Rory McPherson
The last 18 months for oil have escalated from being generally disliked into outright victimisation, seeing it take a 75% nose-dive from its $110 price-tag in June 2014. The recent “bull-market-bounce” to circa $35 has provided some respite but it remains to be seen if the worst is over.
$35 oil should, in theory, be good news for companies and good news for consumers. The reality has been much less pleasant. The low price has been seen as an indicator of low growth and low inflation, with the worst of the sell-off coinciding with the US Fed raising rates. Such dismal reality has prompted doom-monger theories calling for $10 oil; whilst not likely, this is plausible and would have serious consequences for equity markets.
The Fed, with its December rate rise, is doubtless one of the playground bullies - it’s no coincidence that oil’s 25% fall to $26.50 began post the December 16th announcement. However, there have been other (potentially more powerful) tormentors pushing oil’s head towards the proverbial toilet bowl. Sticking with the US, the lifting of the oil export ban (for the first time in fourty years) was not well timed. It came two days after the Fed’s rate rise. This served to raise supply in an already over-supplied market; landing a punch when oil’s hands were already down.
Any hopes oil had for a fresh start in 2016 were short lived. Spats between Iran and Saudi Arabia diminished all hope of motherly intervention via OPEC supply cuts. Concerns over Chinese growth rained down further punches, with the raised sanctions on Iranian production sending poor oil to the canvas. $27 oil saw the emergence of doom-monger theorists with their $10 price targets. $10 oil is clearly too low. It would paint a disastrous picture for inflation, equities and global growth. This picture could well look like a recession if it coincided with further concerns over Chinese growth and a tightening Fed.
Sadly, $10 oil is possible due to the huge over-supply in the market. We have about sixty-five days’ worth of oil in supply. This number is ever-increasing owing to the 1.5 million excess barrels being produced each day. As over-supply increases, so too do storage costs for producers. These guys are currently paying up heavily to store their oil to such an extent that oil to be stored and sold one year from now trades well above today’s market price. Oil for delivery in one year’s time trades at around $43, with buyers happy to pay the extra as they believe the price will be higher (than $43) this time next year. Furthermore, with the cash cost of global oil at around $25, and $50 for US shale producers, they are not keen on offloading it for a loss today. The futures market forms an up-sloping curve and the market is said to be in “contango”.
Re-emergence of those bullying forces would see further negative movements for oil. The $10 level could then come as a result of an over-shoot as holders capitulate; lose faith in global demand and rush to off-load their expensive supply.
Oil needs to work through its over-supply and ideally this comes through stronger global growth, with companies and consumers spending the net gains they’ve been saving from cheap oil. Low oil, combined with a strong dollar plays havoc with inflation which itself grabs the attention of policy makers.
Recent action by European, UK, US and Japanese policy makers should help stoke inflation and give growth a kick-start. Added to this, positive noises from old mother OPEC may help protect oil from the bullying forces and look forward to a brighter rest-of-year. Oil and other risk assets will take reaffirmed faith in policymakers as a tonic to steady their nerves after a long and torturous start to the year.
Rory McPherson is head of investment strategy at Psigma Asset Management
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