Four Reasons Why Oil Prices Remain Sluggish
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Four Reasons Why Oil Prices Remain Sluggish

by | published December 13th, 2018

During my career, I’ve found myself intimately acquainted with airports. Sometimes it seems as though I’ve spent more time on airplanes than in my own home.

I am about to get on an airplane again, this time bound for our home base in Baltimore and meetings with staff.

And while I sit in the lounge and wait for my flight, I have a continuation of the discussion in the last Oil and Energy Investor in mind that I think we should undertake today.

I’m not one to be a drone to my phone, so when I have a long wait, my attention tends to go to what’s happening out the window. And watching the comings and goings of the planes to and from their designated parking spots is strangely calming.

Not to mention evocative.

See, when it comes to rising and falling, the markets tend to emulate flight patterns.

Until they stall.

Much like the oil markets these days.

Now, this is not going to be an easy read but it is important.

Earlier this week, I described the reemergence of an accentuating debt concern among U.S. oil and natural gas producers.

Nothing would deflect this rising problem more than a rebound in crude prices.

Well, today I am considering why, with all the factors that would seem to dictate higher prices, oil has remained under so much pressure.

Here is my conclusion…

Part I: A Geopolitical Problem

If nothing else, the chart of recent crude oil prices is adventurous.

Both WTI (West Texas Intermediate, the benchmark rate for futures contracts in New York) and Brent (the more globally used equivalent set in London) have been slowly rising. But, as of close of trade on Monday, WTI remained down 14.2% for the month; Brent 14.4%.

All together, since their most recent high daily closing prices (both posted on October 3), they have declined 32.4% and 30.4%, respectively.

This is against a backdrop of anticipated price rises. Those increases were supposed to result from geopolitical factors that would constrict supply colliding with continuing robust global demand.

The former was to come from the early November re-imposition of U.S. sanctions against Iran, combined with the ongoing collapse in Venezuelan oil production, a Libyan civil war, and increasing domestic problems affecting extractions in Nigeria.

The demand is certainly still there, and even expanding in developing areas of the globe like Asia where prices are increasingly being set.

And the geopolitical restrictions on supply are also present, save for one major caveat.

Iran.

This is the first of four primary reasons why oil prices have not taken off. It is also a matter I have considered in Oil & Energy Investor on several previous occasions.

OPEC (the Saudis in particular), Russia, and even American producers have ratcheted up volume with the expectation of a significant Iranian export contraction.

However, at the last moment, Washington exempted the eight largest importers of Iranian crude from the sanctions for six months. That meant Iran is continuing to export just about as much oil as before.

Meanwhile, the increased production from others has resulted in excess available supply hitting the market, and reducing prices.

The rationale for the U.S. action was clear enough.

The White House was concerned that lower crude supply would result in higher oil product prices. That, in turn, would raise prices for gasoline and distillates moving into a midterm election.

After showing stout determination to teach Teheran a lesson, that lesson was effectively delayed for half a year by a U.S. domestic political decision.

Left to its own devices, the resulting glut will take some weeks to work itself through the market.


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Part II: The Viennese “Two-Step”

Okay, but shouldn’t prices be rebounding after the OPEC-Russia decision last Friday?

The second factor is this: in response to the Iranian move from Washington, producers were expected to cut volume to buttress prices.

OPEC had a meeting in Vienna that ended Thursday without a cut. But once OPEC outsider Russia arrived the next day, an accord was quickly announced, calling for an “official” OPEC-Russia cut of 1.2 million barrels a day.

However, with the force majeure recently declared by Libya (resulting in the cancellation of oil shipments) and the accelerating financial implosion in Venezuela, the effective amount is closer to 1.4 million.

Exactly where I had estimated it would be earlier this month.

In addition, Canada is withholding 300,000 barrels a day of heavy oil from the Athabasca oil sands region in Alberta due to low global prices. That put the real reduction at 1.7 million.

This should provide a floor for oil trading, but the OPEC and Russian cuts don’t kick in until next month. And they should have provided for a movement up nonetheless, as traders look forward to availability in near-term consignments.

Were it not for the third factor…

Part III: An Inversion and a Recession

Broader markets worldwide are exhibiting unusual volatility, which has occasioned some of the wildest daily stock value swings in memory.

This is accentuated by the unparalleled computer trading predicated on some very suspect strategies. The entire rollercoaster ride has engulfed all manner of tradable assets, especially liquid commodities.

Oil leads the list of such commodities.

In this environment, downward swings in equites are by themselves a disconcerting element. But when this is compounded by an inversion in bond yields, investors really start to panic.

Such an inversion takes place when longer-term paper offers lower interest rates than shorter-term. This can quickly become an academic and complicated conversation.

However, it essentially comes down to this.

If short-term debt needs to pay higher yields over a protected period of time, it is a signal that a recession may be on the way.

There is considerable debate about the time lag between a yield inversion and a recession, or whether one automatically follows the other (they have not always done so in the past). But a few trading sessions ago, the U.S. government two-year note began paying higher interest than the five-year.

And inversion angst hit the market.

This is where matters in the investment markets became irrational. A genuine and prolonged inversion is viewed by some as a clear signal of an oncoming recession.

Of course, historically, when the recession has hit it has been a year or more after the inversion.

Recessions mean less economic activity. Less economic activity translates into a reduced need for oil.

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Without any genuine data (which usually takes upwards to six months), jittery investors, speculative computer trading algorithms, and the guys in the following fourth factor, have all converged to drive down both equity and oil markets.

Part IV: No Apocalypse in Our Future

We are once again in the throes of significant short actions on oil – and on sectors of the broader market.

Shorts are run when the trajectory of prices for an underlying asset is perceived as subject to further weakening. In the case of a commodity, large short volume can have a life of its own and further exacerbate downward pricing pressure.

Conversely, an accelerating pricing environment tends to result in a similar move to long contracts, where profits are made when the underlying price increases.

Of course, getting either of these wrong can be painful.

In the current situation, we will know when the “short party” is over. Holders must unwind positions to avoid greater losses. In turn, that contributes to a higher rise in underlying prices.

Thus far, there has not been a rapid retirement of short positions. But there hasn’t been an expansion of them either and the overall impact is shrinking.

Absent any other external factors hitting (you know, a lemming stampede to the cliff… another Chinese exec detained in Canada… a zombie apocalypse) this will be calming down.

It would be nice to have an oil price again genuinely determined by market fundamentals.

Sincerely,


Kent

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