much a quantitative assessment focusing on the supply side of the equation, with strict enforcement of and compliance with US sanctions on Iran the main wild card.
The bearish case for oil prices – which must be noted is more expecting limited upside to current oil prices rather than any significant downside – stems from powerful energy producers Saudi Arabia and Russia desiring to keep prices relatively close to current levels to minimize North American shale development. Additionally, the US government, friendly to these energy producers (ceteris paribus; we must watch how the Khashoggi situation unfolds) has recently committed itself to keep oil prices in check as Iranian sanctions are reintroduced ahead of US November elections. After all, for the very near term, President Trump has shown himself to be clearly against higher oil prices and he has a tool in the form of the SPR to affect commercial crude supplies. In summary, the Bear’s case lies primarily with demand growth concerns and the combined will of Saudi Arabia, Russia, and the United States aligned to keep oil prices from spiking too far from current levels.
In the world of higher oil prices, there are winners and losers
Bloomberg does a great job identifying the biggest winners and losers, should oil prices move higher, among emerging market economies. Note that the prices cited are accurate through October 12th (the date of the article's publication), but the longer-term themes remain intact. Read all about it here.
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The Ignorant Investor decided to focus on oil prices for today's discussion, although commentary on the various fears currently unsettling markets was also quite tempting. Yes, the news that the US is not talking with China is disappointing (not unexpected, however). True, interest rates have accelerated quite quickly in recent months. And of course equities have experienced a somewhat volatile decline punctuated with sharp moves higher these last several weeks. Since we are not dwelling further on the subject, The Ignorant Investor will merely suggest taking refuge in the fundamentals - wait on earnings! - that have been driving stocks forward while keeping a wary eye on how changing market conditions may affect investments.
