Monday, February 23, 2015

Notes On Oil Part II

These are some short notes taken from a presentation I gave last week:

Supply side issues

  1. Global oversupply is only likely to ease by the end of this year. Peak oversupply will be in 2Q2015;
  2. Despite the various contributions of Iraq, Libya and other countries, about 60% of the oversupply is coming from the US;
  3. Just four countries commercially produce shale oil, and the vast majority of it is from the US;
  4. But this production is expected to peak by 2020;
  5. Bottom line: global oversupply is really a US story, and it will persist for the next half decade.

Demand side issues

  1. All the BRICs are in the top 10 oil consuming nations, but only India is seeing faster growth;
  2. Energy efficiency of growth is increasing. For example, despite growth in size and numbers, US government energy needs are 40% below what they were in the 1970s;
  3. Overall global demand for oil will be flat this year, and only likely to recover in 2H2016.

Refinery Bottlenecks

  1. Shale oil is light and sweet crude, but most major US refineries are built for heavy and sour crude;
  2. In addition, no major new refinery has been built in the US since 1976. Shale oil production took refiners by surprise;
  3. Geographical dislocation: Most tight oil production is in the interior or on the Gulf Coast, but light sweet refineries mainly on the East coast;
  4. US government has a ban on crude oil exports. That means US crude demand (and prices) depends critically on refinery demand;
  5. Worker strikes beginning in February have taken 10% of US refining capacity offline. Further work stoppages this week has doubled that number;
  6. Insufficient refining capacity, storage at full capacity and worker strikes means heavy downward pressure on US crude prices, driving a wedge between WTI and Brent.

Monetary policy and FX trends

  1. USD in the middle of a 5-6 year appreciation phase;
  2. Pending Fed tightening will boost USD valuation vis-a-vis other currencies;
  3. Approximately 20% of Brent and 25% of WTI movements explained by USD movements (our estimates).

Bottom line

  1. US rig count decreasing, but rig efficiency is up;
  2. Economics of shale oil (heavy continuous investment, max production for a very short period) means incentives to maximise production from existing wells irrespective of current prices;
  3. Current EIA projections puts max production surplus in 2Q2015;
  4. Refinery constraints only likely to ease in 2016 (new facilities, expansion of old ones);
  5. Monetary policy divergence means USD strength likely to continue;
  6. Bottom line: Despite the recent rebound in prices, crude oil will remain under pressure, but market players are beginning to differentiate between US prices and international prices.

Technical Notes:

  1. Most data taken from the US Energy Information Administration
  2. Rig count data from Baker Hughes


  1. Hello Mr. Hisham, would like to know where do you think USDMYR might be heading? Despite the gain in crude oil price, MYR has continued depreciating against USD, especially in the past week, is this more related to US factors? If so, what should one look out for.. unemployment reports.. inflation reports.. Fed meeting notes?? Apologies for the entry level questions, I'm only starting to learn all these and would appreciate guidance from the professionals.

    1. @anon

      When I was in university, we had one lecture devoted entirely to exchange rates. What the lecturer said was, we've got 11 different classes of models that try to explain how exchange rates move - every single on of them was wrong.

      Almost no model consistently beats a random walk in forecasting exchange rates. Implication: you can only really forecast short term volatility, not exchange rates themselves.

      I've no idea where the Ringgit is heading, your guess is as good as mine.

    2. Thank you Mr. Hisham for your reply. I work in a manufacturing company where we import raw materials and export some in USD, trying to grasp the timing of buying/selling USD has been quite stressful in the past few months. After re-reading your posts and catching the point on continual strengthening of USD, I'd stop dreaming about MYR appreciation following oil price rebound.

    3. @anon

      You're welcome.

      If your business is big enough, I'd recommend reading up on hedging strategies e.g.

      One piece of advice: Since you use imported raw materials, you only need to hedge the proportion that is local value added, not the entire foreign sales value (i.e. there's no need for a 100% hedge).

      It's also important to know whether the countries you are sourcing materials from are also affected by a strengthening USD (and whether the prices you're getting are being adjusted as a result). The other side is also important - where you're selling your products. If the USD is being used purely as an invoicing currency, it might be more important to focus on the cross rates instead, both on the supply side as well as the demand side.

      Some scuttlebutt: One reason why the Ringgit hasn't followed oil back up is due to market structural factors.

      First is that I'm told some banks have already hit their FX loss limits for the entire year in just these past few weeks. Since they can no longer take open positions, that takes away some liquidity from the market and amplifies the effect of the remaining FX positions. Second is that there were some short USD positions that were covered last week because traders didn't want to carry them over the long CNY holiday. In a an already thin market, that overrode the positive news flow from oil.

      In any case, I think this oil rebound will fritter out soon. I don't expect a sustained price increase in oil (and thus the Ringgit) until the second half of this year.

    4. Hello Mr. Hisham, really thank you for the insights on banks' FX loss limits and market liquidity, that gave me some talking points to explain to the boss, credit to you of course! If as you and other analysts have pointed out, 2H this year post a more promising note for ringgit, we ought to review strategy and start contemplating swaps and options.

      Thank you very much for blogging, I have really learned about econ in actual practice from reading your blog and comments.

    5. @anon

      You're welcome. We're reviewing our FX strategy too, which is how I came by all this intelligence.

      A few of the risk factors I see over the next few months (in no particular order):

      1. Slow/incomplete resolution to 1MDB debt/asset sales

      2. Fed rate hike (tomorrow's statement will be critical)

      3. Diminishing oil storage space in the US. Production is not slowing, but lack of storage means excess production is going to get dumped on the spot market, depressing WTI prices and increasing the spread between WTI and Brent.

      4. Probable (i.e. likely) Fitch downgrade at the end of June

  2. Good, Hisham, I want to post this part ll to complete the oil cycle in my blog. Keep up the good work!

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