In last month’s Capital Observer (May 11, 2018 - a limited circulation finance magazine), we noted that geopolitics and fundamentals were colliding in the oil price discovery process, and we asked rhetorically – which one will win? At that time, oil fundamentals have already become less price-friendly, as illustrated by the graph below. The summation of aggregated global supply less aggregated global demand/consumption has already rolled over at that point, and we were confident that it was just a matter of time before oil prices register the inflection point and then decline accordingly (see graph below).
It was just the slow simmer in adverse geopolitical events that was keeping sentiments of oil speculators still bullish at that time. We said that “at the moment geopolitics has the upper hand, but not for very long, in our opinion.” The information provided by the oil price model, and our conviction that the grip of geopolitics will soon loosen, actually triggered a hedge to protect my personal E&P investments, and were the basis for PAM's USO and DWT trades which delivered tidy profits for the partnership and PAM subscribers.
Then by the third week of May, came the talk of OPEC potentially raising oil production by as much as 1 million bbd after global oil inventories have gone back to their five-year averages. Oil prices promptly collapsed, hastened along by a series of US inventory builds and a surge in US oil production to new record levels.
At crude oil’s lowest point in the sell-off on June 5, WTI oil lost $8.52 (to $64.28/bbl from $72.80 on May 21), which matches the Middle East risk premium of $7.00 to $9.00 per bbl. Why is this significant? Because removing that much from WTI oil price means that the oil discovery process will now rely more on fundamentals than on geopolitical events. While it is also true that the current lower oil price again opens the commodity to a new series of Middle East political machinations, nothing threatening is on the horizon, except possibly for a quicker-than-expected imposition of US oil embargo on Iranian oil exports. But that too has already been discounted by the market, especially after Saudi Arabia expressed willingness to make good any shortages caused by US action.
The only event which one may call “force majeure” is a complete collapse in Venezuela’s production. This slow-motion train-wreck has also been discounted by the market, as it is more than made up for by a new surge in US oil production (to a new record), higher Russian oil production, which already started ticking higher, and rising stockpiles of OPEC oil supplies (see chart below).
The most significant wild card facing the market is the June 22 OPEC meeting. It is shaping up to be a contentious one, after news broke that the U.S. government asked Saudi Arabia to increase oil production before Washington pulled out of the Iran nuclear deal. According to Reuters News, a high level Trump administration official called Saudi Arabia a day before Trump was set to announce the U.S. withdrawal from the Iran nuclear deal, asking for more oil supply to cover for disruptions from Iran. This has incensed Iran, and the apparent willingness of Saudi Arabia to comply with Washington’s request has ignited furor from within OPEC.
But this is not a special case, and there is no surprise that Saudi Arabia is just too willing to go along with the Trump administration. Anything that can financially hurt Iran, and slows down their capability to produce a nuclear bomb, will always be welcome in the Kingdom. Moreover, there is historical precedent. The last time the U.S. government pressured OPEC into adding supply, it was also over Iran. The Obama administration wanted the cartel to offset disrupted Iranian production, after an international coalition put stringent sanctions on Iran in 2012.
Roughly 1 million barrels per day were knocked offline, and OPEC finally made good the shortfall after oil prices' run-up to $125.00, and triggered a severe global growth slowdown which just stopped short of a recession. That global shortfall (and concomitant higher oil prices) ignited US shale production to a point where US oil output became almost exponential from late 2011 onward. That held global oil prices in check, which helped convince the OPEC to leave the Iranians to their own devices (see graph below) and made good the shortfalls.
Iran, and now, Venezuela wrote to OPEC members, asking them to denounce U.S. sanctions. But the OPEC steering committee rejected Iran’s request which will be the likely fate of Venezuela’s entreaties as well. Venezuelan oil minister Manuel Quevedo wrote: “I kindly request solidarity and support from our fellow members. The group should discuss the constraining effects of unilateral sanctions imposed by the United States of America, which represent an extraordinary aggression, financially and economically, for our national oil industry’s operations and the stability of the market.” (Reuters).
Nonetheless, the fact that two founding members of OPEC are rocking the OPEC boat suggests that the June 22 meeting will be contentious. It suggests that a good portion of the cartel could line up against any move to increase production. It could set the stage for a heated meeting in Vienna and OPEC watchers are already suggesting it might be one of the worst OPEC meetings since 2011. At that time, Saudi Arabia wanted to increase production to ease triple-digit oil prices following the conflagration in parts of North Africa and the Middle East during the Arab Spring. The Saudis were overruled. And they may yet again be overruled come June 22, if the Saudis propose increased output, which is not yet clear at this time if indeed they intend to do so.
There is a lot of farcical overtones in discussions going into the June 22 meeting, as the OPEC+Russia consortium’s pact to limit output is a sham, for lack of better words to describe it. We have seen the power of any hint to increase production at this time - the price of oil promptly comes tumbling down sharply. Aside from Iran and Venezuela’s gripe about the US “unilateral” embargo, there is therefore little incentive to increase production from OPEC, which could further depress prices. Ultimately, the only beneficiaries of higher production would be Saudi Arabia and Russia anyway, and to a lesser extent some of the Gulf States like Kuwait and the UAE.
