Musings: Is There Something Wrong with the Crude Oil Market?
With the official end to summer, the Labor Day weekend, behind us and the nation's largest energy company investor conference underway, the oil market received several shot-in-the-arm positives last week. Wall Street talking-heads had a difficult time understanding what was going on with the price of gold and crude oil futures soaring on the first trading day following last Monday's holiday. Gold futures traded over $1,000 an ounce and crude oil prices jumped by $3 a barrel. The inability of the talking-heads to explain the phenomenon left us wondering if we were seeing a global investor reaction to Washington politicians returning to work. Those of us living in Texas have a reaction when our legislature goes into session in Austin. We hold onto our wallets during those few months of the legislative session every two years since that is our peak exposure to politicians inflicting serious financial damage on our wellbeing. Our thought last Monday was that global traders may have been adopting the "Texas-view" of the risk to the U.S. economy and the dollar's value from the actions of politicians in Washington. That view seemed to be reinforced by the Labor Day announcement of President Obama addressing a joint session of the Congress later in the week on the issue of health care reform.
The inability of the talking-heads to explain the phenomenon left us wondering if we were seeing a global investor reaction to Washington politicians returning to work
Currency traders, seeing Washington about to go back into session with health care reform and cap and trade legislation on the agenda and a pressing need to raise the government's debt ceiling, combined with serious international trade and diplomacy issues, could only conclude that government actions would increase the nation's deficit and to deal with that problem would resort to the printing press to meet our financial shortfall. That scenario heightens investor fear over a possible acceleration in future inflation and a correspondingly lower value for the U.S. dollar.
That fear was almost immediately reflected in a declining U.S. dollar index. In turn, a falling dollar value makes commodities worth more as a hedge against further deflation in the currency's value. One can see in the accompanying chart the roller coaster ride the U.S. dollar index has experienced over the past year, but more importantly it reflects the sharp drop in the index's value in the last few days. Some traders might argue that this precipitous drop might be overdone and the dollar is poised for a sharp recovery, but the growing economic data is demonstrating that while the economic recession may be ending, other countries around the world may be poised for sharply faster economic recoveries than the U.S. As the risk premium associated with possible future financial and economic calamities diminishes, the need for investors to pile into the U.S. dollar for safety is reduced, and relative economic growth rates become more important.
The comments by UN officials last week that the world should consider looking toward another global currency standard, coupled with the recent sale of Chinese Yuan-denominated bonds designed to enhance its role in the global currency market, suggest that more investors are beginning to consider alternatives to holding growing piles of U.S. currency. These concerns were amplified by questions of the oil ministers representing the various members of OPEC at their meeting last week in Vienna, about whether they would like to see oil denominated in a currency other than the U.S. dollar. In the past these oil ministers have talked about the possibility of denominating oil in a basket of currencies, or some other arrangement such as special drawing rights created by the International Monetary Fund. OPEC members delicately sidestepped the question this time because, with oil prices in the $70s a barrel range, they can afford to absorb some erosion in the value of the currency they are paid in. Starting a battle over currencies would do little but make OPEC look more like "price-gougers" at a time when the organization is enjoying being out of the media limelight. That is probably even more important as the topic of how to restrict the role and power of "speculators" in commodity markets raises its head bringing oil prices back into citizens' and the media’s focus.
Investors are beginning to consider alternatives to holding growing piles of U.S. currency
The chart of the U.S. dollar index for the past month shows clearly the sharp drop experienced last week. Although the index has a ways to go to reach its historic bottom below 72 established during the first half of 2008, the contrary move of the dollar index and oil prices in the last few days was clear. For the first four days of September, before the Labor Day weekend, oil traded in a very tight range of $67.96 to $68.05 per barrel. Some observers suggested this tight range was due to it being the last week of summer and before all of Wall Street came back to work, and that oil was waiting to see what OPEC did at its upcoming meeting and what the International Energy Agency (IEA) would say about global oil demand. But from Tuesday to Friday of last week, oil prices rose from $68.02 to an intraday high on Friday of $72.90. At the same time, the dollar index fell about 3.5% from just under 78.50 to 76.55, a new low for the year, providing additional impetus for the rise in oil prices.
Exhibit 16. Dollar Index Move Explains Oil Price Jump
The inability of the oil futures price to breech the $73 mark Friday morning set the stage for significant profit-taking in the last few trading hours of the week. The NYMEX chart of the near-month crude oil futures prices by time of the day for last week clearly shows Friday's attempt to breech the $73 price mark and the subsequent sell-off. The nominal excuse for the retreat in crude oil futures was that it couldn’t establish a new high, so the market's technical factors turned negative. Traders grabbed on to emerging concerns about weak oil demand as the prior day's EIA's inventory data showed a weekly build in gasoline and heating oil stocks, despite a huge drawdown in crude oil supplies. Coupled with this data was concern about global oil demand as China's national statistical agency said the country's August oil demand fell 6% from July. When given any reason to take a profit, especially hours before a weekend, traders usually do. Oil futures prices dropped slightly over $3 a barrel from Thursday's close to Friday's close, but from the intraday high, the price retreat was $3.79 a barrel.
