Addendum: oil prices, short term - variables at play

This is an addition to the previous post in which we have analysed oil prices based upon fundamentals estimates based on supply & demand. As anticipated in the same post we have warned against large changes in prices due to other variables such as geopolitics.
Since our last post the price of OIL has continued its down spiral and as of today we are sitting at a 5 ½ years low.

We would therefore like to shed some light on the current variables at play and also advise on the non sustainability of such pricing in the long run. These are exceptional times and they should be treated as such.

Variables currently pushing the OIL price down:

• Policy of containment towards Iran, Syria, Islamic State and Russia adopted by OPEC Gulf States;
• OPEC members interest in slashing fracking projects profits and delay or contain their production;
• Weaker than expected Chinese economic performance although we believe that the current statistics with regards to economic performance are not justifying the current price drop;
• Weaker demand demand than expected from the US side. 

In spite of the large reserves of some OPEC suppliers trapped into their Sovereign Funds, many of these countries have set up their countries expenditures and development against a higher price per barrel. Please be reminded that these countries are tax free regimes and their economic performance and development plans are affected directly by the price of OIL.

Further, a low OIL price and a strong dollar combination is going to hurt significantly all development projects in the Oil & Gas industry that are financed in USD, something clearly undesirable for many powerful US lobbies.

Lastly, while the mainstream media in the USA are hailing the low OIL price as a welcome stimulus to the economy this will not turn into reality. The US is facing a lethargic demand that is not supporting the recovery picture portrayed on the media. Please note that statistically any time that there was an energy tax cut in the US there has been no subsequent sign of positive stimulus afterwards.

Because of the above listed reasons we believe that the current significant price drop is temporary and far exceed the drop potentially justified by a weak US and partial restatement of Chinese growth.

We would only expect OIL at current price for a protracted period of time in the face of a recession 2009 which could be fought once again by the Feds with a new and improved set of QE cycle.

Oil prices - short term considerations & long term perspective

As recent oil news make headlines we have decided to take a closer look at the OIL price and provide a perspective in considerations of few significant industry and geopolitical trends.

Fossil oil is and will play a significant role in satisfying global energy demand. The medium to long-term trend is determined by multiple factors such as among others: the status of the global economy, geopolitical events, technological advances as well as consumer choices. The two main variables impacting supply and demand have been on the one hand a significant increase in the energy demands of developing countries, and on the other hand the emerging of a wider variety of energy supply typologies (i.e. oil sands, fracking technology) altering the traditional energy supply routes and therefore also geopolitical choices.

1.     OVERVIEW OF THE OIL SUPPLY AND DEMAND

In 2013 crude oil global consumption grew around 1.3 million b/d (+1.4%), with an average of 90.4 million for year. The Energy Information Administration forecasts an increase of 1.1 million b/d in 2014 and 1.4 million b/d in 2015.

In the medium-term period (2012-2018) Reference Case Demand could increase by an annual average of 0.9 mb/d, reaching 94.4 million b/d in 2018. Europe, Asia and Russian demands are rising very slowly, as illustrated in Table 1 while developing countries demand rise faster, with an increase of 1.1 mb/d every year.

The outlook for the second half of 2014 shows that the oil demand of non OECD countries will be higher compared to the OECD countries.

Table 1 Medium-term oil demand outlook in the Reference Case[1]

Source: World Oil Outlook 2013

In the long-term period (2012-2035) Reference Case Demand could reach an increment of 20 mb/d each year, this value could rise up to 180,5 mb/d in 2035. The biggest share of this forecasted increase should come from developing countries.

Table 2 World oil demand outlook in the Reference Case

Source: World Oil Outlook 2013

Oil and other liquid combustibles global supply is estimated to grow 1.5 mb/d in 2014 and will decrease to 0.9 mb/d in 2015. Nevertheless, Non-Opec countries supply presents an estimated upward trend, with forecasts assessed at around 1.8 mb/d in 2014 and 1.1 mb/d in 2015.

Figure 1 Change in non-OPEC supply, 2012–2018

Source: World Oil Outlook 2013

In the medium-term 2012-2018, as illustrated in Figure 1, total non-Opec supply is expected to constantly rise by 5.7 mb/d. The two main variables impacting these estimates are the supply of “tight oil” and “oil sands”.

