By Chris Cook, for Trend Agency
In the next 3 to 6 months, in the absence of major coordinated production cuts, I believe we will see the market price collapse, possibly to levels which test the lows of $26/barrel or so reached in January of this year.
In my analysis, the doubling of market benchmark prices (US WTI and North Sea Brent/BFOE grades) since then represents a financial bubble. This was created by the purchase of massive futures contract positions by managed funds. These market positions - only some of which are the hedge funds whom commentators blame - are supported by liquidity sourced from Euro Quantitative Easing by the European Central Bank.
Furthermore, the current market noise blaming supply disruptions - which to be fair do exist in Nigeria and Libya particularly - ignores the record levels of Iraqi oil production and Iranian oil production which has almost reached pre-sanction levels.
But there is another far more important factor which is not widely understood. Most market commentators have a fixation on reported crude oil inventory levels and their daily recommendations and comments react breathlessly to changes in stocks of oil.
Now, while oil producers and refiners maintain buffer stocks for resilience reasons of security of supply and demand, oil buyers such as China, increasingly also have a financial motivation which is that they prefer to hold oil stocks as a reserve asset to holding dollar reserve assets, which return zero percent per annum.
Commercial oil producers & refiners, and oil traders, on the other hand, are intermediaries or middlemen who are motivated by dollar profits and not by charity. What I mean by this is that such market participants will not maintain an inventory of oil stocks above an absolute minimum unless their costs of storage in tank or tanker, insurance, and bank debt interest costs are met.
Over a year ago, in 2015, the spot oil market price was at a sufficient discount to the forward price (known as a 'contango' market price structure) that many commercial players locked in risk-free profits through buying spot oil and selling oil forward on the futures markets at a level enabling them to make a risk free arbitrage profit. This time-honoured trading strategy is known as a 'cash and carry'.
However, as I predicted in February, this contango has shrunk (and even briefly reversed into a 'backwardation' price structure, where the spot price was higher than the forward price). The outcome of this change in market price structure has been that it is no longer profitable for commercial participants to maintain excess inventory and it is therefore now being released onto the market as cash & carry positions expire.
So what we now see is an increasing amount of oil which is being held in oil tankers either queuing to be offloaded or without a buyer at all. This recent Bloomberg article "Oil traders are borrowing to store oil at a loss" and its striking image of tanker congestion show the true state of the market after the noise from investment bank analysts and other market players 'talking their book' has been stripped away.
The general commodity market rule is of periodic cycles of booms and busts, and I believe that if my forecast is accurate we will see oil producers panic once the price collapses again, with emergency meetings held - as they were in 2008 - this time involving both OPEC and non-OPEC. I think that there is a strong possibility of the liquidation of one or more major oil traders, and probably also financially exposed petrochemical producers with fragile business models. I would not rule out a 'rush for the exits' and a meltdown of exchanges such as the Intercontinental Exchange (ICE), which concentrates market risk in a manner that is not widely appreciated.
The market price will probably spike down, and there is no lower limit, and will then clear and rebound again. This medium term process could take between six months and a year to work its way through. In other words, 2016/2017 could be an exciting time.
As I have written in Trend before, I agree with former Saudi oil minister Zaki Yamani's view that the Stone Age did not end for lack of stones, and that the Oil Age is not ending for lack of oil. This is why the Saudis have been pumping crude oil flat out, and are also proposing to sell capitalised future oil production from anyone foolish enough to buy Saudi Aramco shares. In my analysis, market share was never the Saudi motivation - it is simply an outcome - but an outcome which enables them to rationalise their actions to credulous observers.
I believe that the global market in crude oil has reached a historic inflection point of 'Peak Demand' and will never again remain for long above around $50 per barrel (all things being equal). The first reason for this is 'affordability'. Above this price level, the cost of energy, and its knock on effects on goods and services, has reached a level which is unaffordable for a majority of people in the developed world, which increases daily with austerity and automation.
The second reason is that renewable energy megawatts are increasingly substituting carbon fuels. I was struck by a recent article by Robin Mills which pointed out that large scale solar energy installations in Dubai had reduced electricity production cost from US 6 cents per kilowatt hour (c/kWh) in December 2014 to 2.98 c/kWh now. The author pointed out that this cost is equivalent to oil at $23 per barrel and natural gas at $4 per million British Thermal Units (MMBTU).
The final and most important reason is what I like to call Nega Barrels of oil. The fact is that the more expensive carbon fuels like gasoline, diesel and fuel oil become in dollars, the more dollar profits are to be made by saving them.
So I believe that when the market price rebounds in the medium term it will be effectively capped in the long term and the result will be that a new and collaborative - energy-as-a-service - market paradigm will come to replace the existing competitive oil-as-a-commodity paradigm.
Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and a commentator.