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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.

November 19th – Top Stories

1/ US


- Senate banking panel to vote on Fed’s Yellen on Thursday - Reuters


The Senate Banking Committee will vote on Thursday on President Barack Obama’s nomination of Janet Yellen to be the next chair of the U.S. Federal Reserve, a sign her confirmation to become the first woman to lead the central bank was advancing smoothly.
The committee will meet at 10 a.m. (1500 GMT) to vote on whether to send Yellen’s nomination to the full Senate for consideration, it said in a statement on Monday.


2/ China


- China Money Rate Declines Most This Month as PBOC Adds More Cash - Bloomberg – By Bloomberg News

China’s benchmark money-market rate declined the most this month after the central bank stepped up cash injections into the financial system.
The People’s Bank of China added 35 billion yuan ($5.7 billion) via seven-day reverse-repurchase agreements sold at 4.1 percent today, according to a statement on the website. That’s the biggest amount pumped in since Oct. 8. The seven-day repurchase rate, a gauge of funding availability in the banking system, jumped the most since June on Nov. 15 after the PBOC drained money in the last two weeks. The yield on 10-year government bonds climbed to the highest in at least six years.


3/ Eurozone & UK


- EU Considers Loans in Return for Economy Overhauls - Bloomberg – By Rebecca Christie


The European Union is considering whether it could encourage countries to make long-term economic changes by offering them loans at below-market rates, an EU official told reporters in Brussels today.
The idea is to spur reform in areas like labor policy, vocational training or the judicial system, the official said on condition of anonymity because the proposal is still in early planning stages. The loans could be most attractive to smaller countries that don’t have reliable market access, while bigger nations might benefit from looser budget targets in exchange for reform commitments.


November 18th – Top Stories

1/ US


- U.S. House Democrats clamor for Obamacare fix this wee - Reuters – By Richard Cowan


U.S. House of Representatives Democrats, seething over the botched startup of President Barack Obama’s healthcare law, are urging U.S. officials to swiftly help people whose existing insurance policies are being canceled due to Obamacare.
Democrats are facing a potentially difficult House vote on Friday, when Republicans will hold a vote on a bill allowing people to keep their current health insurance plans if they like them, even if those plans do not meet the Affordable Care Act’s minimum standards for coverage.


2/ China


- China Reform Plan Sets Scene for Local Clampdown: Economy - Bloomberg – By Bloomberg News

China’s Communist Party signaled a bigger focus on fiscal concerns during President Xi Jinping’s tenure, setting the scene for a clampdown to control the finances of indebted regional authorities.
Local governments will be able to sell bonds to fund construction and officials will be rated on measures including borrowing levels, the party said Nov. 15. An easing of the one-child policy and extra land rights for farmers also featured in the biggest package of reforms since at least the 1990s.


3/ Eurozone & UK


- Will ECB Break Its Bond-Buying Taboo? - WSJ


For five years, the European Central Bank has resisted calls for it to engage in quantitative easing. Is it time to break this final taboo? Last week’s euro-zone third-quarter gross-domestic-product data offered something for both sides of this increasingly polarized debate.


November 15th – Top Stories

1/ US


- Message From Yellen Is Full Speed Ahead on the Stimulus - NYT – By NELSON D. SCHWARTZ


The stock market reversed an early loss and moved steadily higher in the morning as Ms. Yellen, President Obama’s nominee to head the Federal Reserve, testified at her Capitol Hill confirmation hearing.
Despite the run-up, Ms. Yellen also said that she did not believe that the trillions in stimulus money the Fed has injected into the financial system since the near collapse of the global economy had created a bubble, another very good sign of her supportive views as far as Wall Street is concerned.


2/ China


- China Stocks Surge on Policy Optimism While Bond Yields Increase - Bloomberg – By Bloomberg News

A 20,000 word document approved at the plenum lays out 15 areas of reform and 60 “concrete tasks,” the Communist Party’s People’s Daily newspaper reported today. Speculation on the contents was fueled by photographs circulating online of portions of an unidentified document referring to topics such as requiring state-owned enterprises to pay larger dividends, encouraging more private investment in state projects, and offering farmers more property rights.
Policy changes may be announced over the next seven to 10 days, Jonathan Garner, the Hong Kong-based chief Asia and emerging-market strategist at Morgan Stanley, said in an interview from Singapore yesterday. Investors will regain some confidence in China’s structural reforms next week, Lu Ting, a Hong Kong-based economist at Bank of America Corp., wrote in an e-mailed note.


3/ Eurozone & UK


- Greece must step up efforts, to unlock funds – Eurogroup head - Reuters – By Jan Strupczewski and Martin Santa


Euro zone finance ministers pressed Greece on Thursday to speed up structural reforms and continue fiscal consolidation and privatisation to unblock more of the international loans that keep it afloat.