What a difference 5 months makes.
It seems like it was yesterday when Goldman’s commodity strategist, Jeffrey Curie, wrote in a July 28, 2014 note that:
The long-awaited global recovery appears to be getting on track, lifting commodity demand
Apparently unaware that just 5 months later precisely the opposite narrative would be used by everyone, Goldman included, namely that plunging commodity prices (and demand) is a boost to the economy, Currie added the following:
One of our key macro views for 2014 has been a gradual return to the ‘Recovery’ phase of the business cycle – where accelerating growth would drive a gradual (but persistent) closing of the large negative output gap which opened following the 2008/09 crisis. Disappointing 1Q14 growth raised question marks over this view and appeared reminiscent of the previous “stop-start” recovery patterns of 2010-13. On aggregate, DM growth fell to +0.4% annualized (from +1.9% in 4Q13) and EM growth fell to +2.5% annualized (from +4.7% in 4Q13).
Our economists continue to see global growth accelerating to above trend later this year and into 2015. Accordingly, we expect a narrowing of the still sizeable global output gap, with DM economies leading the recovery.
As we have argued for some time, commodity prices and volatility are sensitive to the business cycle. As a pro-cyclical asset, returns tend to be weakest in the Slowdown and Contraction phases of the business cycle as consumers spend less and previously planned capex projects are either delayed or abandoned altogether. In contrast, the Recovery phases of the business cycle tends to see improving consumption and investment demand, which eventually peaks at the end of the Expansion phase. This stronger demand for goods (particularly investment goods) boosts commodity demand.
Uhm… OOOPS. Guess we aren’t in the Recovery phase of the business cycle after all.
Which means we are either in the expansion phase (which means the peak is nigh), or more likely, already in slowdown.
And, lo and behold, after predicting that “Brent will stay at $100 for the coming few years” just in mid-October, here is Goldman again, thoroughly destroying its “Recovery” narrative and saying it expects even more downside (!) for oil from here on out.
Here is what Jeffrey “The long-awaited global recovery appears to be getting on track” Curie sent out to Goldman’s muppets overnight:
The New Oil Order: Finding a new equilibrium
1. The decline in oil prices continues unabated. We believe the oil market is experiencing a cost re-basement which makes determining when the market is oversold extremely difficult, as the price at which rebalancing occurs is now a moving target to the downside. For the market to be oversold, it requires prices to be far below costs, which are in flux as much as the oil price given the sharp declines in other commodities, currencies, rig rates and oil services costs. On top of downward cost pressures, efficiency is being forced on the industry with evidence of ‘high grading’ where rigs in non-core areas are being re-directed towards core, lower-cost resource plays. All this suggests that costs are falling nearly as fast as the price, which means oil producers can spend less to get the same or potentially even more in terms of production.
2. Although we are not willing to take a strong directional view at current price levels, there is some evidence of rebalancing beginning to happen, and it is trending faster than our forecast which was based upon $70/bbl. But the rebalancing is far from sufficient which creates more downside risks. While the overall rig count in the US dropped by 29 last week, this was almost entirely in vertical rigs, not the horizontal rigs used in shale production. Since early November, 12 US producers representing an estimated 8% of 3Q 2014 US oil production have issued 2015 capex/production growth guidance. Weighted average capex budgets are down 12% yoy. However, each is still forecasting production growth on average in 2015 vs. 2014, except one which is guiding to flat yoy production. So while reductions in capex are coming faster than expected, it is unlikely to translate into less supply than expected, highlighting both the rapid cost reductions with rig rates already down by 15-20% and efficiency gains through high grading.
3. Slowing the rebalancing and creating further downside risk is a very strong consensus view that this pull back is temporary and that oil prices will quickly rebound as they did in 2009. According to a recent Bloomberg survey, the median WTI forecast for 2016 is $86/bbl (even we forecast it going back to $80/bbl). All of these forecasts are based upon now outdated cost data that is shifting as fast as the price. It is precisely this strong view for a rebound in prices and the behavior it creates, that not only suggests that oil prices can go lower for longer, but also that the new normal is far lower than we thought just one month ago. Instead of optimizing against a lower price environment, many oil producers are trying to position themselves for the rebound in prices. There are many options available to an oil producer than just simply cutting production in response to lower oil prices – lower costs and increase volumes, sell more equity, tap a revolver or preserve liquidity to survive until another player with deeper pockets buys them even if the cost is more leverage.
