Once upon a Time in the Oil Market

One of the overarching characteristics of asset markets is that its participants are prone to harbour the eternal Doublethink whereby the consensus usually revolves around a sempiternal bullishness with regard to equity prices and an equally unshakable millenarian gloom regarding the wider prospects for the human race.

With regard to the latter, it should be recalled that, only a few short years ago, the media were overly solicitous of the morbid declamations of both Hubbert’s Peak Malthusians and their lesser brethren who saw naught in prospect but depleted mineral seams and planetary-scale dustbowls. All of this ilk were much given to tortured Old Testament visions of an imminent, resource-exhausted Dystopia were we not instantly to repent of our unrighteousness and sin and to follow their always anti-economic and frequently anti-scientific prescriptions for society instead.

These croaking birds of ill-omen perched oh-so comfortably alongside all the other rag-tag avians of despair – the anti-capitalists, the eco-catastrophists, and the would-be Guardians of a global Gulag – to warn us that we (though rarely they) should become persuaded – and, if not, then mercilessly compelled – to give up our dreams of a first home, a second car, a third child, a fourth holiday, and in general all aspiration to a less materially constrained existence. Rather, they railed, we should volunteer en masse to enlist in their compost-toilet Collective where we, the last residuum of humanity graciously allowed to survive their multi-billion being cull, would selflessly toil to scratch a communal living (a morally superior ‘organic’, if alas an agronomically derisory one, naturally) in our own, zero-impact, carbon-neutral, low food miles back yard.

Fast forward through six or seven years of switchbacked commodity markets and stubbornly elusive ‘recovery’ and the prognosis has flipped through almost 180° even as the prevailing level of pessimism has remained locked at the maximum 5 on the Saffir-Simpson scale of depression.

For if the prophets of doom in 2007 were warning of Peak Oil and population pressure, now the theme has become Peak People and petroleum plethora. ‘Secular stagnation’ and ‘demographic deflation’ have become the new buzzword ailments. For these, you may not be entirely shocked to learn, the Clerisy (to borrow Deirdre McCloskey’s contemptuous denomination of our elite opinion makers) can recommend as a palliative no more than one determined push after another to inflate asset prices ever higher and to force bond yields ever lower while sanctimoniously deploring the Cantillon effect-exacerbated degree of ‘inequality’ this permabubble approach cannot fail to deliver.

In the particular case of the oil market, the ironies are especially rich. Barely six months ago, front-month WTI was tantalizingly close to staging a breakout from the long, narrowing, sideways range it had mapped out since first being jolted higher in the wake of the Arab Spring and, more importantly of the reduction of Libya to a Hobbesian failed-state wasteland. As prices rose, so too volatility declined to less than half of its post-LEH norms and speculative long positioning grew ever heavier – combining to offer a compelling picture of complacency and herding.

Participants were further desensitized to risk by dint of being paid to run these positions thanks to the constellation of a drumbeat of near-term supply disruptions and the hedging pressure being exerted at the far end by America’s surperforming shale drillers meant that the curve of price against time sloped steeply downward at a negative gradient of around 15% – a degree of difference not seen in a decade. This condition – one commodities traders call ‘backwardation’ – meant that the buyer of a futures contract could expect it to move ever upward in value as its expiry approached.

In all, at the late June peak, more than a quarter of all open interest on Nymex was attributable to speculative holders who had by then amassed command over 880 million barrels in WTI and Brent – roughly ten days’ global consumption – for a notional value of getting on for $100 billion dollars in heady Groupthink. Fund managers to whom we spoke at the time, whether in the smallest family office or at the largest pension fund, were all eager to show off their new-found familiarity with the goings-on in the Permian or the Barnett shale and proud to volunteer their benchmark beating exposure to the E&P firms engaged therein.

Though Nemesis followed unusually hard on the heels of this mass outbreak of Hubris, we are still some way from expunging all those bulls in the manner that we briefly once did at the height of the 2008 panic. True, WTI longs have been cut by some 45% but they still remain at 270 Mbbl and at 18% of all O/I; Brent positions have shrunk rather less – by around a quarter – to sit at 300 Mbbl or so. Notional holdings have therefore plummeted by no less than $58 billion, but still remain at something over $35 billion as of the time of writing.

Worse, volatility has undergone a rapid mean reversion, meaning the cost of buying protection – so universally despised amid the easy gains of late summer – has climbed drastically as it always does in a sell-off. Moreover, rather than earning money for sitting idly by as contracts successively rolled up off the board, the curve has whipsawed into a steeply positive 10% slope – where the roll down now entails a 4 1/2 year high exaction of carry cost – with front contracts having fallen 35-40% and longer term ones off a more modest 15% from what were previously lower absolute levels.

As for the profound alteration this has caused to that collective unconscious we tend to personalize as ‘The Market’, we must digress a little to explain what we think is the great import of this shift.

Most people outside the circus of the financial markets (and all too many from within the narrow ring of sawdust in which it takes place) fondly imagine that the business of producing ‘analysis’ and of delivering an exegesis of the madcap daily swirl of red and green tickers is in some way related to science. Disinterested researchers gather all the data, diligently apply the tools and techniques they have learned to tease out their underlying patterns, then formulate an objective diagnosis from which will swiftly issue an all but indisputable prognosis. So we would like to kid ourselves it happens.

