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January 2015

Understanding the Weakness of Oil Prices

Following several requests, we decided to write an article concerning oil prices to identify:


1) The main factors which explain the recent weakness.
2) What to watch to catch the next move.


Before starting, we would like to thank our friend, Christophe Barraud, Chief Economist & Strategist at Market Securities but also Top Forecaster of the U.S. Economy, who sent us a lot of stuff in order to complete our views.



It is important to remember that the short term supply and demand curves for oil are very steep which means that a small shock on one side has significant consequences on prices. However, in recent months, there were both a sharp increase of supply and a lack of demand.




1/ U.S. output expanded to the highest levels in more than three decades thanks to “shale gas revolution”. The quadrupling of oil prices between 2002 and 2012, associated with significant technological improvements in hydraulic fracturing technology and horizontal drilling (increasing productivity and lowering costs), created conditions for a second shale revolution. As a matter of fact, in 2005, according to the North Dakota Industrial Commission, almost 200 wells were producing oil in the Bakken formation. The number of wells soared to 2,000 by 2010 and more than 8,000 in 2014. In this context, production from this area surged from 2,500 b/d in 2005 to 250,000 b/d in 2010 and more than 1.1 million b/d by the end of 2014.



Other output increases have come from the application of fracking techniques in Texas (Barnett, Eagle Ford, Haynesville), Oklahoma (Woodford), Arkansas (Fayetteville), Pennsylvania & West Virginia (Marcellus)…

The result has been an extraordinary rebound in U.S. oil production. According to the EIA, Output has surged from just 5 million b/d in 2008 to an average of more than 8.5 million b/d in 2014 and now remains above 9 million b/d at the start of 2015.


2) Signs of a return of Libyan production to historical levels (end of supply disruptions). Libya’s production, which had dropped to 250,000 barrels per day (b/d) in April, May and June 2014, from around 1.8 million b/d before the civil war, rebounded to almost 900,000 b/d over the following three months. The increase was significant mainly because it was unexpected. However, according to Reuters, since the beginning of 2015, Libya has produced just 350,000 b/d due to rebels’ attacks in the south.


3) Oil output in Russia (non-OPEC) surged to the highest levels in decades in December 2014. The surge in supply in Russia signaled no respite in early 2015 from the glut. Russian output rose 0.3 percent in December to a post-Soviet record of 10.667 million barrels a day, data e-mailed by CDU-TEK, part of the Energy Ministry, showed.


4) Prices war began with OPEC (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, U.A.E, Venezuela). Throughout the end of 2014, speculation intensified about possible production cuts by OPEC members, led by Saudi Arabia, to support prices. Nevertheless, the Saudis downplayed this scenario (even After King Abdullah’s Death). Saudi officials informed specialists not to expect production cuts and indicated that the Kingdom was ready to allow prices to slide. The fact is that cutting production to sustain prices at an artificially high level would only sacrifice Saudi Arabia’s and OPEC’s market share and allow shale production to continue expanding. Instead, the Kingdom determined to allow prices to fall low enough to begin curbing the investment in new shale wells. Note that that this move was facilitated by the dollar’s strenght againt major currencies which allows OPEC producers to rebalance their public finances (reducing import costs). Without surprise, according to Bloomberg, OPEC pumped above its quota for a seventh month in December


5) Higher capacity of storage. After a decade of investment, substantial excess storage and tanker capacity suggest the market can run a surplus far longer than it has in the past. As an example, in its latest weekly report (Jan. 23), the EIA showed that “U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 8.9 million barrels from the previous week. At 406.7 million barrels, U.S. crude oil inventories are at the highest level for this time of year in at least the last 80 years.”




