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Oil Price: Beginning Of A Downtrend

Oil Price: Beginning Of A Downtrend thumbnail

Summary

  • The IEA’s Mid-Term Oil Market Balance may be the only chart you need, to assess longer-term oil suply-demand.
  • Based on abundand supply and slow demand growth, the recent drop in oil price is likely the beginning of a downtrend.
  • Investment implicaitons: exposures to crude oil and oil producer stocks are not recommended.

Crude oil prices recently plummeted to around $80 per barrel of the WTI contract, from the recent peak around $105 in June – a more than 23% drop. The Brent contract price stands around $86, even a steeper drop from its peak. This came as a surprise to many energy experts, given ongoing serious geopolitical issues in oil-producing regions such as ISIS advances in Iraq and Syria, and sanctions on Russia. The lower WTI price has negative consequences for earnings of U.S. oil producers. And, while lower oil price is a net-positive for the U.S. economy in the longer term, it may have a negative short-term impact on U.S. job growth broadly.

Many lengthy articles were published recently, including here on SeekingAlpha.com, arguing that producer countries/companies will reduce their crude oil output, which will provide a floor for oil prices and contribute to their rebound. Some authors look at short-term (3-4 year) charts, where each time WTI oil price dropped to around $80, it rebounded back above $100. However, among many problems with such arguments, let me highlight the most important reason why a price rebound is unlikely: the supply-demand balance.

(click to enlarge)Tactical investment management - 10y WTI oil price

As I’m sure most folks would agree, supply-demand fundamentals drive the price of oil over a longer-term period, say, 2-3 years (if you don’t, you probably have better things to do than reading this article). Trouble is – in order to assess these fundamentals, there is multitude of data points to consider. But I’m going to argue, somewhat simplistically (but not much), that in order to assess these supply-demand fundamentals, you only need to look at ONE chart. That chart, shown below, is the Medium Term Oil Market Balance from the International Energy Agency’s (IEA) annual Medium-Term Oil Market Report.

(click to enlarge)

Source: the International Energy Agency’s 2014 Medium-Term Oil Market Report

The chart synthesizes the most essential data that are critical to oil supply-demand assessment: spare production capacity, world demand growth, and world supply growth. Oil trade is global, so we need only consider global data. These data have been great leading indicators of longer-term (2-3 year) trends in oil price:

2004-07: In 2004, global spare capacity was tight – only 2 million barrels per day (mb/d) – and remained tight through 2007. Demand growth slowed down to around 1 mb/d in 2006-07 (the declining orange line means slower, but still positive growth), but so did supply growth. The result – oil price rallied from around $40 in 2004 to above $100 in 2008.

2008-09: That completely changed during the 2008-09 economic downturn. Oil supply continued to expand, but demand actually declined (the orange line moved below zero). Spare capacity jumped to 5.7 mb/d in 2009. The result – oil price crashed, reaching a bottom of $42 in January 2009.

2010-11. Supply-demand conditions tightened up again in this period: supply growth was below demand growth, and spare capacity declined. The result – you guessed it – oil price rose above $70 by the end of 2009, and above $80 in 2010, where it remained since.

Current Oil Supply-Demand Balance

The supply-demand balance changed again in the last two years. As you are probably aware, the U.S. oil production surged, driven by the fracking technology and by advances in shale extraction, making the U.S. the largest producer in the world this year. I highlighted this rise in North American production in my November-2013 article Crude Oil Fundamentals Bad For Price. At the same time, demand growth remained low, around 1.3 mb/d, due to slower global economic growth, and to gradual but steady transitioning to environmentally-friendly energy sources. In its 2013 Medium-Term Oil Market Report, the IEA went as far as to warn of a “supply shock”:

The supply shock created by a surge in North American oil production will be as transformational to the market over the next five years as the rise of Chinese demand has been over the last 15.

What is this chart telling us now? In this year’s Mid-Term Oil Market Report, the IEA shows spare capacity to be 5 bm/d this year, the highest since its 2009 spike, and projected to exceed that peak in 2016. Supply growth exceeds demand growth this year, which is to continue through 2017. So, the “supply surge” that the IEA warned about, is well under way.

