Tuesday, August 30, 2016

Preparing for September

Last week ended with another heavy statement from the Federal Reserve Chairwoman, Janet Yellen, addressing her fellow central bankers at an annual conference at Jackson Hole. Her words, "In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months," were enough to inject a small dose of volatility into trading on Friday. Equities which had grown earlier in the day weakened in later trading, and the dollar jumped against foreign currencies.

from WSJ
Trading opened the week with Yellen's remarks in mind and a fresh batch of economic data in the morning. Income and inflation metrics met consensus estimates with earlier estimates revised slightly upward. Personal income and consumer spending inched upward in the last reported month showing signs that the economy has begun to stabilize, but a small increase will fuel pessimism surrounding third quarter results in a couple months. Consumer goods and services should be wary of a flat consumer consumption growth, and utilities will have the edge. Sluggish prices also fuel the slow growth trend that the Fed will reconsider in September. A "lower for longer" oil scenario translates to a limp PCE index which could discourage any hawkish action by the Federal Reserve during the next meeting. An inflation target of 2 percent looks very lofty when looking at yesterday's numbers. According to projections in June, PCE inflation should be at about 1.4 by the end of 2016, but the current reading of 0.8 suggests a pessimistic outlook. On the other hand, Core PCE is on target to meet the Fed's projections of 1.6. Most sections of the economy appear to be moving fine which supports Yellen's comments on Friday. Perhaps the most troubling numbers are personal income and consumer spending which appear stagnate. If more optimistic data supported a growing consumer, then a low rate of inflation wouldn't be as dangerous.

Inflation could be supported September when OPEC meets for the second time to consider an output freeze. In the last meeting, a sanctionless Iran ruined any hopes for a deal when it asserted that it needed to resume production to pre-sanction levels. After a couple months and a 600,000 increase in Iranian output, OPEC members will try again. Investors initially traded the news bullishly, but losses on Monday and Tuesday this week suggest that most don't think that a deal will go through. The pessimists have a good reason to doubt the chances as well; the current state of the oil market is bullish for countries and companies looking to produce more. OPEC's own monthly reports have set the scene perfectly with updated data.

  • Spot prices are significantly higher 

Every major crude oil spot price is trading higher over the past couple of months. Brent crude and the OPEC basket price have gains over $1,00 higher than WTI crude oil suggesting the international oil market may even be more balanced than the U.S. market despite the output freeze failure. The members' own price metric has grown the most according to a percentage calculation implying their situation may be improving faster. If an output freeze couldn't be negotiated at April 17th prices, then a deal in September will be unlikely especially considering an end-of-the-year target around and above $50 a barrel for Brent and WTI.

  • Oil consumption estimates and projections are bullish 

Monthly reports gauged global oil consumption as higher in August than in April. For the month of April, world growth in consumption was expected to be 1.2 million b/d for the 2016 year, but four months later, the same number came in 30,000 barrels higher at 1.22 million b/d. The increase is not enormous, but it asserts a positive outlook on the demand side which will bolster more production from OPEC members. The report upgraded demand estimates for North America, Europe, Africa, and India. The important players are India and Africa as they will be major sources of demand growth in the near future. On the other hand, Chinese demand was revised slightly lower along with Latin America which had the largest decline. A source of concern may be China's flat demand trend. The Asian giant is a neighbor to many OPEC members, and thus, has become their biggest consumer. A strong China is necessary for the cartel's survival. Oil product markets also looked to be heating up in some areas of the globe. In the United States, the product markets showed more demand which could bolster OPEC exports. Asian markets, though, appeared to weaken. This bearish concern may outweigh U.S. product demand strength in the long run.

Since the oil market is turning in their favor, participants at September's summit will be less likely to conclude with a deal negotiated. Yes, revenue streams are still pinched, but the small amount of breathing room that the market has allowed will send producers into a wild-goose chase for more market share. The competition could threaten the survival of the oil cartel, in the long run, a death that would shake the global economy to its core. With two important meetings in September (Fed and OPEC), the month has the potential to instantly shift the current market trend in either direction.

Thursday, August 25, 2016

Does Iranian Oil Still Matter?

With a crude oil rallying looking to end out a hot summer, investors will be focused on OPEC supply reactions that will develop over the next couple of months. At the end of last week, WTI contracts are trading up 9.16 percent over the past month posting a year-to-date gain of 11.04 percent, and Brent contracts are up 9.55 percent and 14.58 percent respectively. Worries that a glut still remains have subsided, and instead, investors have piled behind a rally off of all-time lows that were seen at the beginning of the year. Now, eyes are on producers to see how they will react to the higher prices.