But think again, dear reader. We market actors do love our creation myths to be confirmed by the recent price action so that we can all nod sagely at each other when we recycle the tale in our written commentaries and during our two-minute TV talking head slots. This means that our sacred texts get rewritten every few months in order to reshape the facts as they arrive so that they give a semi-coherent voice to our emergent re-interpretations. This becomes all the more compelling when the market trajectory has gone decidedly counter to our previous orthodoxy and when the resulting mass embarrassment must quickly give way to the shameless amnesia of an outright paradigm shift.

The fewer dissenters there exist who did not buy into that earlier consensus and have therefore annoyingly earned the right to chant ‘I told you so’ as the sheep are now shorn, the greater the ease with which any half-way convincing piece of post hoc reasoning of the opposite investment case to that now being demolished will tend to be adopted by a sell-side crowd whose members will then pretend – above all to themselves – that they were the ones telling us so all along.

This means that, in the face of a perverse market trend, what is never to be underestimated is the flimsiness of any conclusion reached by means of what we like to flatter ourselves are the ‘fundamentals’. In fact, if the contrariness long persists – as it clearly has with regard to the development of today’s oil prices – one should always expect the ‘fundamentals’ themselves to be neatly massaged to reflect the new reality. Rationalizers tend to rule the roost, not rationalists.

Thus, from jointly imagining oil was about to launch higher, the late summer relapse first produced reams of warnings that while it might dip further it could not long trade below $100, or $90, or at worst $80, for either the state producers’ budgets would implode or the private sector drillers and explorers would have their credit lines slashed. That way, any temporary surfeit would quickly be turned to dearth by suspensions of production, whether via cartel agreement or force majeure.

In his prior incarnation, just ahead of the cartel’s now notorious November meeting, your author publicly expressed his doubts both about OPEC’s motivation and about the means by which it might ensure everyone would pump less had it indeed desired them to do so. He has also frequently taken issue with much of the associated cost-of-production reasoning – a line inevitably trotted out at moments like these – as being little removed from Marx’s and Ricardo’s long discredited labour value theorem.

In contrast, we must not lose sight of the incontrovertible truth that things sell for what the most urgent buyer offers to pay for them, not what they cost their maker to create. What is more, since the latter part of the 19th century we have been aware that we can expect goods on a rising cost curve to be produced right up to the point where the last quantum sold will just cover the outlays made in fashioning it and getting it into the purchaser’s hands. This implies that any and every lessening of the latter’s appetite as reflected in his bid price will entail either a short-term entrepreneurial loss (hopefully one to be offset with new innovations somewhere in the business) or a reduction in supply or both. Thus it should be no surprise that when the price of crude falls – or the price of copper, cotton, comic books, or cocktail sticks – someone, somewhere will be at least temporarily discommoded and may even be driven from the marketplace altogether.

The problem therefore for those trying to call a bottom in crude prices is twofold: out in the real, dirty world of pricking Mother Earth deep in her bowels, then trans-shipping and cooking the associated goo to order, all too many of the major players suddenly seem be playing a reverse men’s bathroom game of boasting how small is theirs (their break-even price, that is) and, secondly, we financial market screen-jockeys have started to invent new reasons why our previous floor prices were hopelessly wrong and hence why oil can fall much further yet.

Some of these arguments turn upon how the possibility of enforcing some sort of discipline within OPEC has been fatally compromised not just by extra-economic considerations such as East v West and Sunni v Shia, but by the tripolar nature of the new order wherein Saudi Arabia, Russia, and the US are all roughly equal in scale and each holds very different views about the merits of co-operation and competition from its peers

Beyond that, there is genuine disagreement over just how quickly a lower price will act to dry up supply from the game-changing shale oil formations of the US. It should be noted that the best guesses at present still deal with second derivatives of increase and not with outright contraction. While some contend that a form of ‘high-grading’ will occur – with the more prolific, lowest-cost fields receiving the lion’s share of new investment and so keeping the pipelines filled – others point to the way the so-far uninterrupted march of technical prowess has inexorably lowered – and presumably will continue to lower – the cut-off point, just as it has ever since the revolution began a short half-decade ago.

Others adduce the fact that many calculations of the pain threshold wrongly incorporate the sunk costs of acquiring leases, building infrastructure, and undertaking the initial drilling whereas all that matters looking forward is what it costs to complete unfinished wells and to lift hydrocarbons from across the whole portfolio. Furthermore, there are those who argue that the industry’s high debt load will force many to sell whatever they can get out of the ground at whatever price it will bring in order to try to service that debt and so hang on to the underlying assets for as long as possible. Yet others foresee a shake-out which certainly will wipe out existing note-holders and equity investors but which will thereby deliver the associated physical capital on a lower, post-bankruptcy cost base to those with deeper pockets and potentially better management skills with which to exploit it.

The point is not to wonder whether the boasts made by the likes of Exxon that it can deal with $40/bbl indefinitely bear up to scrutiny, or to try to decide how much weight if any to attach to ‘names’ such as Fadal Gheit at Oppenheimer talking about a sub-$30 ‘half-cycle’ level or to Ed Morse at Citi playing up a $5.50 well-completion cost, but simply to note that the market dialectic is now clearly being structured around questions of how low and for how long in a radical reversal of its previous rhetoric.

That in itself tells us that, absent some fairly dramatic new developments in the real world with which to disrupt this novel calculus, the line of least resistance still points clearly downwards.

NB The foregoing is for educative and entertainment purposes only. Nothing herein should be construed as constituting investment advice. All rights reserved. ©True Sinews