Investment Implications

Based on these data, the drop in oil price to $80 is not at all surprising – in fact, it’s surprising that it didn’t happen sooner. Regardless of any short-term fluctuations, the IEA’s medium-term supply-demand balance data are telling us that this is likely the beginning of a new trend of declining oil prices, not just a short-term price move. Accordingly, I would not recommend having any portfolio exposure to crude oil as a commodity, whether it is in the form of futures, or ETFs such as The United States Oil ETF (NYSEARCA:USO) or the iPath S&P Crude Oil Total Return Index ETN (NYSEARCA:OIL).

Source: Ycharts

How will Energy sector stocks fare in this environment? Oil producer earnings are levered to crude oil price. If oil stays at the current level, oil producers’ earnings will drop by more than ~13% YTD drop in WTI oil price. Some smaller produces, those with exposure to higher fixed project costs, may experience losses. If crude oil price continues on a downtrend as the mid-term supply-demand balance suggests, it will be a tough environment for oil Exploration & Production (E&P) companies, especially for smaller, weaker players. For tactical investors/ tactical investment managers (those who actively manage their sector exposures over time), I recommend to reduce exposure to these sectors significantly.

Energy share prices dropped fairly consistently with the price of crude, then rebounded last week, for a -4% YTD loss (see chart above). If you have exposure to energy in your portfolio, such as the Energy Select Sector SPDR ETF (NYSEARCA:XLE), the iShares U.S. Energy ETF (NYSEARCA:IYE) or similar, I would use this rebound as an opportunity to significantly reduce it.

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10 Comments on "Oil Price: Beginning Of A Downtrend"

  1. Perk Earl on Tue, 28th Oct 2014 8:41 pm 

    NWR, we were discussing interest rates the other day and it was mentioned that deflation is the concern. Yes, except when bonds, like QE bonds are sold they cause higher inflation, and this is what WallStreet is concerned about, because once rates go up the market descends.

    The stock market started down by some big chunks recently, then the Fed backed off and said there was no plan to sell QE bonds just yet. That’s when the market started back up again.

    Look below at the zero hedge article in which they claim Germany will not stand for QE in the EU, because they remember the hyper-inflation it caused in the past. So we are at a crossroads in which QE pushed things forward for a while, but the reason it can’t go on forever is because that 4.5 trillion in bonds has to be sold sooner or later and when it does it will cause inflation. The only way to combat the inflation when sold is to raise interest rates, but then that causes defaults for loans holders that are already on the edge of their finances.

    At least that’s the way I understand it and this article seems to back that up.

    http://www.zerohedge.com/news/2014-10-28/qe-ends-us%E2%80%A6-and-wont-begin-eu%E2%80%A6

    QE Ends in the US… And Won’t Begin in the EU…

    This is impossible. The ECB cannot and will not engage in QE based on the current legal framework of the EU. It can corporate bonds and other securities, but NOT EU sovereign bonds. The reason is simple: Germany will not stand for it. Germans still remember the hyperinflation that buying sovereign bonds induced in the past.

  2. Plantagenet on Tue, 28th Oct 2014 8:55 pm 

    The EIA doesn’t see US production from the Bakken and other tight oil producing zones stopping anytime soon. The EIA says:

    The supply shock created by a surge in North American oil production will be as transformational to the market over the next five years

    Five more years of cheap oil would be very very nice, thank you very much.

  3. shallow sand on Tue, 28th Oct 2014 8:56 pm 

    Seems to me that 80 WTI is a big deal technically. This price held (at least on a monthly average) during down turns in both 2011 and 2012.

    I still think a drop to 60s could happen, but it will derail US supply growth. I don’t see how Bakken/Three Forks can avoid a down turn with a posted price in the 40s. Further, I would think that HBP lease development would slow, why drill like crazy during low prices if you can wait a couple years for a rebound. The shale development time lines aren’t years like deep water and tar sands.

    Then again, wall street doesn’t like E&P co who are conservative so maybe they will keep going full steam ahead.