The rally came after seven strong bullish trading sessions that were supported by reports of an OPEC output freeze in consideration and a surprise 2.5 million barrel draw on inventory last week. Prices jumped from lows near the $40's into territory well above both the 50-day and 200-day moving averages. Volume was not as strong, but the clear direction of the trend did not lack conviction. We're now at a bit of a resistance where bullish traders have backed off, and the bears have taken control. With relatively bland data coming from North American producers, investors should keep their eyes on production totals from their counterparts in the Middle East. Bolstered by a slightly mitigated glut, OPEC members from that region have continued to pump at higher levels hoping that an increase in fossil fuel consumption will make up the supply difference. Although, reports of a September output freeze in the cards has done enough to convolute the fundamental picture and any rational sentiment. The spotlight will, once again, be pointed towards OPEC's swing producers, Iran and Saudi Arabia, two nations which couldn't put aside their geopolitical difference to arrive at an agreement. In just under a month, the biggest oil producers in the world will come to the table once again, and the hopes for a freeze reside in the unstable relationship between Iran and Saudi Arabia.

The question that most people have going into the September meeting is whether Iran has enough pull to influence the proceedings. There's no doubt that Saudi Arabia remains in the saddle, but the Iranians have the most availability capacity as they continue to rebound from the sanctions that were just lifted at the beginning of the year. Since then, monthly production figures have grown almost 300,000 b/d which makes Iran's output the fastest growing in OPEC. This fact made an output freeze in April all but impossible despite Saudi Arabia's desires to come to an agreement. With Iranian production returning to pre-sanction levels, the nation's available capacity has shrunk. Thus, volatility in output figures should fall in tandem, making an output freeze deal more likely if other OPEC members can cooperate. Countries like Nigeria and Venezuela might show more resistance as their governments, like Iran's, are strapped for revenue and slightly higher oil prices would relieve some financial pressure if the output, at the very least, remained stable. But that shouldn't dim the outlook much, in the end, Saudi Arabia has most of the power. However, Iran will once again be in the spotlight as its fundamental position is brought into the foreground. Investors need to pay attention to updates on its oil output there in preparation for the upcoming OPEC meeting.

Unfortunately, statements from the Iranian government have suggested a dim outlook for the September meeting. The Wall Street Journal reported that Iran said "it doesn’t expect that its production will have risen to the levels the country" and "it needs to justify cooperation with its rivals." Officials say that production would have to breach the 4 million barrel a day level for they would consider cooperation. In reality, this output goal does not appear to be achievable in the near-term, and definitely not by September. Naturally, an output freeze should be counted out, but Saudi Arabia's sway should never be counted out. If a freeze is a necessity, the combined power of OPEC members without Iran would have enough production to influence the global markets. But in allowing Iran to successfully resist, the cartel is endangering its own existence through moral hazard. Nations in monetary distress would feel hard done by and be quick to nominate themselves for an exception. Estimates from OilPrice.com suggest that Iran would need $70 billion in foreign capital to increase its production to its 2021 target of 4.8 million b/d. In the end, Iran's target bring low, steady growth in the long run, a plan that wouldn't be significantly interrupted with a short-term output freeze.

News of oil swaps between Iranian and Russian energy companies might also be disturbing to OPEC going into September. As the largest oil and gas producer in the world, Russia has the potential to undermine any production moves made by the oil cartel. According to Mehr News, the swaps could include a capacity of up to 150,000 barrels a day with the opportunity to increase natural gas trade by a third as well. The Iranian government implemented these plans in order to rehabilitate energy exports which had fallen during a period of trade sanctions. In the first five months of 2016, Iran's exports have grown by 1.4 million barrels a day with hopes of growing above 3.0 million barrels a day in the coming months. Growing exports don't necessarily mean more production, but it certainly means more oil, whether stored or pumped, will reach the markets. A joint deal with Russia will put pressure on other OPEC members to secure their own buyers. Market share has definitely become a real issue as China's growth begins to level off and U.S. oil is allowed to be exported. These concerns will be in the mind of minor and major OPEC members alike and might have enough sway to diminish hope of a freeze.

Iran's recent policy changes and production trends don't bode well for an output freeze in September which will be bearish for oil through the end of the year. North American production has started to stabilize to a less volatile equilibrium point which might do little to move energy futures in the latter half of the year. In fact, OPEC's meeting in September might be the last event for a major crude oil trend shift before the election in November. Speculation before the meeting next month will most likely boost oil, but investors shouldn't be fooled by this peak. If fundamentals are stable, oil will remain in the $40's through December barring any "black swan" event.

