The Oil Pricing Sleight of Hand

The Oil Pricing Sleight of Hand

by | published December 19th, 2018

On October 3, the West Texas Intermediate West Texas (WTI) benchmark set in New York hit a closing price of $76.41 a barrel. At the same time (2:30 PM Eastern), Brent, set in London, reached $86.47.

Both were the highest levels witnessed in more than three years.

As of close yesterday, WTI had lost 39.5%, while Brent lost 34.9%.

The last time this happened it was a freefall. And this time, it certainly looked like déjà vu all over again yesterday.

Yesterday’s 8% dive in crude oil prices was indeed historic, but once again, the figures are leveling off this morning and posting a gain.

However, we have seen that trend several times over the past two weeks only to see the prices retreat, like some poor fellow trying to get out of bed too early after suffering from the flu.

Except this time, it’s almost entirely due to external schemes, rather than what the oil market should have looked like based on its own dynamics.

It makes little difference to repeat some of the points I have been making as this decline unfolded. But let’s start there anyway.

The bottom line is this: most of this dive has been the result of market sleight of hand.

And there are two overriding factors here…

The Sanctions Heard ‘Round the World

First, the concern over global excess supply is primarily a result of a political stunt from Washington – as veteran Oil & Energy Investor readers will recall, the U.S. had vowed to reintroduce Iranian sanctions early last month.

All analysts – myself included – quickly added up the expected losses in exports from the sanctions, combining that volume with the accelerating declines from Venezuela, Libya, Nigeria, and later a 300,000 barrel a day cut from Canada to estimate significant shortages in the market.

President Trump then started jawboning Saudi Arabia and OPEC to increase exports.

The White House objective was obvious: higher crude costs mean higher prices for oil products. And in advance of a crucial midterm election, the last thing anyone wanted was a hike at the pumps.

Riyadh obliged, as did Russia and the United Arab Emirates (UAE), which was matched by a rapid increase in production from U.S. operators. Even with all of this new oil factored in, there would still have been a slight decline in overall global supply.

In other words, the price levels experienced in early October should have been the floor of pricing at the end of the year, and prices should have then begun to rise.

Until the Trump Administration changed the game…

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A Change in the Rules of the Sanction Game

At the eleventh hour, and almost a month later, the eight main importers of Iranian crude were provided a 180-day exemption from the sanctions.

As a result, Iran continues to export most of its oil into what is now a heavily oversupplied global market.

Apparently, the hand wringing in DC over the Iranian threat resulting in Trumped-up hype to justify the U.S. leaving JCPOA (Joint Comprehensive Plan of Action, the nuclear deal every other signatory says is working) was just a device for use in a political reality show script.

The supply/demand balance was thrown completely out of whack, and down went oil prices.

This factor alone would have been enough to explain the bulk of the situation.

But wait, it gets worse.

It will take almost a complete trading cycle, to early January, to offset the impact of a political stunt.

And that’s how long it will take for the major increases in production from the Saudis, Russians, and Americans to roll out of the system.

This is also the case with the 1.4 million barrels a day OPEC and the Russians agreed to wean out of the market at the recent meeting in Vienna.

Remember, that effectively translates into 1.7 million barrels with an additional Canadian pullback – and that’s without even considering the other national production problems mentioned earlier.

The 1.4 doesn’t kick in until January either.

The Effects of “The Sky Is Falling” Mentality

The second overriding factor is that the short players then assaulted the market.

Some of the largest mobilizers of what are now heavily computer-driven trading programs based on some rather speculative algorithms – and who I like to call the Chicken Littles from the “sky is falling” campaign – went on TV to talk about the end of the world as we know it.

This fed into the already rising angst over three things:

  • Whether the stock market had peaked and would move into correction (which it has),
  • Combined with some suspect assumptions on the decline in overall global oil demand (which has yet to materialize in any tangible data),
  • What they believe is an inevitable contraction in global economic expansion (once again, we have no data here and won’t for at least six months).

Once the Washington ploy worked itself out, the objective to continue running a massive short campaign (off non-existent global collapses) succeeded only because of the stock market meltdown.

The primary assumption here is that, since a recession is certainly coming (look at the torturous reasoning surrounding an inversion in interest rates), oil use will certainly go down.

In other words, it was a perfect storm based on very little substance.

As of open this morning, the algorithm I developed to determine effective oil prices (minus short and derivative actions, misinformation, political ploys, in other words, based solely on actual market factors) is exhibiting a major distortion.

According to the EOP (effective oil price) calculations, WTI should be almost $14 higher a barrel than what the market is telling us, and Brent comes in at $12 higher.

At this point, there are four additional important takeaways…

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An Extreme Case of Deja Vu

First, Brent is used more often to settle international trade in wet barrels (actual oil in consignment) than is WTI. That means it is more sensitive to the actual underlying market conditions. That makes the spread between the two a bellwether indicator of what is happening in the market.

As of close yesterday, the spread calculated as a percentage to the difference to the price of WTI – which is the more accurate calculation – was 17.8%.

That is more extreme than at any point since March 12, 2015.

This signals a pronounced decline beyond what is justified by the market.

Second, oil prices have been determined by what occurs elsewhere in the world (read here not North America or Western Europe) for some time. Prices are higher in places like Asia where worldwide energy demand increases are centered, and will be for several decades.

But most of a pronounced increase in U.S. production (intended primarily to offset what is now an Iranian sanction non-event) cannot move into the global market because of export capacity being reached at American ports, resulting in infrastructure problems and volume gluts further upstream.

That excess supply is trapped in the U.S. market, serving to depress WTI prices.

Third, the rise in interest rates has ushered in another acceleration in high-risk debt cost. The most extreme part of that debt (“junk bonds,” in other words) is that of energy companies.

Vulnerable U.S. companies are again facing insolvency, since most ongoing operations are funded via debt, not oil sales.

We are once again in a “one step ahead of the sheriff” cycle.

Sales at current WTI levels are at a loss for the majority of producers, since what they receive is the wellhead price and that is much below the market price.

But more companies are in a position of flooding the market anyway in a rising – and desperate – attempt to keep afloat. The long this situation remains, the greater the merger and acquisition (M&A) trend that will follow.

In the meantime, oversupply results.

Reading Between the Lines

Finally, the downward trajectory has taken place despite clear indications that the market is telling us something else.

Two statements from Saudi officials have declared that global supply and demand have essentially balanced.

The Paris-based International Energy Agency (IEA) reported last week that there will be a supply shortage worldwide by the second quarter of 2019. The IEA has also noted a disturbing trend in Russian production (a matter I have addressed in OEI previously) indicating the nation’s currently record 11.4 million barrels a day production cannot be sustained.

Meanwhile, Venezuelan production continues to decline quicker than anticipated, with state oil company PDVSA having greater difficulty to cover essential pre-finance for export contracts. Meanwhile, Libya’s accelerating civil war has forced the government to declare force majeure and suspend large export agreements.

The return of sanity to this market has taken longer than it should have.

I have no intention of standing in front of the tidal wave of lemmings rushing to the cliff.

But I also have no interest in feeding them as they rush by.



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  1. December 29th, 2018 at 00:00 | #1

    Brilliant reasoning, as always, Dean Brunel

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