As oil approached $100 last week, I started to collect data on oil USO, UCO, OIL expecting that the data would convince me that a shorting opportunity was at hand. What I found on the way to my short destination caught me by surprise.
The fact that I was looking for an excuse to short oil was unusual, as I have been mostly buyer of dips in oil futures for several years. Oil had mostly been in a tight, $8 range for several months, and that can cause complacency. It also seems reasonable to believe oil is overpriced when mainstream oil articles continuously refer to "surging U.S. production", the "shale miracle", and "coming energy independence" of the U.S. The limitation of that knowledge is that the oil market is priced globally, and knowing what is happening in the U.S. is not necessarily representative of the big picture.
With Egypt back as headline news, 2011 served as a logical starting point for analysis- to see what may be driving oil prices. Crude oil bounced during the week of the Egyptian Revolution in January, 2011. The bounce turned out to be a head-fake, though, and oil rolled over to a ten-week low in the next 2 weeks. Oil speculators bought oil on news of the Egyptian Revolution, but prices quickly fell back because the balance of world oil supply was not affected. Traders were bailed out of that losing trade a couple weeks later by riots in Libya, a major oil exporter whose exports were about to plunge. The chart below captures some of the key moments since those events:
3-Year Chart, WTI Crude.
Additional timeline comments: (match blue numbers near price bars to comments below)
Egyptian Revolution of 2011 began on 1/25/11. Mubarak resignation was announced on 2/11/11. WTI crude bounces for a week above $92 and then rolls over to a ten-week low.
1) 2/15/11: Libya- riot in Benghazi, oil market erupts. 2/10/11: Death toll stands at 233. 3/19/11: First air strikes halt advance of Gaddafi's forces on Benghazi.
2) 5/10/11: CME announces a 25% margin hike on crude oil futures, the 4th margin hike of 2011.
3) 6/23/11: Announcement of a global, coordinated release of 60 million barrels of oil from strategic petroleum reserves. The U.S. Strategic Petroleum Reserve will account for half of the 60 million barrels.
4) 8/21/11: Libyan Rebels enter Tripoli; encounter little resistance.
5) 11/11: Saudi Arabia boosts oil production to 10.047 million bpd, the most in more than 30 years.
6) 4/4/12: Oil analysts reach consensus that another SPR release is needed immediately to derail $5 gasoline, just weeks before oil plunges $25/bbl.
7) 8/17/12: Obama administration announces SPR release is possible.
8) 9/12: Saudi Arabia boosts oil production back up the 30-year high production level of 10 million bpd, and holds that level into November.
9) 11/12: Saudi Arabia begins to throttle oil production back to 9 million bpd in 2 steps.
Running through the timeline data, I was surprised to see that Saudi Arabia had to step in and play the role of swing producer, even after Libya's exports resumed (#8).
Referring back to the graph- I added supply and demand data (IEA) to complete the picture. The timing of significant changes in oil supply from OECD countries is presented above the blue line. Non-OECD oil supply has fallen slightly over the past two years and is projected to remain unchanged, and is therefore excluded. Additional supply would have to come from OPEC, or drawn from global oil inventories. Only supply changes of greater than 300,000 bpd are shown (above blue line).
Changes in global oil demand are registered beneath the blue line. Demand is more volatile than supply, due to variations in seasonality, plus additional factors such as field maintenance.
Global demand for oil has increased at an annual pace of approximately one million barrels per day the past two years but the demand surge is not distributed evenly. A surge appears between Q2 and Q3. In 2011, this surge was 1.9 million bpd. In 2012, the jump in demand from Q2 to Q3 was 1.0 million bpd. This demand surge causes a temporary draw on inventories, unless the demand is met with an even greater increase in supply. In Q4 of both 2011 and 2012, oil supply posted a substantial gain.
In 2013 demand is expected to surge from Q1 to Q4 by 1.9 million bpd while OECD supply is projected to increase only slightly, from 20.6 million bpd in Q1 to 21.0 million bpd in Q4. This demand imbalance of 1.5 million bpd would have to be met by OPEC and/or drawdown of existing oil inventories. The IEA data set is shown below, with my emphasis on the demand spike into Q3:
IEA Oil Market Report: World Oil Supply and Demand table with 3 consecutive years of seasonal demand spikes into shown with emphasis.