Tuesday, August 2, 2016

Oil is Going Down Again

After a rough first quarter for oil in 2016, spot price trading has shown reduced volatility compared to the past year and a half. Supply movements have been relatively unsurprising in North America and other oil exporting nations. After the failure of the output freeze, OPEC's role changed from market leader to a market reactor waiting on true supply data to affect commodity traders. For the WTI spot price, a range of $40 to $50 developed with hopes of an upward breakthrough during the bullish summer months. June and July have passed and a different trend has set in. In its July meeting, the Federal Reserve was faced, once again, with tanking crude oil spot prices weighing on inflation. Now, August has come and oil is looking to break through a floor of $40. The EIA has revised their WTI projections from $48 a barrel by the end of 2016 to $44 a barrel. So why has this summer been so tame?

Based on data from the past five years, crude oil prices tend to peak in the first two months of the summer with refineries operating at full capacity. In 2015 and 2016, we're seeing deviations from this trend. Last year, volatile pricing was caused by a trend of climbing domestic production which overcame refinery inputs. This year, domestic production is stabilizing if not falling, so increased refinery utilization should help demand and reduce supply, but the WTI spot price hasn't responded accordingly. The average difference between the price of the first and eighth week during the summer over the past five years was +$0.53, in 2016 it was -$4.56. This deviation has troubled analysts who expected more bullish sentiment to be coupled with shrinking output.

Falling input prices have translated to even lower regular and diesel gasoline prices during the
summer months. The 2016 trend deviates from the usual pattern of high gas prices due to more demand from the summer driving season. In fact, the 1st to 8th-week difference in 2016 is larger than the past five years. Why is that? There are two sides of the coin to consider, the supply and demand side of the pump. On the demand side, 2016 transportation consumption remains strong and is already outperforming the previous two years according to the EIA's Monthly Energy Review. Compared to the first four months of 2015, petroleum consumption this year is up over 200 billion Btu. Therefore, supply-side factors can be assumed to have made the biggest impact.

Record high crude oil stocks have been the most bearish factor weighing on the price of oil. Initially, firms hoped that inventories would start to recede with less domestic output in the beginning of the year, but that wasn't the case. As soon as analysts started to see a reversal in upward crude oil stockpile trends, domestic production stopped falling. Going into the summer months, oil companies were faced with a rebound in spot prices, but inventories that have never been seen before. Typically, investors can expect a strong draw on stockpiles over the summer months with refinery inputs at their highest, but this year may be different (as it was last year). In fact, supply estimates for the last week of July reported an increase in crude oil stockpiles, weighing on the bulls.

The truth is, downstream trends could be having a larger effect on supply issues than producers. In 2015, we saw crude inputs rise well above 2014 levels as crude stocks grew with the oil glut, but that phenomenon did not carry over to this year. Crude oil estimates for this year have been in line with last year's even though stockpile estimates were much higher. What does this mean? For the first time in years, the U.S. upstream sector is outrunning its downstream sector which, previously, required imports to satisfy the refinery input demand. This summer, fully utilized refining operations are over-supplied and this is causing prices to fall on the producers' side. A bearish summer will force price expectations for the winter even lower as the maintenance season reduces weekly crude oil inputs.

The flood on the input side of the refinery is causing drivers to be flooded with cheap gas. Weekly motor gas production estimates have reached five-year highs. U.S. firms have maxed out downstream operations because it has become significantly cheaper to operate with growing from the transportation sector. As a result, gas prices dropped the faster this summer than the all of the past five summers. After growing to about $2.30 per gallon, prices at the pump plummeted back towards $2.00 a gallon with the EIA only projecting a rebound to $2.16 by the end of the year. The Short Term Energy Outlook forecasted summer prices to average $2.25 a gallon. The maintenance season should help stabilize prices around $2.15, but high finished motor gasoline production will persist to the end of the year.

After a seasonality analysis of the first two months of the 2016 summer, here's what we can expect:

  • By the end of the summer, a smaller draw on inventories or possibly a surplus if production increases.
  • Crude oil inputs to remain in line with last year's summer peaks
  • Motor gasoline production to peak higher than last year or follow in line with transportation consumption to show modest growth
For energy traders following WTI and regular gas prices, these three points will prove to be bearish factors in August and the fall. Rotary rig counts for June show that U.S. producers are beginning to increase their drilling activities after adding 10 active rigs in that month. If you think that the supply picture is continuing to improve, that is not the case. In fact, firms who have cut unconventional costs will find it profitable to produce at prices as low as $40 a barrel. When the industry finds this is possible, the glut will reemerge and weigh on prices more permenantly.