These could create additional supply, in particular in Latin America (Brazil and Colombia), in Middle East and Africa, even if in those countries supply may be negatively affected by political instability.

EIA’s data show that crude oil Opec production had an average of 29.9 mb/d in 2013, with a decrease of 1 million with the respect to the year before, due to the oil production outage in Libya, Nigeria and Iraq. This decrease is partially mitigated by a strong growth in non-OPEC country supply.

The EIA outlook indicates that Opec production should decrease of 0.3 mb/d in 2014 and by other 0.2 mb/d in 2015.

In fact, 8 of 12 Opec members, present a negative production in 2013, such as Libya. The other 4 countries try to maintain a stable production, furthermore, Iraq increase its production from 1.75 mb/d to 3.25 mb/d starting from 2005 to 2013. OPEC conservative production allowed to preserve oil price around 100-110 dollars per barrel during the last few years.

The graphic below, reported by Kent Moors, Phd, in Money Morning, shows that demand will continue to grow until 2025, while supply instead is expected to decline. Based upon these estimates it is possible to experience  a shortfall between demand and supply.

Figure 2 World oil demand and supply

Source: Money Morning 2014

2.     FORECASTING OIL PRICES

Lately crude oil forecasts depend heavily on the oil exporters geopolitical uncertainty. The reduced risk to Iraqi oil exports and the news regarding increasing Libyan oil exports contributed to a drop in the Brent crude oil spot price to an average of $107 per barrel in July2014, $5/bbl lower than the June average, as reported in EIA outlook of August 2014.

The Saudi active intervention in price setting over the past few weeks, coupled with further signs of a weakening of the Chinese economy have both contributed to driving the price to a 4 years low ($80 USD/bbl). Some add that there may be geopolitical interests at play to further weaken Russia by virtue of keeping the price of oil particularly low. Regardless of the geo-political reasons behind this short term oil price low, it is reasonable to expect a medium term increase to a more reasonable price level, especially if the US economy confirms its acceleration as indicated by the latest indicators released by the Federal Reserve.

Based upon recent events oil price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecasted levels. Implied volatility averaged 16 %, establishing the lower and upper limits of the 95% confidence interval for the market's expectations of monthly average WTI prices in November 2014 at $84/bbl and $111/bbl, respectively. Last year at this time, WTI for November 2013 delivery averaged $103/bbl and implied volatility averaged 21%. The corresponding lower and upper limits of the 95%confidence interval were $85/bbl and $125/bbl.

Figure 3 Uncertain oil prices are expected to fall

Source: IMF 2014

According to World Oil Outlook (2013), the nominal OPEC Reference Basket price[2] will be remain on an average of $110/bbl until 2020, and then it will increase in both real and nominal terms.

In nominal terms, we suppose that the nominal price will reach $160/bbl within 2035, whereas in real terms it will reach $100/bbl. It represents a slight shift upward than WOO 2012 expected.

Table 3 OPEC Reference Basket price assumptions in the Reference Case

Source: World Oil Outlook 2013

3.     CONCLUSIONS

Eventually, oil price is set to rise, influenced by fear and uncertainty from Middle Eastern and North African countries. The new geopolitical instability of the late 2014, continued nowadays in Iraq and in all Middle East, causes oil production shortages that could take oil price back up to $110-120/bbl.

We judge the existing low price as temporary and due to the following conjunction of few geopolitical and economic events: a slow down in Chinese manufacturing output, Saudi oil discounting IS heavily discounted although limited supply. We acknowledge the above as short-term temporary factors.

Although we expect oil prices to rise in the long-term (2014-2035) we forecast that any sustained price above $150 USD maintained for a long period of time is going to accelerate the oil for gas substitution trend. We therefore believe that the probability of high OIL prices for a sustained period of time is be quite low.

Oil price is closely connected to the futures market, that forecasts an increase oil price and it is minor influenced by the production.

As political instability grows in key oil producing areas and extraction technology progresses, oil companies have more incentives to explore and extract oil in international waters away from conflict areas. Thanks to new technologies these new offshore areas are now within reach.

REFERENCES

EIA, Short-Term Energy Outlook August 2014, Energy Information Administration, U.S. Department of Energy: Washington, DC.