    I do like that everyone is freaking out that WTI is 80 and that is deemed a “low price”. Would assume 80 is still pretty good for the boring onshore conventional producers and shallow water offshore. I don’t remember as much hype about 80 being low in 2011 or 2012. Prior to 2008 80 would have been considered sky high. That’s just 7 years ago.

  4. Makati1 on Tue, 28th Oct 2014 9:42 pm 

    Plant, 5 more days is too much, thank you. I don’t know how old you are, but if you are under 40, you need to think about your future on a hotter planet. You may think climate change is BS, but, are you willing to bet your life and that of your family on it? The sooner the economy crashes and takes down Big Petro and it’s cousins, the better for humanity as a whole.

  5. Northwest Resident on Tue, 28th Oct 2014 9:54 pm 

    Perk Earl — Yeah, I’ve been reading about that too. In fact I’ve been reading a lot about it. I’m no financial expert, but it doesn’t take one to realize how big their problems are over in Europe. They have to keep the EU together because there are some very critical issues that a single currency and EU “government” solves (more or less), but by pressing all those EU countries together they are creating even more problems, some potentially much more serious than the ones they are attempting to solve. Germany is obviously top dog in Europe, but they can’t control events forever. I realized quite a while back that Europe is just plain screwed, more so every passing day and sure to climax into violence and bloodshed as the economic pressure grows. It is interesting and fascinating to observe what is happening in Europe, but at some point I anticipate that fascination will turn to horror. Being the doomer that I am, I kind of expect that almost everywhere, but I can see how in Europe it could get really bad.

  6. Plantagenet on Tue, 28th Oct 2014 9:58 pm 

    Makatai, you may think that climate change is BS, but if you don’t then you should understand that the main source of CO2 emissions to the atmosphere is coal burning in electrical power plants in China. The only way to reduce CO2 from china, india, the US, the EU and Russia is have a post-Kyoto binding climate treaty that restricts CO2 emissions from all countries.

    Get it now?

  7. Perk Earl on Wed, 29th Oct 2014 12:36 am 

    “It is interesting and fascinating to observe what is happening in Europe, but at some point I anticipate that fascination will turn to horror.”

    Yeah, NWR, the EU for sure and Japan could also be tossed into that pile as both seem perched on a financial razor’s edge. Diminishing returns on full display as they have squeezed just about every desperate effort conceivable, yet of course the situation just keeps worsening. Apparently though they keep expecting things to turn around.”

    The US is headed to that same place as QE ends and the stomach for desperate policies seems to be waning. We are just going to get it a little later, or fall hard when the EU and or Japan seize up.

    I keep wondering if BAU will get pushed so far beyond what is a reasonable response to an energy predicament, that when s does htf, the floor falls out in short order leaving people gasping in disbelief, with the economy completely seizing up.

    I see that as a distinct possibility because whenever a problem is ignored, (like in this instance with sharply declining EROEI), and instead some other set of tactics tries to override the problem, it only accentuates it until it finally blasts through all at once.

    I don’t know if it really should be characterized as doomerish, because in another sense it is simply the logical outcome of understanding the situation as if it were an equation. Where do the ideas inherent in the predicament lead to after the equal sign? It may be that the one’s failing to recognize the outcome should be labeled ‘intentional ignorance’. I’d rather be labeled doomerish than that – LOL. Ignorance may be bliss, i.e. until shtf.

    There is the old saying “You can’t fight city hall”, and in the case of declining net energy it’s not something that can be outflanked by shifting money here or there.

  8. Northwest Resident on Wed, 29th Oct 2014 1:20 am 

    Perk — I’m pretty sure that TPTB realize that time is running out. The US Military certainly is aware and has been aware of the dangers, and they have their plans. It seems obvious to me that TPTB are planning and making moves to deal with the coming collapse. Whether those plans end up benefiting me or you is another question. It looks to me like the global economy is beginning to feel the contraction. The falling oil prices at this point in time carry significant meaning, I think, it almost looks like writing on the wall. Hey, we have front row seats to this historic drama as it unfolds, and unlike most people, we also have “The Idiot’s Guide To Collapse” which most people don’t have. We’ll have a much better idea of what is really happening and what is likely to happen and the reasons for it than most others. Pity that man who works at the local warehouse with a wife and two small kids when he wakes up one day to gas lines, pandemonium and no job, with nothing in the refrigerator but two day old leftovers and no idea in hell what is going on. I hope it won’t come down to that, but I suspect it will.

