Oil, Dollars, and Gluts

Last weekend the Wall Street Journal carried two interesting headlines:  “Dollar is Pressured from Many Directions” and “U.S.  Oil-Price Rally is Longest in Years”.

The direction of oil prices is the subject of endless conjecture, questions, speculation, fantasies, and analysis of bad data.  As noted in my previous comment, oil prices started a prolonged decline in August 2014 after the Federal Reserve stopped Quantitative Easing – which means they stopped pumping $80 billion per month of new dollars into the financial system.  Oil prices declined for four months before the Saudis announced they would not cut their production rate to support prices; they wanted to maintain their market share rather than continue as the swing producer.  After that, the price continued to fall but storage rates did not increase above historical levels until 1Q 2015.

Most reports, analyses, and commentators ascribe the fall in oil prices and their failure to regain previous levels to increased domestic US production resulting from widespread use of improved techniques of horizontal drilling and hydraulic fracturing in very low-permeability rock formations which could not be developed and produced economically with older methods.    The logic was that an excess of oil production rates above consumption would cause price decreases in a marginal pricing system on an open exchange (both the NYMEX and the London ICE) and that increases of US production had caused such an excess capacity.   This excess capacity became commonly referred to as a “Glut”.  The trouble with this logic was that the first indication of excess production was several months after the initial price decline.

Not only that, but The Glut was quite elusive; it was very difficult to find and quantify.   Most attempts to determine its size eventually estimated that world excess production capacity was somewhere near 1.5 million barrels per day.   Total world production rate was about 95 million barrels per day so the excess capacity was about 1.5% of total production.  This seems rather small to be classed as a Glut ( a Mini-Glut?) especially when one considers world production rates, storage volumes, and consumption rates are not known with an accuracy of 1.5%.

For a while, quoted oil prices increased and decreased based on estimates of production rates, decline rates, rig counts, consumption, and other indications of changes of the excess production rate – inherently an exercise in futility because the excess is a small difference between two large numbers, production rate and consumption, which are not known accurately.

Many commentators conjectured the Saudis expected low oil prices suppressed by continuing production at historical rates would put many American oil companies out of business and cause a quick and significant reduction of US production rates.  In fact, many American companies entered bankruptcy but US oil production increased through 2015 and then started a slow decline.  It seems the Saudis were possibly not aware of the extent of price hedging by American companies or the idiosyncrasies of American Chapter 11 bankruptcies.

By the end of 2016, Saudi Arabia realized that lower oil prices had reduced their national income considerably but had little effect on worldwide production rates which were still in excess of consumption by about 1.5%. The Saudis then organized an agreement to reduce production rates by 1.2 million b/d with several other OPEC countries and 600,000 b/d with Russia and other non-OPEC countries.  OPEC members Nigeria and Libya are exempt from the agreement.  Compliance with the agreement was better than expected which put some upward pressure on prices but US, Nigerian, and Libyan production rates have increased by amounts offsetting the cuts and prices recently have declined again.

Even oil market traders and journalists eventually realized the difficulties inherent to estimating excess production capacity as an indicator of long-term oil-price trends.  The Glut was re-defined as the excess of oil in storage above historical volumes.  With this logic, one could determine whether the price of oil would rise or fall based on growth or shrinkage of the amount of oil in storage.  Crude oil storage is not the only factor; storage considerations must include other petroleum liquids such as gas condensates and petroleum refined products.

Storage at Cushing currently is about 60 million barrels.  Gulf Coast commercial storage is about 260 million barrels and the US Strategic Petroleum Reserve is about 680 million barrels.  Total commercial US petroleum liquids storage is about 1.33 billion barrels; combined with the SPR, the total US storage is about 2 billion barrels.  OECD storage, which includes the US, is about 3 billion barrels of SPR storage plus a little less than 3 billion of commercial storage for a total of almost 6 billion barrels.  These figures are derived from many sources at different times and are subject to revision over a few months after they are first published.   One cannot believe they are accurate on a given day to within 1.5% error.