Just about every OPEC member outside of the Gulf is unable to increase production anyway, so it is of little surprise that they are, and will be, opposed to higher production. Venezuela, Angola, Libya and Nigeria don’t have official limits on their output as part of the OPEC deal, so there is little upside for them in supporting production increases from other countries. And they won’t. Even the Gulf producers are already at maximum output, and they have resorted to calling natural decline rates as “output cut” (see graph below).
Russia (Rosneft) has already started raising production; and on Saturday (June 9) Russian news agency Interfax reported that Russia’s oil production, the world’s biggest, had risen to 11.1 million bpd in early June, up from slightly below 11 million bpd for most of May, and well above its target output of under 11 million bpd as part of the deal. OPEC oil supply has also started rising, as extraneous output goes into storage. Effectively, OPEC supply has bottomed in May, coinciding with the top in oil prices. OPEC supply will rise going into summer, and that will remove some of the support for prices. There is a distinct inverse correlation between OPEC oil supply and price, so going into the June 22 meeting, this might pressure prices further (see graph below).
This could also be a significant development as further declines, after a circa $9.00 price losses in just a few weeks, could harden the attitudes of the major producers. Historically, OPEC increased output during times of high prices, not when prices are falling. We therefore see little incentive for the cartel to move the goal post at this time.
Our take: we expect OPEC to reject any proposal to lift output soon, and the cartel will likely opt to let the agreement run as originally crafted.
A hardened resolve from OPEC will likely provide another upwave to crude oil’s bull run. A new rally in oil prices should in fact coincide with, and support, a new bull market in equities up to an expected July-August peak. However, the rally should be tempered by increasing US oil production during H2 2018. Demand is also expected to moderate somewhat, so there could be a test of the previous $72.80 top, but the calls for $80.00/bbl oil are unlikely to materialize. This theme is confirmed by a simple price model using the variance between global oil consumption and global supply (see graph below). The simple model shows that an oil bottom is likely in June followed by a further moderate rise in price over several weeks.
Aside from global supply-demand data, US seasonal tendencies will be favorable going into late summer. First, a pick up in H2 2018 is also supported by seasonal tendencies for oil demand and consumption to rise until Q3, this year and in most years (see graph below). This tells us that the bottom we expected for equities and bond yields by the 3rd week of June, may be the same period when oil prices bottom and go on to retest the previous top.
Second, it should also help that US-centric seasonal gasoline consumption and inventory patterns go into overdrive during the second half every year. The prime mover is the OECD CO&LF consumption pattern, which sets the pace for gasoline inventories and refinery crude oil input. And this year, EIA forecasts very large consumption numbers for OECD, which should translate into large US gasoline inventory draws and just as large refinery crude oil inputs (see graph below).
The final kicker here is that US total oil inventories (which lag oil inventories by 6 weeks) will be drawing soon, likely significantly, in response to the OECD consumption and gasoline inventories trends. Although oil inventories severely lag behind, a lot of investors make their energy investment allocation decisions based on this lagging indicator. So it is important to track its course, if only to anticipate necessary (but perhaps temporary) adjustments for adverse inventories data (which are known in advance for most times using the gasoline inventory correlations).
Moreover, large oil inventories draws will incite the Money Managers (Hedge Funds) to increase bullish bets again, especially as the draws will be preceded by the oil term structure going into deep backwardation again. We have developed a model which has a long history of successfully leading the transitions from contango to backwardation, and vice versa. That model flashed the signal for a transition to backwardation several weeks ago, and last week we finally saw the start of the widening of the C1-C2, C2-C3, C3-C4 oil spreads into backwardation. The spread will likely continue widening deep into backwardation territory over the next few weeks (see chart below).
What convinces us about a likely Hedge Funds bullish response is that the same model captures the transition of oil inventories from builds to draws and vice versa, as well.
Simply put, there is more than enough factors going for a positive oil outlook which should appeal to Hedge Funds - these bullish factors equate to a slam dunk of bullish bets from the Money Managers. The HF operators will soon pile into long oil trades, like the lemmings that they are.
E&P equities are about to soar again
The appropriate conclusion to this article is a look at what happens to E&P equities. I wrote earlier that the global supply-consumption/demand model configuration by the second week of May triggered a hedge for my E&P holdings and various USO and DWT trades which became extremely profitable after oil prices collapsed. I have reinstated my E&P holdings (CLR and EOG) after our model for E&P equities suggested that a continuation of the rally for these equities is at hand (see graph below).
This model is driven by almost real-time global oil and G-10 oil demand data from third-party sources subscribed for by the company I consult with (I use the data with their consent). My modeling work confirms that E&P equities respond more to changes in global supply and consumption/demand rather than to changes in oil prices, or from the US oil data set, for that matter. This special model has an ample lead time over oil prices, so it serves to double check the conclusions of the other oil models derived from the EIA and IEA databases. That has worked out very well, and that should be true for the future as well.
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Disclosure: I am/we are long CLR, EOG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.