Admittedly it didn't hurt oil prices that last week the IEA raised its global oil demand forecasts for both 2009 and 2010 by about 500,000 barrels a day. Improved economic statistics out of the United States (lower initial unemployment claims, increased consumer confidence) and China further helped the oil demand outlook. The IEA now says that global oil demand will average 84.4 million barrels a day (mmb/d) in 2009 and increase to 85.7 mmb/d in 2010. Those new demand estimates mark the second consecutive month the agency has increased its forecasts. Despite the recovery in demand, 2010's projection still puts total demand 0.8 mmb/d below the 2007 peak of 86.5 mmb/d. If consumption growth continues, it is likely that 2011 will mark the first year in which oil demand exceeds that historic peak, but only four years later in contrast to the nine-year time period needed during the 1980s to surpass the prior demand peak in 1979.
The IEA now says that global oil demand will average 84.4 mmb/d in 2009 and increase to 85.7 mmb/d in 2010
The one concern reflected in the IEA forecast is its heavy dependence on China's oil demand continuing to grow. The IEA acknowledges that some of the implied energy demand in China is due to the country filling its strategic storage facilities that will come to an end at some point. Could August mark that point? Additionally, as China continues to expand its alternative energy supplies oil demand growth could slow, although the latest car sales figures might mitigate any fear of a near-term oil demand slowdown.
In China in August, 858,300 passenger cars were sold compared to 451,300 cars sold a year earlier and 832,600 sold in July. For the first eight months, there have been 6.23 million passenger cars sold in the country, nearly equal to the 6.76 million sold during all of 2008. Total vehicles sold for the first eight months were 8.33 million putting China on track to sell an estimated 12 million units in 2009.
An interesting question will be whether China, with its increased control over growing overseas oil supplies, will switch its focus from domestic storage capacities to merely making sure that its ability to transport oil supplies from abroad is not interrupted. That may be partly behind the increased government spending on China's navy. In the end, however, a growing population and economy will necessitate larger storage volumes, but maybe not as much if the government becomes less concerned about long-term interruptions in supplies.
Will China switch its focus from domestic storage capacities to merely making sure that its ability to transport oil supplies from abroad is not interrupted?
At the end of the day, however, the dependence of the IEA's forecast on continued rapid growth in China's oil consumption is a hidden risk. Friday's oil demand release by China confirms that possibility. China is known for its opaque economic statistics, creating a cottage industry of "China economy watchers." So far, China's aggressive economic stimulus plan in response to the global financial and economic crisis has succeeded, at least as measured by the reported statistics, but some of the economic measures of this success reflect money allocated but not actually spent. Also, China still has to deal with its structural economic issues -- the lack of strong domestic consumption growth and the conflicts among regional, local and national government agency investment objectives.
The dependence of the IEA's forecast on continued rapid growth in China's oil consumption is a hidden risk
At the 30,000-ft. level, the sheer size of China's population and economy should dictate growing energy demand. In earlier periods the pace of China's demand growth would not have been a major concern since oil consumption all across the world was growing. But now the growth of oil consumption in the developed economies in the world is no longer assured, and with global warming and aging demographic issues confronting these economies, we may actually be experiencing the start of a new era to be marked by lower oil consumption for a significant portion of the world's economies.
For the period 1966-1979, the world's oil demand growth averaged 2.4 mmb/d annually
If a new oil consumption era is dawning, then the rate of oil consumption growth in the future may be lower than we have experienced in the past. As the accompanying chart shows, for the period 1966-1979, the world's oil demand growth averaged 2.4 mmb/d annually. If we exclude the recessionary period of the early 1980s when global oil demand was negative, world oil demand grew at about a 1.06 mmb/d rate through 2008. On the other hand, if we include those weak demand years, consumption grew at only 0.69 mmb/d a year. It is interesting to note that if we include the revised IEA annual demand growth projections for 2009 and 2010, the 1984-2010 rate becomes 0.964 mmb/d, some 96,000 b/d lower than the rate experienced through 2008. The 1980-2010 growth rate of 0.63 mmb/d, however, is only 60,000 b/d lower than the 1980-2008 rate.
The oil industry's focus increasingly will be on the critical issue of how to get more from existing reservoirs and how best to extract the lower quality unconventional oil resources around the world
Will we be looking at an even lower demand growth rate in the future? Only time will tell. For the world's oil market, slower demand growth may be perceived as a relief valve from pending peak oil concerns. While slower demand growth will take some pressure off the supply challenge, aging oil fields and accelerating depletion rates remain a relentless cancer in the industry. The recent media flap over comments by Fatih Birol, chief economist at the IEA, about a peak in global oil production coming much sooner in time than the agency has publicly acknowledged may be the tip of the iceberg highlighting that depletion has displaced growth as the principal driver for the global oil business. While finding new fields will remain important, the oil industry’s focus increasingly will be on the critical issue of how to get more from existing reservoirs and how best to extract the lower quality unconventional oil resources around the world. This sounds like a good environment for the oilfield service industry.