Asset classes go in and out of style faster than all the couture collections displayed on the Milan, Paris and London catwalks put together. Are we a part of the Asset Management industry or the Fashion industry? I would like to think its the former but given the moves seen recently in sectors and asset classes violently going in and out of vogue (no pun intended), sometimes I wonder if I should start attending Fashion week instead of the Energy conference in Miami to gain better insight into the cognitive and behavioral trends of my potential investors.
Commodities have been in decline for the majority of this year given the years of investment finally generating the supply needed to soak up the demand growth over the past decade. As supply catches up, the highest quartile cost producers get squeezed out first, eventually slowing or shutting production till prices reach a level of equilibrium where supply meets demand. This is how Commodity markets should behave; it’s logical. But it’s not always that simple. Commodity markets are sensitive to other asset classes as well, especially foreign currency markets given the negative correlation of the dollar vs. Commodities. Hence fickle Central Bank policies and dissenting member votes have added another layer of complexity and volatility to Commodity markets.
November has been a diabolical month for Commodities. Goldman Sachs Commodity Index (GSCI) down 10% this past month. Oil is the main culprit down 18% for the month alone together with Copper down 7%. However it was the last ten days that caused the brutal sell off with Brent Oil falling 12% post OPEC meeting ending November 27th where they decided to keep production unchanged at their target of 30mln bpd. But wait, since when did OPEC adhere to that target in the first place? When did the headlines ever match actual production coming out of the region? They have been over producing for the past few months and are currently about 500-800kbpd above their “quota” to begin with. There has always been some form of cheating.
So I ask myself…haven’t we seen all this before?
Let’s look at what OPEC is actually doing vs. what it is saying it is doing. It is important to look at real time deliveries coming out of the region to get a grasp on true production; November data is showing a fall of 0.4 mbpd month on month from October. Technically OPEC could still reduce by 500k bpd, a “cut” unofficially, but still be in line with their “official” statement. So it seems that it is withdrawing barrels in the market even as I write this blog. Whether or not OPEC says it is “keeping production unchanged” or conspiracy theorists claim that OPEC is trying to squeeze out US shale, it is important to put this in perspective.
For Oil to fall $8/bbl on the day of OPEC’s “in-line” statement was an over reaction to say the least. Going into q4, there is always seasonal pick in demand from winter heating oil plus refineries are coming back from maintenance. This in itself is a marginal increase from q3 and even with the supply here (no cut and over producing) this can soak up the excess supply through q115. It would be quite punchy to announce an aggressive cut right before winter heating demand kicks in. The S&D balance currently suggests a cut is not required before March. So at worst case, oil prices can hold here. But what if there is a pick up in demand globally either via US given recent strong data or China who are strategically adding to reserves at these rock bottom prices? We can only move higher.
It is not OPEC’s responsibility to appease US shale producers with positive headlines so that they are able to sustain their production and growth plans. After all they all should share the loss of revenue from falling oil prices. OPEC will cut as when they see fit post q115. They will wait to hear from US shale producers in early q1 when they update the market next on their capex plans. If you were OPEC, wouldn’t you want US shale producers to share some of the loss of production too? It seems OPEC did the sensible thing, for now.
The conspiracy theorists are talking prices could fall as low as $50/bbl. As things stand, Oil prices will not stay below $60/bbl for long as it would severely affect Canadian oil sands and US shale oil projects. The industry is reacting at these levels; recent permits new wells dropped 15 percent across 12 major shale formations last month, according to exclusive information provided to Reuters by DrillingInfo, an industry data firm, offering the first sign of a slowdown in a drilling frenzy that has seen permits double since last November. Investors need to wait and see how things progress into q1 and assess the physical market balance to gauge how much slack is in the system.
I think it’s time we move away from being perennial headline junkies and conspiracy theorists more to fundamental investors.