***Lack of demand


1) Demand destruction in developed countries. According to the WSJ, “the US is experiencing the largest and most sustained drop in oil demand since the start of the petroleum era in 1859 thanks to improvements in efficiency and the switch to alternative fuels. Quietly and almost unnoticed by most commentators, efficiency and fuel switching are making an even bigger contribution to the North American energy revolution than hydraulic fracturing and horizontal drilling. Fuel savings have contributed more barrels to the supply/demand balance than the combined output from North Dakota’s Bakken and Texas’ Eagle Ford. Efficiency gains and the switch from crude oil to natural gas and biofuels have cut the consumption of petroleum products in the US by more than 2 million barrels per day since 2005, according to the Energy Information Administration. If consumption is adjusted for the rise in population and economic output, oil use has actually fallen by between 3 and 4 million barrels per day compared with the previous trend.” The fact is that the soaring cost of gasoline, diesel and jet fuel encouraged motorists, truck operators and airlines to do everything possible to reduce fuel consumption in all developed countries.


2) Asia slowdown. Demand destruction in the United States, Europe and Japan provided room for rapidly developing economies in China, Southeast Asia, Latin America and the Middle East to increase their own fuel consumption without repeating the 2008 price spike. However, in Asia, too, there were signs in 2014 and early 2015 that consumption growth was slowing in response to a general slowdown across the region. The fact is that Chinese officials are still implementing structural reforms which imply less growth and a shift toward services’ industry instead of manufacturing. In this context, growth prospects have weakened and that’s why the IMF slashed its growth expectations again, putting the country’s expansion in 2015 at the lowest rate in 24 years.



3) Geopolitical tensions. An escalation in geopolitical tensions between Russia and Europe concerning Ukraine’s situation, resulted in a tightening of sanctions which pushed Russia into severe recession as soon as 2015. The negative effects also weigh on European exports and should last given that fights in Ukraine have intensified since several days in Donetsk, Luhansk and Mariupol.


4) U.S. weather. Weather conditions were particularly mild in December. According to the national climatic data center, this ranked as the second warmest December on record, and the warmest since 1939. Every state in the contiguous U.S. had above-average December temperatures, with nine states across the West, Southern Plains, and Northeast having a top 10 warm December.



***What to watch to catch the next move?


1) The response of the shale drillers – how far they cut drilling and production rates, and how far they can improve efficiency and cut costs to reduce the breakeven price for new wells and sustain production in a lower price environment. Breakeven prices for shale wells range from as low as $30 per barrel to as much as $75 or more, that’s why drilling activity in North Dakota’s prolific Bakken field is already falling so that production is expected to drop by summer. As a matter of fact, North Dakota’s commissioner of mineral resources, Lynn Helms, said on Jan 14th that in many areas of Bakken, break-even costs already exceed current oil prices and companies are shutting down development.


2) OPEC willingness to cut production by mid-2015. Given the situation, such a move seems unlikely in the short term.


3) Global growth. An upside surprise is likely given the global accommodative monetary policy (increasing balance sheet, cutting rates).


4) Geopolitical tensions around Ukraine. EU and Russian foreign ministries are trying to implement Minsk agreement which could result in easing mutual sanctions as early as March 2015, however, recent developments suggest that the conflict should persist and could even lead to more reciprocal sanctions.


5) U.S. weather. Heavy storm and blizzard used to hit the East Coast in winter and could lead to a peak of consumption.

ECB QE Amount came Above Expectations with Low Risk Sharing and Legal Headwinds

The ECB unveiled a bigger than expected QE plan that will involve buying €60B a month including government bonds, covered bonds and ABS but excluding corporate bonds. The program scheme will begin in March and last until the end of September 2016; or “until the ECB sees a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2 per cent”. Therefore, it implies at least €1140B of purchases (19 x 60) so that the ECB balance sheet will exceed its 2012 top level in Sept. 2016 (previously than investors expected).




Assuming €10B a month of  ["covered bonds" + "ABS"] purchases, it implies €50B/ a month of sovereign bonds. In other words, in 2015, sovereign purchases should reach €500B which is almost 56% of Eurozone gross issuance and 2.3 times the net issuance. Through September 2016, the total amount of sovereign purchases would rise to €950B and will be based on the Eurosystem NCBs’ shares in the ECB’s capital key (and won’t exclude Greece).  Note that for Germany, the table shows that purchases through the end of 2015 will reach €129B which is more than 20 times the amount of the net issuance scheduled for 2015.