Non-OECD data are even more problematic.  Most of the countries in this group have no means to make accurate measurements and mostly do not want to.   The largest country component in these data is China which has no interest in releasing accurate data on imports, exports, purchases, sales, consumption, or storage.  Various estimates of the total storage of this group which, besides China, includes India, South Africa, and seaborne storage are around 2 billion barrels; that figure is estimated from various secondary sources.

If the Glut is defined as the amount of increased storage above historical levels it is very difficult to determine how much it is, where it is, or who owns it.  As world daily consumption increases it is also expected that “normal” storage volumes will increase to maintain a certain number of days’ supply in storage.

Trading on the NYMEX is for contracts for 1000 barrels of West Texas Intermediate oil in a tank in Cushing, Oklahoma.  Trading on the ICE is for 1000 barrels of Brent crude.  The most accessible storage data for traders on the NYMEX or the ICE are for the oil storage terminal at Cushing, Oklahoma and US Gulf Coast storage followed by data for OECD countries.  Press reports of “draws” or “builds” of Cushing storage can quickly influence trading prices on the NYMEX.  The 60 million barrels of oil in storage at Cushing is roughly 0.75% of worldwide storage or 1.5% of worldwide commercial storage.  Traders use Cushing data as a surrogate for variations of the worldwide Glut, evidently because it is the only data they have, not because it is a reliable indicator.

So to predict the price of oil tomorrow, next week, or the medium term or the long term, traders and analysts spend a lot of time micro-analyzing very bad data.

This takes our considerations back to the headlines quoted at the beginning of these comments and to the fact that the oil price started declining in August 2014 when the Federal Reserve stopped Quantitative Easing; not because of a supply “Glut”.  It is also noted that when Quantitative Easing 2 started in November 2010 the oil price increased from a level fluctuating around $75 per bbl to about $100.  When the Fed started QE the price went up and when it stopped QE the price went down.

I have attached a copy of a plot prepared by the Hein Energy Team, previously published by Enercom, showing the relationship between the dollar/ Euro ratio and the price of oil.  The relationship between the value of the dollar and the price of oil is subject to endless debate as to causes and effects but the correlation is high, obviously better than coincidental, and raises many questions about The Glut.

Commentary.OilPricevsUS$-Euro.1

One cannot deny that short-term oil price volatility may be strongly affected by traders responding to variations of bad or irrelevant data.  Typically, prices fluctuate daily and weekly over a $10 range around an average but the range may remain fairly constant over monthly and yearly terms.  Significant changes to the high and low levels of those ranges seem to be responses to other influences, however.   As one considers longer-term trends one cannot ignore the influence of financial market events, particularly actions of the Federal Reserve, which brings us back to the Petrodollar and its effects on the markets and government policy, if any, as discussed in the previous commentary.

I shall be traveling for the next 3 weeks or so but shall try to maintain these communications – but it may be a bit sporadic.

 

The Petrodollar: Trump’s Saudi Coup

Last winter I had an exchange of correspondence with a group in Washington hoping to have some influence on the new Trump Administration regarding foreign policy, oil supplies, interlinks between the international oil and financial markets, and financial policy.  As some of you know, I also gave a speech on those subjects with the general theme of “Where are We?, How Did We Get Here?, and What Can We Do About It?”  Those efforts got sidetracked by delays making appointments to the various departments, the noise over Russian influence on the election, Comey, and other Democratic obstructionism.

During the last few weeks Trump made a trip to Saudi Arabia, gave a speech regarding exporting energy last week, and has rescinded regulations pertaining to energy, approved pipelines, and announced various policy considerations regarding energy and international supplies. My communications with friends in Washington resumed.  These have evolved into a series of analyses on various subjects regarding the oil business and foreign policy.

This is the Fourth of July, so I decided to share these opinions and analyses with you for whatever interest you have or value you get from them.  This may be a series at irregular intervals.  If you wish not to receive them, just let me know.  Your comments, suggestions, and additions are welcome.