Kent Moors, Money Morning, August 2014

IMF (2014), Regional Economic Outlook. Update: Middle East and Central Asia Department, International Monetary Fund: Washington, DC.           

OPEC (2013), World Oil Outlook, Organization of the Petroleum Exporting Countries, Publications: Vienna.

Authors: Marta Pezzoni & Luca Gorlero

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[1]The Reference Case scenario in the World Oil Outlook 2013 indicates that demand for energy is expected to increase by 52% over the projection period 2010–2035. As for oil, its demand increases by around 20 million barrels a day (mb/d) in the years to 2035, representing the first upward revision in oil demand growth since the WOO was first published.

[2]Introduced on 16 June 2005 from World Oil Outlook, is currently made up of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

Economic Outlook for 2014

Dear friends, following are some of the important economic themes for this 2014.

As always we welcome any feedback, I have mode detailed information about each of the topic discussed below but I have summarised the content to fulfil the purpose of this blog which is meant to be informative but not the place where to analyse in depth each subject. If anybody is interested in additional information please connect with me directly using the contact form at www.affinitasconsulting.ae or info@affinitasconsulting.ae.

Overview

We recommend a cautious investment approach to 2014. While at the turning of the year many media outlets run big optimistic titles for 2014 we remain instead very prudent and skeptical about the health of the global economy. We see several reasons for weakness especially in the equity sector. Clearly, as always even weaknesses or a downturn uncover opportunities for successful money making but we leave those strategies to the people in the field and we would rather concentrate the following analysis on long term trends likely to affect economic growth instead.

The tapering of the US QE exercise is bound to have ripple effects globally, especially across the emerging market economies.

We reckon the US economy is not as healthy as mainstream media believes and we expect the Feds to evaluate tapering sometimes after Summer when additional signs of weaknesses are going to appear. Now that the elections in Germany are over and done with, and the upcoming banking stress test from the ECB looming we expect the Eurozone to create some waves again. Spain and Italy are bound to catch the spotlight: the first because of weaker than expected banking system and the latter because we expect the government to be challenged in the coming months.

Bottom line: it may be time to cash out on the equity gains accrued over the last few months and wait for bargains during the volatility that is bound to take place due to the tightening moves of the next few months. Some institutional investors or asset allocators may look into specific infrastructure projects which have demonstrated a low correlation with equity markets oscillations.

Investors or asset allocators may also explore and evaluate financial instruments that have as objective the isolation of the interest rate differentials.

A STRONGER DOLLAR

The tapering program announced by the Federal Reserve is going to be one of the key elements behind a likely appreciation of the USD against the other G10 currencies.

I believe we will see an even appreciation of the currency throughout 2014. While portfolio flows in 2013 definitely favoured Europe we believe that strong equity valuation discounts eliminated any chance for further growth hinderances. 

In addition US Banks are decreasing their exposure against foreign borrowers and we see this as a clear sign that the USD is no longer used as a funding currency but rather as a destination for investment.

With specific regard to the USD/EUR rate we simply believe that in spite of the PR coming from the EU there are significant unresolved problems in the Eurozone that are bound to flare again at any time (more below on this topic - EU problems all over again).

We are forecasting the following key rate: 1.20 $/EUR 

USD Investment Destination (Graph)

PRESSURE ON CORPORATE PROFITS

This topic is directly linked to a phenomenon that many economists have been discussing for more than a decade: the decoupling of productivity and wage growth, the so called Jaw of the Snake.

The decoupling between productivity and wage started to appear around the beginning of the 80s, we believe that the spread of the personal computer and the adoption of information technology greatly favoured this trend. 

Fundamentally: since 1990 German labor productivity increased by 25% with no appreciable difference in wage growth; in the US labour productivity has increased to-date 85% versus only 35% of the hourly wage. In a study published in 2012 & 2013 by the International Labour Organisation we learned that the share of labor as part of the gross national income has declined since 1975 by more than 10% across the 16 high-income economies.

This allows for a redistribution of the national income away from labor and in favour of capital owners.

ILO (International Labour Organisation) research goes therefore at the core of the problem: the decline in the labor share of the national income hinders aggregate demand; that is because the consumption propensity from labour income is much higher than the propensity to consume out of capital income.

