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Why the Energy Sector’s Perfect Storm Is About to Blow Over

by | published July 28th, 2015

There is a “perfect storm” brewing in the energy sector.

And as storms go, this one has certainly attracted attention. The ongoing concern over supply gluts both in the U.S. and abroad has combined with a Chinese stock collapse to drive down the price of oil.

Now, it is true that the decision by OPEC first to keep production constant and then to increase exports has certainly put pressure on shale and tight oil producers in the U.S.

Then there is the pending Iranian nuclear accord, blamed for everything from the end of the North Dakota economic boom to rising unemployment in every oil patch nationwide.

Neither of these is as advertised, of course. But the alarmist projections certainly make for a good show on TV.

This is a perfect storm only in the minds of those who created it.

Here’s my take on why this storm will soon pass…

We Have Excess Reserves

Supply excess has contributed to a downward pressure on prices, and an adjustment was certainly warranted. But not the collapse that we experienced. That was a result of opportunities exercised by short traders in pursuit of a quick buck. Recently, I even discussed here in Oil & Energy Investor that Sovereign Wealth Funds associated with OPEC producers were shorting their own production.

There is nothing “natural” about a market in which the primary producers are deliberately overproducing only to bet against their own profit on the other end. This remains all about suppressing competition and maintaining market share.

As always, this remains an equilibrium situation. Fundamentally, we are in a cyclical pattern similar to that experienced over the past several decades. Production will need to adjust with demand. But the interesting matter to keep in mind here is that, unlike during previous cycles, demand is not declining. In fact, global needs are increasing.

For the first time in more than 40 years of analyzing this market, I’m seeing the normal supply/demand equation significantly altered. One no longer has to worry about one side of the equation. We have plenty of excess reserves that can be easily brought to market.

Nonetheless, as in every instance where supply exceeds demand, there will be a rebalancing. Oil product use increases as the price remains low, thereby elevating the demand side, while production is cut, reducing supply.

Problems in Iran and China

The opportunity here is in identifying those companies that will occupy a stronger niche in production by running more efficient operations.

When it comes to Iran, I have devoted several issues of Oil & Energy Investor to explaining why there will be no upfront surge in either Iranian production or exports. The Western sanctions will be lifted gradually in stages and only after compliance is demonstrated. Iran’s fields are a mess, and the infrastructure for increasing exports even if new production were available requires banking, insurance, tankers, and pre-contact financing.

And all of those are not simply going to be turned on once the agreement is signed. There is also opposition to the deal from both the U.S. Congress and the Iranian leadership. Nothing is happening here beyond giving short artists more leverage to play games.

But now the problems on the Chinese stock market have become the new mantra of those pushing down oil futures.

Pundits are now getting in line to be the next Chicken Little from “The Sky Is Falling Brokerage Firm.” We are going to test historic lows, one talking head says. This time it will be a major blow putting crude oil prices at $40 a barrel for a considerable period of time, says another.

They are distorting projections of Chinese energy needs so that square pegs can fit into round holes. Yes, the Shanghai Index has taken a pounding. Yet unlike Western industrialized countries, the stock market in China is no automatic bellwether for what is coming in the broader economy. The stock market and the economy are largely separate and distinct.

Chinese Energy Demands Remain

What has been lost thus far is largely paper wealth in a market that is still up significantly for the year. The majority of Chinese investors use unsophisticated trading strategies, buying on margin, having bought a government line that stocks will always go up. All of this has little if any relationship – direct or otherwise – to actual economic indicators at play in the nation as a whole.

To say, therefore, that the “historic” loss in the Chinese stock market is a harbinger for a massive industrial slowdown causing massive cuts in oil imports is not only incongruous. It is also quite misleading.

We would need about two quarters of figures to back up such a claim, not knee-jerk reactions from opportunists claiming their 90 seconds on TV.

Chinese economic expansion has to cool down at some point. It cannot be sustained at 7% or more indefinitely. Yet disposable income is rising, as is the population of the country’s middle class. Energy demand remains in a nation that will not meet its own needs domestically for generations (if ever).

This psychologically inspired market stampede is about to peter out. After all, not every thunderstorm ends up being the storm of the century.

I’ll continue to monitor the situation.

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  1. Robert in Vancouver
    July 28th, 2015 at 18:35 | #1

    Very good points made in the article, including the growth in China.

    If China grows only 5% this year it’s actually more growth than 5 years ago when it was 8%. That’s because 5% growth today is on top of a much higher base than the base was 5 years ago.

    Same results as if you add 5% onto a 50 story building instead of adding 8% onto a 20 story building.

  2. Thomas Baydala
    July 29th, 2015 at 14:25 | #2

    Well written and sagastic points..but it would be nice to have a few companies which you believe are poised to make a rebound.
    warmers regards

  3. August 2nd, 2015 at 07:24 | #3

    I wonder how will affect desicions in the Paris meeting. If we finally build carbon tax in order to push for co2 emissions reduction. Renewable are growing at an exponentail rates. Getting more competitive every year. This and shale gas are definitly pushing on oil for electricity. Electric cars revolution is also around the corner. With Li exploration, batteries cost will be reducing and that will definitly hit hard on oil demand for transportation. But these are long term tends while we go for climate change solutions.

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