4. As we argued several months ago, this sell-off has been driven by long-dated prices (a proxy for the normal price) as opposed to a weakening in the forward curve timespreads as in past bear markets. The current shape of the forward curve does not incentivize the storage of oil. Although the spot price is only at $58/bbl, the 5-year forward oil price is already lower today at $69/bbl than it was in December 2008 ($70.50/bbl) when spot WTI prices fell to $33/bbl. The reason that the forward curve was in such a deep “contango” in 2008 was that OECD inventories had swelled by 60 million barrels on a seasonally adjusted basis in October and November of that year. This October and November, the seasonally adjusted build was only 18 million barrels – far from being a significant surplus that challenges storage capacity and requires a deep contango. It is instead the expectation for forward balances to be in severe surpluses that is driving the longer-dated price decline and will ultimately help rebalance the market. We have used the phrase “long-term surpluses create near-term shortages” to characterize this trading pattern i.e. sell the forward prices on concerns of long-term surpluses that can make the reality of surpluses self-negating.
5. While this is the first time we have seen a backend driven bear market, the bull market of the 2000s was also backend driven but with weak timespreads, i.e. “long-term shortages create near-term surpluses” – the near opposite of what we are seeing today. As low-cost oil supplies were exhausted in the early 2000s the market turned to higher cost resources and input costs escalated quickly as demand increased. The higher oil prices resulting from higher costs slowed US growth, weakened the US dollar which in turn strengthened the commodity producer currencies which further drove up the cost of producing other commodities that were inputs into oil. It was a reinforcing dynamic to the upside that created cost inflation that drove up the long-dated (normal) oil price. Now it is all working in reverse as the market searches for a new equilibrium – lower oil prices, weaker commodity currencies, lower material and oil service costs and increased efficiency are all reinforcing to the downside.
6. The natural gas experience of 2011-13 is the rule, not the exception. Despite the collapse in natural gas prices several years ago, US natural gas production has continued to grow above expectations. It is often cited as an exception as the higher oil prices subsidized the associated gas output and new low-cost fields such as the Marcellus and Utica were available. In other words, the industry just shifted its activity to the lower part of the cost curve and continued to grow output. The reasons we see this as the rule, and not the exception is that we have seen this in iron ore, coal and gold as well. So there is a likelihood we could see this in oil as producers shift all their efforts to the lower part of the cost curve.
7. With no obvious new low-cost US shale oil field, beyond the high grading to each play’s sweet spot, we believe that the oil market’s Marcellus is most likely to come from abroad. Kurdistan and Southern Iraq will likely continue to grow production, with Iran potentially contributing medium term as well. Further, in a market anchored at shale’s marginal cost of production, it is in OPEC’s interest to maximize revenue through volumes, pointing to potential increases in production over time in core OPEC too. Russia could be the oil market’s Marcellus field as well. It is important to stress that the Russian ruble has weakened almost as much as the oil price has declined, leaving oil prices in Russian ruble near an all-time high. This is important as all costs are Ruble denominated while revenues are USD denominated, leaving Russian oil companies’ margins insulated despite the dollar decline in price. In addition, the Russian government is easing the export taxes which further improve the profitability of Russian oil.
8. While core-OPEC such as Saudi Arabia have substantial dollar reserves to weather low oil prices for a very long time, distressed-OPEC like Venezuela are in a very difficult position. In fact, these producers are some of the top candidates to aide in the rebalancing of the market in 2015. In addition, Libya has experienced setbacks with increased fighting over the weekend leading to another output loss to below 500 thousand barrels per day. While this may help keep the market from experiencing near-term surpluses, the temporary nature of it doesn’t help solve the longer-term imbalances.
9. While historically a 40% pull back in prices would stimulate demand by 50bp, the responsiveness of demand and global growth is likely far less than what it was historically. In the US, net imports are around 25% of demand, levels only seen during the depths of the early 1980s recession. In China and other emerging markets, governments are taking advantage of the decline in oil prices to reduce subsidies and/or introduce consumption taxes as nearly all developed markets have. Further, the sharp decline in nearly all commodity prices and the weakening in commodity currencies creates headwinds for oil demand in the commodity producing emerging markets in Latin America and the Middle East. Historically these regions didn’t contribute much to oil demand, today they do.
10. It is important to emphasize that this is a supply driven bear market and not demand driven. We have to go back to the mid-1980s to find another supply driven bear market. Because the surplus is supply driven it is easily observable in the future unlike demand shocks that are instantaneous, so the market is trying to rebalance the future, not so much the present. In the 2000s we forecasted severe supply driven shortages that never came, because long dated prices dragged the market high enough to slow demand and bring on marginal supplies –hence long-term shortages created near-term surpluses. Once again the market is trying to rebalance the future, by re-basing industry costs to take out the excess marginal production. As the industry takes the ‘fat’ out of the system that was built up over the past decade, the new equilibrium price is dropping sharply – where it settles is unknown right now, but we can comfortably say it is likely below our estimates from last month. Once we have cost data early next year from this time period we will have a better idea, but in the meantime volatility will likely remain high with risks skewed to the downside as the market searches for a new equilibrium.