We therefore believe that pressure on corporate profit will come directly from the spreading income inequality that is accelerating in many of the G10 economies. In fact, lower aggregate demand lowers government tax collection, and further hinders the ability and willingness of companies to invest.

Adjusted Labor Income Shares (Graphs)

Increasing Income Inequality (Graph)

EU PROBLEMS ALL OVER AGAIN

While the marketing machine hails the Banking Accord of 2013 we believe that its positive effects will take very long time to take effect, and during this time a lot can and will happen. Be aware that the resolution fund part of the accord will not reach its target till 2026! 

Throughout 2014 there are going to be several junctures testing the solidity of the union and especially its banking system. We expect the upcoming banking stress test by the ECB to be one of such tests. It is likely that the test is going to uncover the requirement for additional capital especially in Spain, Greece and Italy. The stress test is promised to be more stringent than the previous one, especially since the previous one proved to be inconclusive since after passing it with flying colors the Spanish Bankia, the Cyprus Laiki and the Franco-Belgium Dexia went belly up just months later.

We also believe that the Spanish economy hasn’t sufficiently deleveraged, especially in its real estate sector.

The figure below shows that notwithstanding the collapse of property prices, Spanish mortgage debt has adjusted by only half the magnitude of the US adjustment. 

Any alarm in the banking sector would have repercussion on the valuation of the sovereign debt. The vast amount of Spanish government debt is in fact held internally by domestic banks.

IMF projections give the Spain structural deficit as one of the worst globally over the next five years. It is likely that additional fiscal tightening is going to be required in the upcoming future to meet the required targets.

We remain quite pessimistic in the future of the Euro zone in spite of the victory speeches of some of its leaders. 

Since the local governments are going to be forced to fund their own bank bailouts till the European fund gets up-to-speed we expect a continuing shortage of credit. With a chronic shortage of credit given to the private sector we expect growth to remain weak or non existent for most of the EU countries and deflationary forces will remain at play during the entire year.

Reality will seep through in 2014 and equity returns should start to be driven by corporate earnings instead than Quantitative Easing operations by the central bank. 

It is clear that Eurozone leaders have addressed some of the issues on hand and made significant steps forward, especially steps that have been blessed by the German leadership. Nevertheless these steps remain insufficient to resolve the disparity between the different countries in the zone and time may be running out before additional shocks are going to rock the system.

Reverse globalisation

Global trade hasn’t recovered to the same levels prior of the 2008 crisis and its growth remains below trend since 2011. Further note that additional data leads us to believe that there is an underlying trend of re-shoring currently in place.

The Manufacturing Advisory Services survey show that among 500 UK small and medium size companies interviewed a significant percentage of them was in the process of reshoring or thinking about it.

15% of the manufacturing business in the South East was already reshoring and an additional 25% of the companies was considering reshoring activities over the following 12 months.

Shipping Remains Subdued (Graph)

Similar trends are not exclusive to the UK manufacturing industries but also in the USA where industrial reshoring has been a key theme of 2013. In the USA the trend is predicated on the falling energy prices (“fracking revolution). 

Over the next decade as labor cost rise in China and other Asian exporters we predict this trend to gain pace.

Shipping Indexes (Graph)

Reasons for Re-Shoring (UK)

DEBT SERVICE BURDENS

As the monetary stimulus keeps on being retracted the lid that was put on government bond yields is going to be lifted little by little. It is therefore normal that interest rates sooner or later are expected to be raised.

Our point is that as this happens we expect service burdens for household to rise and therefore depress consumption expenditures.

Debt Servicing Costs

We indicate few countries that are likely to hit particular consumption degradation at the rising of interest rates: Canada, Netherlands and Sweden. These countries experienced a fair amount of household leverage during the last 10 years with no sign of decrease since 2008.

A study from the Canadian Chartered Accountants found that 29% of the respondents would struggle to keep up with payments if interest rate rose by 2% and further 29% would consider challenging more than 3%.

Canada, the USA and Sweden have a high proportion of non mortgage variable debt outstanding that is used for consumption. As monetary policy keeps on tightening over the course of 2014 investors are best to avoid any consumer centric type of equities.