My considerations are focused on the oil business because it is the business I am in, it is the largest internationally-traded commodity, and international oil trading priced in dollars maintains the dollar as the international reserve currency and intertwines the international oil and financial markets.

These considerations are also influenced by my experience during what might be called the Decade of Confusion: 1973 to 1983, in which the United States exchanged an oil price and supply system dominated by the international US oil companies and a dollar backed by gold for a system dominated by foreign governments, a dollar backed by other countries’ oil, and the price determined on an open exchange.

During that period it seems no one in the US Government understood the industry.  The US Government, and many others, reacted strongly to two Energy Crises which did not exist.  Many policies were initiated based on the belief that the United States was threatened with a shortage of oil. In fact, no oil shortage ever existed during the entire decade of turmoil from 1973 to 1983.  Exactly the opposite was true, the international oil industry had approximately a 12% surplus production capacity in 1973, developed many new fields and sources of supply in response to the oil price increases and by 1983 had approximately a 30% surplus capacity.  Once oil started trading on an open market and the surplus capacity was widely recognized the price fell precipitously in 1986.

The Petrodollar was born in 1974.  Kissinger negotiated an end to the Saudi Oil Embargo imposed during the Yom Kippur War.  He renewed Roosevelt’s World War II US guarantee of Saudi security.  The Saudis agreed to sell oil only for US dollars.  Other producers followed suit; the dollars used in the international oil markets became known as Petrodollars.  The Petrodollar still exists.  Oil is still priced and bought and sold in international markets in US dollars.  All purchasers of oil must have had a supply of dollars from 1974 until now.

The perceived shortage of oil by the US government and public caused a sense of vulnerability in the US which led to many policies which are still in effect and a belief that only through globalization would the US have access to the resources it needed from other countries. The US, long a mostly self-sufficient economy thus embarked on a path of global involvement which is now being questioned critically; we are in a transformation period politically, economically, and socially.

Creating the Petrodollar allowed the US to incur significant debt for social programs which in effect have been financed by the international community.  As US Government debt increased significantly during the past two administrations considerable resentment developed regarding the dollar as the international reserve currency.  Several countries have expressed intentions to establish a successor to the US dollar, so far without success although some one-on-one transactions use other currencies, e.g.: China buys Russian oil and pays in yuan.  As the Saudis tried to increase their market share in exports to Asia, China attempted to establish the trade in yuan; unsuccessfully for the time being.   An effective alternative to the dollar has not been found – but at some point, one may be; which is an ongoing threat to the US economy.

The US dollar welds the international oil markets intimately to the financial system.  The oil price reflects changes in the strength of the dollar and Federal Reserve policies.

In July 2008, market perceptions of impending supply shortages spiked the oil price over $147 per barrel.  As the financial crisis developed, the price dropped below $30 in early 2009 and then recovered to approximately $75 per barrel.  The Federal Reserve started injecting dollars into the financial system on November 3, 2010 with the program called Quantitative Easing 2.  The Saudis announced they would respond with a $25 increase in the price of oil.  Oil traded in a range around $100 until August 2014 at which time the Federal Reserve stopped the Quantitative Easing program.  The oil price started declining and had dropped to about $75 by late November.  At that time, the Saudis announced they would not support the $75 price and the price continued to decline to the $50 range in early 2015 and to the $30 range in January 2016.

The critical point, not widely recognized, is that the price of oil started its decline when the Federal Reserve ended Quantitative Easing, not because of excess supply as commonly reported.  Unusual storage increases did not start until early 2015 when the price had already dropped to the $50 range.

Trump pulled a real coup with his trip to Saudi Arabia.  His warm personal welcome by the King and his blatant re-assertion of close ties with the Saudis indicate that threats to the Petrodollar have been deflected.  The US can expect the US dollar will be the currency used for most oil trading for several more years and the dollar will remain the international reserve currency.  This is a major benefit from his visit but was not reported anywhere in the press that I saw.