Thursday, September 15, 2016

Slip Sliding in the Oil Patch

China’s latest economic indicators showed some strength. However, that strength hasn’t shown up in commodity prices. China’s industrial production and real retail sales rose 6.3% and 9.3% y/y through August. While those growth rates were a bit better than expected, they remain close to recent cyclical lows in both series.

The CRB raw industrials spot price index rebounded earlier this year from last year’s plunge. It has been meandering sideways since the spring. The index includes the price of copper, which is highly correlated with the growth rate in China’s industrial production. Both remain in their downward trends of the past few years.

Like the CRB index, the price of a barrel of Brent crude oil recovered earlier this year after plunging by 76% from mid-2014 through early 2016. It has been hovering between $42 and $52 since mid-April.

In many ways, the price of oil is the tail that’s wagging the dog. It is highly inversely correlated with the trade-weighted dollar. Causality probably runs both ways, so a weaker (stronger) oil price seems to put upward (downward) pressure on the dollar. That may be because oil exporters have fewer (more) dollars to convert to other currencies when the price is weak (strong).

Of course, there is a feedback effect from the dollar to oil and other commodity prices. The CRB raw industrials spot price index, which doesn’t include oil, tends to strengthen (weaken) when the dollar is weak (strong).

For now, I foresee the choppy sideways actions of the dollar, oil prices, and other industrial commodity prices continuing through the middle of next year. The Fed’s process of gradually normalizing interest rates is turning out to be very gradual, which should keep the dollar from moving higher given that it is up 19% from its low on July 1, 2014. On Monday, Fed Governor Lael Brainard said that the Fed/US econometric model shows that such an increase is equivalent to a 200bps hike in the federal funds rate. In other words, the foreign exchange market has already done much of the Fed’s work.

Nevertheless, if the oil market’s fundamentals push the price of oil back down again, the dollar could move still higher and depress other commodity prices. So let’s review the latest developments in oil’s supply and demand:

(1) Inventories. The combination of weak demand and increased OPEC output pushed oil inventories in developed nations to a record 3.1 billion barrels in July. Yesterday, the International Energy Agency (IEA) predicted that the surplus in global oil markets will last for longer than previously estimated. So world oil stockpiles will continue to rise through 2017, resulting in a fourth consecutive year of oversupply. Just last month, the IEA predicted the market would return to equilibrium this year.

(2) Supply. The IEA’s revised estimates of the supply/demand oil balance on Tuesday followed a similar revision by OPEC on Monday. The 9/12 WSJ reported: “In its closely watched monthly report on market conditions, OPEC said non-OPEC members like the U.S., Russia and Norway will produce about 190,000 barrels a day more than expected in 2016, a sign that production outside the cartel has remained resilient despite low prices. By 2017, the cartel’s data suggests that oil supplies will outstrip demand by an average of about 760,000 barrels a day, over three times higher than OPEC predictions made just last month.”

(3) Strategic petroleum reserve. In August, the US Department of Energy released its “Long-Term Strategic Review of the U.S. Strategic Petroleum Reserve.” It said that instead of the nearly 700 million barrels the US currently stockpiles, an SPR around 530-600 million barrels would be more appropriate. Much has changed since the SPR was set up in the aftermath of the 1973 oil embargo. The US is one of the largest oil producers in the world, so energy security isn’t as important.

(4) US production. That all seems very bearish for oil prices. However, keep in mind that lower oil prices probably will continue to reduce oil production in the US. Arguably, the new swing producer in the oil market is now the US rather than Saudi Arabia. The weekly US oil rig count seems to be a very good 18-month leading indicator of weekly oil field production in the US.

Production is down 11.5% from a recent high of 9.6mbd during the week of July 3, 2015 to 8.5mbd during the week of September 2, 2016. The rig count has rebounded slightly in recent weeks, but remains down sharply from the peak of late 2015. The implied drop in US oil production could provide some bullish support to offset the bearish factors highlighted in the IEA and OPEC reports.

Meanwhile, US gasoline demand over the past 52 weeks through the 9/2 week rose to 9.3mbd, matching the previous record high during 2007.

On the other hand, Apache found lots more oil last week. The 9/7 WSJ reported: “Apache Corp. said it has discovered the equivalent of at least two billion barrels of oil in a new West Texas field that has the promise to become one of the biggest energy finds of the past decade. The discovery, which Apache is calling ‘Alpine High,’ is in an area near the Davis Mountains that had been overlooked by geologists and engineers, who believed it would be a poor fit for hydraulic fracturing.”

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