Moreover, the maturities of sovereign bonds purchased will range between two and 30 years and could offer negative yield.


However, after strong pressure from German and Dutch officials, national central banks will assume most of losses from any default or restructuring of their national debt, breaking with the tradition set by previous sovereign bond-buying schemes. There will be risk-sharing on only 20% of the assets, largely debt issued by European institutions bought by national central banks.


Finally, also on the negative side, the ECB QE is already facing legal headwinds in a context where the FT reported that:


Peter Gauweiler, a conservative MP who has launched multiple legal actions against the common currency, announced on Thursday that he had instructed a law professor to prepare a case against the QE programme.”

While government ministers refrained from comment, Werner Langen, a leading European Parliament member of Chancellor Angela Merkel’s conservative CDU, went on morning television to attack QE, saying: “This is wrong, it does not help, it is not the right instrument [ to aid economic recovery]. The ECB has reached the end with its monetary policy.”


Moreover, within minutes of Draghi’s announcement, deputy chancellor Hans Michelbach asserted that the ECB was “violating its mandate” while several hours later, Ifo economic institute President Hans-Werner Sinn says ECB’s bond-buying decision is “illegal and unsound state financing through the money-printing press.”


All in all, Draghi reassured investors by choosing both a monthly and a total amount above the consensus, including Greece and a large choice of maturities. Separately, in order to ease pressure from German and Dutch officials, he decided to cap risk-sharing on only 20% of the assets. However, it’s clear that it’s not sufficient and the QE is far from being implemented.

The ECB QE will be between €600B and €1.1T – Bloomberg, WSJ, FT

Several articles coming from Bloomberg, WSJ and FT unveiled details concerning the ECB QE announcement:


1/ According to the WSJ, the bond purchases would reach €50 billion per month that would last for a minimum of one year, which implies a total of €600B (lower bound):


A proposal from the European Central Bank’s Frankfurt-based executive board calls for bond purchases of roughly €50 billion ($58 billion) per month that would last for a minimum of one year, according to people familiar with the matter.
Still, the executive board’s proposal indicates that the ECB could move more aggressively than financial markets have expected. Forecasts among analysts have recently centered on a figure of around €500 billion or higher for a quantitative-easing program, but the executive board’s proposal suggests that bond purchases could amount to at least €600 billion.


2/ According to Bloomberg, ECB proposal circulated to Governing Council foresees asset purchases of €50 billion a month through the end of 2016. Purchases would not start before March which means that the higher bound would be €1.1 trillion:


The ECB president and his Executive Board recommended asset purchases of 50 billion euros a month until December 2016, according to two euro-area central-bank officials.
Purchases of sovereign debt or other assets in addition to the ECB’s existing covered-bond and asset-backed securities programs wouldn’t start before March 1, one of the people said. It hasn’t yet been decided if the target of 50 billion euros a month would include the existing programs, or how much of it would be sovereign debt.


3/ Finally, the FT confirmed the first headlines noting that the ECB is mulling buying around €50 billion-worth of government bonds a month for between one and two years as part of its quantitative easing programme set to be unveiled on Thursday.

The European Central Bank is mulling buying around €50bn-worth of government bonds a month for between one and two years as part of its quantitative easing programme set to be unveiled on Thursday.
The proposal implies the ECB will buy at least €600bn-worth of government bonds, and possibly as much as double that if it continues buying for two years.

ECB PREVIEW: Sovereign QE Imminent; Size, Risk-Sharing in Focus – Bloomberg

Bloomberg made a review of economists’ views ahead of the ECB meeting:


Morgan Stanley
- Expect ECB to embark on sovereign QE and announce government bond purchases of EU500b and private sector asset purchases of EU100b, economists including Elga Bartsch say in Jan. 19 note.
- A negative deposit rate makes it difficult for ECB to meet its target merely through funding facilities as it effectively introduces a tax on excess bank reserves.
- Difficult for ECB to raise deposit rate to zero without raising the refi rate at the same time
Workable compromise for ECB would be a hybrid program with a core component where financial risk is shared across Eurosystem and an optional component relating to national central bank risk.
- Remain skeptical on QE impact because of dissent inside the ECB, potential political backlash, legal uncertainties on government bond buying.