Interest Rate Vulnerability (Graph)

Please contact the Affinitas Consulting team (www.affinitasconsulting.ae) for any additional query or information.

Syria, what is really at stake?

Recent events draw me into writing an opinion about Syria. It has mostly been the abundance of misinformation on the topic that motivated me to start the writing.

As we all know, in spite of the rhetoric of the media, the whole point is not about protecting neither the lives of the innocents nor US national security.

Since the beginning of time the super powers at play, although changing over time: from the Persians to the Roman Empire, through to Great Britain and now the USA, have given proof over and over that what counts is not justice but POWER: its acquisition or its protection. 

We therefore need to look at history, even recent past to be able to use the “right” yardstick to measure the reach of the events, and to look at them behind the right “lenses”.

Therefore, lets wear the “power” glasses and start analyzing some of the interests revolving around Syria. I believe that this approach is going to get us quite a bit more perspective than the usual “freedom” arguments.

The government of Syria is one of the last allies of Iran, supported by Hezbollah, and an official ally of Russia. The latter has a military base in the country that gives access to the Mediterranean, and still the latter is providing military supplies.

The country is small with negligible oil supplies. The population numbers unappreciable as its overall size economy.

It happens to be sitting on the path of a potential gas line connecting Qatar to Turkey which would be a game changer both for Turkey and eventually for Europe (news among others: http://www.thenational.ae/business/energy/qatar-seeks-gas-pipeline-to-turkey). Please don’t forget that Turkey’s cost of petrol is some of the highest in the industrialized world (#4 highest prices as of the latest available stats: http://www.fuel-prices-europe.info/index.php?sort=4).

There are current many attempts to carry gas and oil into Europe bypassing Russia, but so far the ability to turn those into reality have met significant challenges. Please refer also to the Nabucco pipeline that is supposed to connect Azeri oil with Turkey via Georgia. 

Let’s also identify some of the key factors defining who is supporting who in the conflict:

1. Gas & Oil: Qatar & Saudi Arabia on the supply side and Turkey and France/UK on the demand side against the Syrian government;
2. Access to the Mediterranean: Russia is supporting the Syrian government to preserve key assets in an important geography;
3. Containment of Iran and protection/appeasement of Arabian Gulf States (Qatar, Saudi Arabia & UAE mainly): USA in contraposition to the Syrian government.

Let’s analyze point 3 in a little bit greater detail because I believe that some of the current discourse is failing to point out the true geopolitical reach of the shale gas development in the USA and its implications for the Middle East. 

We all know that the discovery and exploitation of shale gas in the USA is accelerating by the month. This is a significant variable that is bound to change the geopolitical strategy of the USA moving forward.

News are telling us that the USA is bound to be energetically independent by 2020, just 6 years away.

At that point the USA will no longer need oil resources coming from the Middle East changing radically some of the key relationships with the Gulf States that are currently supplying the US with their oil (although not as much as thought by mainstream people).
The players that will require most of Middle Eastern oil will remain China, India, few countries in South East Asia. 

The US involvement in the region is not bound to lessen though as it will be necessary for the superpower to exercise its political and military influence to control the oil supply into third countries like China and India, the former perceived as a country to contain. Price and access will be defined by many factors, and political stability in the region will be a key factor. The ability to influence the stability (or instability) of the region is going to act as a price gauge and therefore an economic control over the countries that are bound to import energy resources.

Therefore, instability in the region might be considered an advantage for the US on two counts: manage the cost of economic resources for the countries to contain: China as well as continue selling all necessary military hardware to the players in the region: see Saudi Arabia, UAE, Qatar, Bahrain.

Russia and China are completely aware of the stakes and can’t let go of Syria. Too much at stake after having let the Libyan affair take place.

To our readers: please go behind the surface. 

Sirya is just a symbol of a new geopolitical order in the making. Energy resources and control is the name of the game. 

Russia's involvement and diplomatic leadership shown recently is bound to bring stability to a very volatile situation. The red line after all seems to have been drawn by Mr. Putin more than by Mr. Obama in this case. A resolution of the latest tension is bound to benefit the stability in the region.

We reassert our opinion that while the Middle East remains a complicated region it is also one of the regions that mostly favor foreign direct investment and that has been successfully shaken off the 2008 crisis showing proper growth over the past few years.