  9. Davy on Wed, 29th Oct 2014 8:21 am 

    Perk said – I keep wondering if BAU will get pushed so far beyond what is a reasonable response to an energy predicament, that when s does htf, the floor falls out in short order leaving people gasping in disbelief, with the economy completely seizing up.
    Perk this is the key question now. We know we have a global financial dysfunction in progress. We know here were have an approaching liquid fuel issue. One or the other may strike first but it is the combination of the two that is so serious.
    Your point on the extension of BAU beyond a soft landing is so valid. The point of correction should have been the 70’s ideally. We are currently near a time of criticality with multiple predicaments in diverse areas from physical to the abstract. Resources issues being physical and the human socio-political being abstract. I see a criticality going from linear to non-linear.
    This phase change from linear to non-linear happens suddenly. We get the resulting turbulence of steam and water reaction. The turbulence is the random and chaotic results of phase change. It was a slow warming to boil but then the process proceeds swiftly and violently. During this warming period we were oblivious to the dangers IOW we are going to be blindsided by the transition.
    I personally feel we are very near a phase change because of financial dysfunction and liquid fuel economic quality/quantity depletion. These two issues are the block of the global engine. Capital and resources must be properly applied in an act of trust in trade and exchange. All modern efforts are liquid fuel driven.
    These two central variables are a Liebig’s law to the global system. All locals are in codependence to the global. The global is in a state of limits of growth with a condition of diminishing returns facing over population and carrying capacity overshoot. Vital ecosystems are degrading quickly in a linear and some non-linear fashion. Hockey sticks graphs are evident.
    This condition may or may not be beyond a corrected survivable equilibrium. There are too many unanswered questions both known and unknown. We do know in nature in association with our natural laws is inertia and momentum. I see a great momentum in a vast interconnected system with access to huge amounts of resources, driven by vast amounts of knowledge, technology and infrastructure. This system’s inertia is its drive towards growth.
    This drive to growth is good and bad. The good part of this is it does provide resilience to all of our locals in codependence with the global. A localized drought will be a famine managed down to food insecurity. The bad side of this is this drive towards growth is it cannot continue in a finite world. Eventually growth reaches diminishing returns when it approaches limits. Complexity breaks down and dysfunction and abandonment begin. The longer the growth over extension the more delocalized and exposed out locals become through the drive toward efficiency and productivity.
    This is basically where we are at now. We are at an inflection point where the bullet is slowing and dropping. At a point gravity will pull the bullet quickly back to earth. Entropy is to our global system as gravity is to a bullet. We are at the end time when entropy is going to quickly overwhelm a complex system. The key question for our survival is degree and duration of the fall. The longer we push out the correction the more dangerous the correction.

  10. MSN Fanboy on Wed, 29th Oct 2014 6:17 pm 

    “The longer we push out the correction the more dangerous the correction” Davy

    Exactly, this is why a slow drawn out rational decline is becoming less likely with every passing month.

    Collapse will happen on the periphery at first (third world etc…) but as the dominos fall it will undermine the global system.

    At some point (most likely a financial “CORRECTION”) occurs and the value of fiat currency becomes exposed.

    Credit and pensions can’t be drawn and insolvency of STATES across the globe.

    Riots ensue as peoples entire lives savings or entitlements are revealed to be mirages.

    At this point anything such as financing capex fails…

    Then we hit peak oil from a geological and financial perspective.

    I will make no more predictions lol… im destined to fail but may give a general picture.

    See collapse is simply convergence of all our short-term descisions coming back to equalise the equation.

    The problem is to “equalise” the equation involves the 4 horsemen.

    Anyway, Davy’s spot on lol

    BUT NEVER UNDERSTIMATE THE CAPACITY OF STATES AND CORPORATIONS ALONG WITH RICH INDIVIDUALS TO DRAW THIS OUT.

    That was the mistaken forcast of 2008 lol

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