- Expect ECB to announce government bond buying of between EU500b and EU700b over 18 months, analysts incl. Athanasios Vamvakidis, Gilles Moec, write in Jan. 16 client note.
- Program likely to include all investment grade govt bonds, with monthly or quarterly pace for purchases; mutualization likely, ECB would retain considerable discretion on details of purchases.
- Crucial issue is if ECB manages to create “open ended” feel; communication will be key for market reaction.


- Expect ECB to announce expansion of asset-purchase program to include govt bonds this week: technicalities will likely be announced in March, strategists including Nikolaos Sgouropoulos say in client note dated Jan. 18.
- Central bank may signal program will stay open until CPI expectations are firmly re-anchored.
- Any QE without shared risk may be counter-productive, analysts including Giuseppe Maraffino write in separate note.

Deutsche Bank
- ECJ’s opinion on OMT last week makes it easier for ECB to act sooner and reduces risk of too much compromise on program’s design, economist Mark Wall write in client note dated Jan. 16.
- Even if central bank waits until March, Draghi has to send a clear signal on Jan. 22 of imminent QE; if vote on QE is in Jan., full details are only likely in March.
- Expect a broad-based asset purchase program encompassing investment grade corporate bonds as well as sovereign bonds, Wall writes in client note dated Jan. 9.
- No target size to be set for sovereign purchases; expects formal announcement of public QE from ECB on March 5.

Goldman Sachs
- Expect ECB to announce expansion of asset-purchase program on Thursday, with focus on sovereign debt and size of EU500b-EU1t, economist Dirk Schumacher writes in Jan. 13 note.
- Purchases to be mutualized and conducted according to capital key; degree of risk-sharing remains contested among GC members, so other modalities are possible.

JP Morgan
- ECB likely to announce EU500b sovereign-debt purchase plan, spread over coming year and with clear signal that it could be scaled up if needed, economist Greg Fuzesi writes in Jan. 16 note.
- Expect ECB to be pari passu to other bondholders and share credit risk on investment-grade bonds across national central banks; sub-IG risk to remain with national central banks.
- TLTROs to be made more attractive; ECB also likely to start buying non-financial corporate bonds.

- ECB is likely to announce a broadening of asset purchase program to include corporate and government bonds, economist Janet Henry says in Jan. 16 note.
- ECB may not announce magnitude of purchases; may stick with previous statement that it intends to expand balance sheet back to early-2012 levels.
- If size of eventual purchases is capped or degree of risk-sharing by national central banks is very limited, announcement could disappoint market expectations.

Credit Suisse
- Attach 70% probability to QE in form of sovereign bond purchases this wk, economists including Christel Aranda-Hassel says in client note dated Jan. 16.
- Expect ECB’s QE announcement to be accompanied by broad guidelines rather than all details; bond-buying should start before mid-Feb.
Base-case scenario, to which CS attaches odds of 50%: ECB announces EU500b-EU750b of sovereign, investment-grade bond purchases.
- Expect ECB to unveil “hybrid” bond-buying program in which some risks are taken by national central banks, strategists incl. Helen Haworth, write in Jan. 15 note.

- Expect ECB to announce QE this week; decision will probably be taken with comfortable majority, economist Guillaume Menuet says in client note dated Jan. 15.
- To maximize effectiveness, QE would need to be open-ended, fully mutualized, encompass all sovereign debt issuers irrespective of credit ratings and include instruments such as supranational issuers and inflation-linked bonds.
- ECB will probably be conservative because of the likely reluctance to pre-commit.
- Suspect inflation generated by QE may be limited, probably leading to another program like QE2 or QE3, possibly by mid-2016.

- ECB is likely to announce this week purchases of EU1t including sovereign debt, possibly augmented by corporate and supranational debt, economists including Reinhard Cluse write in Jan. 19 note.
- ECB will leave door open to do more should inflation fail to move back toward target within acceptable period of time.
- Unlikely for program to include Greek debt just 3 days before Greek election (on Jan. 25)
EUR may fall toward 1.10 USD if ECB QE exceeds expectations.

