“The most bearish oil report of all time”

Nick O'Connor

In today’s Capital & Conflict… an extraordinary situation in the oil market… how to use the surplus to predict future prices… why so many people are shorting oil… moving to a multipolar energy system… and more…

In the sound and the fury that ended last week I didn’t get the chance to talk to you about another vital story you need to understand. It concerns an extraordinary situation in the oil market.

Everyone knows the backstory by now. In an attempt to crush shale oil producers in the US, traditional oil nations (read: Opec) have been pumping more oil than the world needs onto the market. That oversupply led to falling prices.

It also led to a surplus of oil in the market. For the past three years the world has produced more oil than it’s used. What isn’t used is a surplus – a global stockpile of oil ready to be used if the demand is there. Think of it like a gigantic reservoir of oil out in the middle of nowhere, ready to be tapped when the need arises.

Surplus oil supply is an important indicator of what’s going on in the market and where prices are heading. A growing surplus suggests there’s more supply than demand, which you’d expect to lead to lower prices. A shrinking surplus works the other way: you’d expect to ultimately see higher prices as it’s a signal there’s more demand chasing decreasing supply.

So what’s happening to the surplus right now? Is it growing or shrinking? And what does that mean for oil prices?

As we discovered last week, it’s growing… and it’s growing much, much faster than previously predicted.

Analysts had expected inventories of US crude to grow by one million barrels last week. They were way off. The US government’s Energy Information Administration announced that crude stocks grew by 14.4 million barrels. That’s 14 times what was expected!

It was the biggest weekly crude surplus on record. And it led one analyst, Bob Yawger of Mizuho Securities USA, to tell The Wall Street Journal: “You could easily make the argument that it’s the most bearish report of all time.”

That’s highly significant. It shows that there’s still far more supply than demand in the market. That would indicate weaker oil prices ahead. It also shows you that lower prices aren’t leading to supply cuts across the board. In fact there are plenty of oil producing regions that are increasing supply.

For instance, increased supply from the North Sea could soon flood into the market. According to figures compiled by Bloomberg, shipments will increase 10% month-on-month in December. That constitutes a 360,000 barrel per day increase from September. Then you have non Opec members like Brazil and Russia boosting output (last month Russia pumped more oil than it has done since the Soviet era).

And it comes right at the same time we’ve seen two other important bearish indicators flashing.

As I showed you recently, at the start of last week oil shorts were at an all-time high. There were more short positions against crude than during its 2007 explosion to $148.

And on top of that, you have continued Opec infighting. We saw last week that Opec is trying to indicate to the market that it’ll cut production. The problem is, a lot of its individual member states don’t really want to do that. A cartel is only as powerful as it is united. And Opec doesn’t seem united.

Break that down. You have a surplus that’s growing at a rapid rate. New supplies coming onstream. Record shorts against the price. And the most powerful oil nations in the world can’t agree on what to do about it.

It might just actually be the most bearish situation of all time.

So what do you do? Does such a bearish situation lead to lower prices? Or perhaps the contrarian argument prevails: if it can’t get much worse, things will go from bad to less bad and the market will go up. Hold that thought!

Is $52 oil’s “magic price”?

First let’s think about how you’d explain this situation.

Here’s one theory. When Opec flooded the market with oil three years ago it did so in an attempt to destroy the shale industry. The idea was to push shale – which was perceived as requiring large capital inflows and high prices to survive – to the limit.

But one side effect of being part of a cartel, with such power to influence the price of oil, is that perhaps you forget just how a real free market actually works. Free markets lead to more competition, which increases efficiency and lowers prices for consumers over time.

Rather than destroying shale, the fall in oil prices has made it stronger. It’s forced the industry to cut costs, innovate and become more competitive and efficient. That’s driven the cost of production down and made the industry viable at much lower prices.

Consider this. Over the summer the oil services group Baker Hughes published a study of the shale oil industry. It showed that during June and July the number of shale oil wells increased by 360% – from a low of 68 to 316.

That figure looks more impressive because it’s coming from such a low base, right at the bottom of the market. But it’s still significant. And that’s because of this: at no point during that expansion did the price of oil move above $52.

To me that’s a signal that increasing numbers of shale wells are becoming economically viable at increasingly lower prices. Whether that’s as low as $52 is unclear. But there’s plenty of research out there that shows $60 could be a significant figure. And if the industry continues to innovate and improve efficiency, that figure could fall even further.

That may explain the record shorts against the price of oil today. Perhaps it’s the shale producers themselves hedging. If Opec moves to cut production and prices rise, the shale industry benefits as more of its wells become viable. If Opec doesn’t (or can’t) agree and the price of oil falls, the shale producers benefit via their short positions.

If that’s true, it’s the exact opposite of the situation Opec wanted to create three years ago.

What happens then? Does Opec throw in the towel and compete – pump even more oil onto the market in an effort to put the shale producers into difficulty again? Or does the market find a new equilibrium, at much lower prices and with more key sources of production?

That would effectively be the end of Opec as the primary player in the oil market. I’m going to go ahead and call it. In energy terms we’re moving from a unipolar world to a multipolar world. Rather than one key energy superpower we’ll have several, distributed around the world – and distributed by type of energy source, as well as location.

That’s good news for consumers. It’d likely mean a freer market, increased competition, increased efficiency and lower prices. It’s also good news for investors, if you understand it. Change isn’t always good for everyone. But moments of great change are when the biggest returns are made.

And if you’re going to talk about a multipolar energy market, you can look well beyond oil. The falling cost and increasing efficiency of renewables like solar will slowly (perhaps not so slowly) emerge over the next decade and provide another source of energy for the world. That’ll fracture the market even more. It’ll likely lead to even more sources of supply, even more competition and even lower prices. More on that in a future issue.

Until tomorrow,

Nick O'Connor's Signature

Nick O’Connor
Associate Publisher, Capital & Conflict

Category: Market updates

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