Feast or Famine? Oil Market in 2018

In the Bible, Joseph was interpreting Pharaoh’s dream of seven fat and seven thin cows, but he might have been talking about the oil market (“Genesis”, chapter 41, verses 29-30).

Just as Pharaoh’s kingdom experienced a cycle of feast and famine, depending on the Nile inundation, the oil market swings between periods of undersupply and oversupply.

“The problem of oil is that there is always too much or too little,” as Myron Watkins, professor of economics at New York University, wrote 80 years ago (“Oil: stabilization or conservation?” Watkins, 1937).

Ancient Egypt’s food supply was alternately plentiful or scarce, but only rarely “just enough”, which is why the state had granaries to store excess from the good harvests to cover the poor ones.

The oil market, too, carries stocks from periods of oversupply to periods of undersupply, and cycles regularly from contango to backwardation as it does so.

The natural state of the oil market is not just enough, any more than the natural state of Pharaoh’s food supply was just enough.

OPEC and other commentators, including myself, characterise the process of restricting oil production and reducing excess stocks as one of market “rebalancing”.

But while rebalancing is useful shorthand for a complicated set of adjustments to production, consumption and stocks, it does not imply the process ends with a “balanced” oil market.

The oil market is rarely balanced, and never for very long.

In the past, periods of oversupply and contango were swiftly followed by a return to undersupply and backwardation.

Something similar appears to be underway at present, with Brent and other international crude grades moving into backwardation over the last three months, after trading in contango since the middle of 2014.

Most analysts have expressed concern about the re-emergence of oversupply, a renewed rise in crude stocks, and how OPEC and its allies will exit from their current production deal in 2018.

But it is at least possible the market is moving towards a period of undersupply, when demand will be growing strongly, supply will be lagging, and stocks will feel uncomfortably tight.

Positive Feedback
Oil prices rarely adjust smoothly to changes in production or consumption (“Essentials of petroleum: a key to oil economics”, Frankel, 1946).

The relationships between production, consumption, stocks and prices are characterised by circular causal or feedback processes (“Cybernetics, or command and control in the animal and the human”, Wiener, 1948).

 

Some of these processes are stabilising and tend to dampen the original disturbance (“negative feedback”), but others are destabilising and tend to amplify the initial shock (“positive feedback”).

Positive feedback processes can cause a lot of instability in the short and medium term. During the oil market downturn between 2014 and 2016, positive feedback made the slump much worse and delayed rebalancing.

On the supply side, for example, the slump led to a fall in the price of labour, raw materials and service contracts, which damped producers’ response to lower prices.

On the demand side, recessions in oil-producing countries as well as the slump in drilling and the slowdown in global freight, all reduced oil consumption, especially of diesel, exacerbating the oversupply.

But positive feedback cuts both ways. Just as it made the slump deeper and longer, it is likely to accelerate and amplify the upturn.

Oil market rebalancing is likely to see a rise in costs as well as faster growth in consumption from oil-producing countries and an acceleration in freight.

In the oil market, like Pharaoh’s Egypt, everything tends to go right (or wrong) at the same time, causing violent swings in the commodity cycle.

 

Upturn Elements
The ingredients for a cyclical upturn in the oil market in 2018 and 2019 are all present.

The major global economies are experiencing the strongest synchronised expansion for a decade and world trade volumes are growing at the fastest rate since 2011.

The combination of a broad global expansion and relatively low oil prices has produced a surge in oil demand, with consumption growing faster than the long-term average over the last three years.

Global oil consumption is predicted to increase by 1.6 million barrels per day in 2017 after growing by 1.3 million bpd in 2016 and 1.9 million bpd in 2015, according to the International Energy Agency.

Oil consumption is forecast to increase by another 1.4 million bpd in 2018, the IEA says (“Oil Market Report”, IEA, September 2017).

Global crude and product stocks are now drawing down rapidly owing to a combination of strong demand and supply restraint by Saudi Arabia.

Stocks are still above the five-year average, but converging towards it, and the five-year average is likely to prove too low given the prodigious growth in consumption since 2012.

The critical question is how quickly producers will respond to strengthening demand and tightening oil inventories.

With most producers already operating near full capacity, most output growth over the next two years will have to come from Saudi Arabia (and its close ally Kuwait), conflict-torn countries in Africa, or the U.S. shale sector.

Saudi Arabia has spare capacity, but will likely want higher prices before increasing its supply to the market, especially with the partial floatation of Aramco drawing nearer.

Nigeria and Libya also have spare capacity but the poor security situation in both countries makes future production increases highly uncertain.

U.S. shale producers can increase production, but their costs are rising, and they are coming under mounting pressure from shareholders to focus on improving returns rather than growing output.

What's Next?
A range of scenarios is possible for the oil market in 2018/19:

 

Many analysts and traders have backward-looking expectations, assuming the future will resemble the immediate past, which is why they tend to miss turning points.

Expectations were much too bullish after the boom years of 2011-2014, which is why many analysts and traders missed the impending slump, and then underestimated its depth and duration.

But it is arguable expectations have become too bearish in the aftermath of the slump and traders are now underestimating the prospects for recovery.

Of course, it’s always possible the market will have just enough supply, with shale and OPEC adjusting smoothly to match the increase in demand.

But if I were advising Pharaoh, I wouldn’t tell him to bet on it.