BNP Paribas
- ECB likely to announce sovereign QE on Thursday, economists inc. Ken Wattret write in Jan. 13 note
Expect deposit rate to remain at -20bps.
- Size of sovereign bond program will probably be ~EU600b per annum, with assets of longer maturity than under OMT and purchases unsterilized.
- Look for conditions to be attached, ruling out participation of Greece.

- ECB is likely to announce EU650b of govt bond purchases; EU650b is a conservative assumption; size could easily be EU1t for sovereigns, head of European rates strategy Andrew Roberts says in client note dated Jan. 19.
- Expect ECB to announce QE this week; program to include corporate bonds and securities issued by EIB as well as sovereign bonds, economist Richard Barwell says in Jan. 19 note.
- Expects no change in ECB interest rates in Jan. meeting.

Societe Generale
- Expects ECB to announce a new purchase program including corporates bonds, EU agencies and government bonds this week, economist Michel Martinez says in client note dated Jan. 16.
- Package will eventually include EU400b of private assets and EU500b-EU600b of sovereign bonds.
- A hybrid system could be contemplated, including part-mutualization based on capital key but with most purchases undertaken by NCBs at their own risk.
- Legal and political hurdles to risk-sharing will remain significant in coming months.

- ECB will probably announce on Thursday a large-scale asset purchase program, including govt bonds, economist Nick Matthews writes in Jan. 19 note.
- Expects ECB to broaden existing ABS and covered bond asset purchases to include corporate bonds, supras and agencies.
- ECB will probably detail monthly flow of public and private sector asset purchases of at least EU40b per month, for as long as necessary, conditional upon inflation outlook.

Credit Agricole
- Easiest way to surprise markets would be with a flexible program of at least EU500b, with more to come if needed, economist Frederik Ducrozet writes in client note dated Jan. 19.
- Expects ECB to commit to monthly pace of EU40b-EU50b of sovereign-bond purchases over 12 to 18 months, or an implied total amount of EU500b-EU700b.
- Sees combination of capital keys and caps on individual bond holdings, with an attempt to keep credit risk at national level.
- EU1t balance-sheet-expansion strategy could be boosted later this year should CPI outlook fail to improve.

ABN Amro
- Draghi will probably announce that ECB will embark on large-scale asset purchase program, mainly consisting of sovereign bonds, head of macro research Nick Kounis writes in Jan. 16 note.
- Program could also include other securities such as non-financial corporate bonds and agency debt.
- Purchases likely to be allocated according to capital key.

- ECB likely to announce broad-based sovereign QE on Thursday, economist Michael Schubert writes in Jan. 16 note.
- National central banks will likely have to buy up own countries’ bonds at own risk; this should ensure that new Greek govt would be cautious about advocating debt forgiveness, and could also result in greater support across Governing Council.
- Purchases likely to be in line with capital key; ECB likely to buy floaters and linkers to avoid market distortions; purchases probably won’t be limited to particular maturities.

- European Court of Justice aide’s opinion on legality of OMT program removed last roadblock to QE, economists inc. James Knightley write in Jan. 16 note.
- Central bank probably won’t present all details of likely program, postponing them to March meeting.

- ECB probably has QE package in pipeline that includes at least EU500b of govt bonds and up to EU250b of non-financial corporate and agency/supranational debt, economist Marco Valli writes in Jan. 15 note.
- Timing a close call; plan could be ready on Thursday, as suggested by recent comments from officials.
- There will be probably be some limit to risk-sharing, with national central banks retaining some or all risk.

Market Securities
- ECB likely to announce corporate and sovereign bond purchases on Thursday, economist Christophe Barraud writes in Jan. 19 note.
- Looks for hybrid approach involving risk-sharing across euro-area, limited to a maximum of 50% of total program, and separate purchases by national central banks.
- ECB may not detail specific amount, could give a range; likely to reiterate commitment to expand balance sheet by almost EU1t.