IEA gives the following reason for the seasonality demand jump in 2013:
The seasonal ramp-up in global crude throughputs is expected to be steeper than normal this year, with runs increasing by 2.2 million bpd from 2Q13 to 3Q13. That seasonal increase, centered in the non-OECD, is due to new Saudi distillation capacity, increasing Chinese runs after heavy spring maintenance, and recovering throughput at Venezuela's Amuay plant after a 2012 fire.
A demand bump of 2.2 million bpd into Q3, if IEA projections are correct, would be the biggest in years. It also will happen in a year where non-OECD oil production is stagnant and OECD production is projected to have the smaller year over year production gain than the past 2 years.
Saudi Arabia is the only country believed to have projected to spare capacity to meet this demand surge. Saudi Arabia reduced their oil production in Q4 2012 by approximately the same amount that OECD supply increased during this time period, and did so while Brent Crude prices were stable near $108 and WTI Crude was priced around $88:
Data compiled and presented by Stuart Staniford.
Note that the rig count (red line) is rising. It is possible that the Saudi Arabia are preparing for an even greater need for their exports.
So, as we move into the second half of 2013, the Saudis represent the only sideline supply that can make a meaningful impact on an additional 1.5 million bpd of demand that will be felt. However, there is no guarantee that Saudi Arabia can supply that much oil, as they have not exceeded 10mb/d in decades. Global crude inventories will be falling- particularly if Saudi Arabia is slow or unwilling to ramp production back to 10 million bpd or higher.
Meanwhile, in the U.S., the Bakken, Eagle Ford, and other oil shale (tight oil) plays have seen an incredible ramp up in drilling activity, but the oil rig count actually peaked last August:
Baker Hughes Data: (Rotary Rig Count) 7/03/2013
With the Oil-directed rig count down in the past year, large increases in U.S. production are not anticipated. This data is incorporated into the IEA projection that anticipates slower supply growth in the second half of 2013.
Daily movements in crude oil are nearly always attributed to weather related delays, like fog in the shipping channel, or pipeline problems, field maintenance, or geopolitics. If you're not careful, you could miss the greatest driver of crude oil prices the past few years (particularly in Q3)- like I nearly did.
Oil is going up for the most simple, yet overlooked reason: supply & demand. Global demand for oil keeps grinding higher and higher and will soon be 2.5 million bpd higher than when the Libya protests caused a price spike in 2011. With OECD and non-OECD supply not keeping pace with demand, the world is building an even greater dependence on OPEC exports.
WTI Crude has already surged $12 since the low in June and is now at the highest level since April 2012. Despite trying to build a case against oil, I came away with the opposite opinion. I now expect WTI oil to trade in the upper end of its 2-year range, between $95 and $115/bbl. I expect to buy oil on any weakness in coming weeks and months, and prefer to buy December 2015 futures, as they are already trading approximately $18 dollars below front-month CL futures.
If demand materializes as expected in the second half of 2013, the market will require an output boost from Saudi Arabia, and willingness and availability of that crude will have a significant impact on global pricing. Saudi Arabia has already answered the call in 2011 and 2012 as the global swing producer, and will be tested further this year.
Macro market analysis begins with oil. With daily consumption of 18.6 million barrels (U.S.) each dollar per barrel increase represents $6.8 billion that is redirected away from the consumer economy. Oil prices tend to trade in the opposite direction as bond prices, and bond price movements eventually affect stock prices. While it will take months to see the effects of this Q3 jump in demand, global inventories should start to drop soon.
If oil prices continue to rise, the second half of 2013 could start to feel like 2007, where the S&P500 SPY topped out and started down, while commodities and commodity stocks stormed higher.
In coming months, I expect food and metals to trend in the same direction as oil, as they typically do over longer periods of time:
We may even hear the word "stagflation" before 2013 is over.
Additional disclosure: long SLV calls