After a short-lived reprieve on hopes that OPEC will suddenly abandon its strategy of share retention instead of price support and that US oil production was modestly lower through the first five months of the year than previously expected, reality is now setting back into the oil futures market (USO).
At the time of this writing, West Texas Intermediate crude oil prices for October delivery are hovering in the $43-$45 per barrel range, and futures have traded wildly between “recession” and “bull market” the past several months and days, respectively. There are three major areas of concern that may continue to impede any sustainable rise in crude oil prices, however.
1. OPEC is not caving in.
OPEC’s strategy to deal with the shale oil revolution in the US has been to fight tooth-and-nail for market share, and to the cartel’s credit, they have been wildly successful. The stark reality is that OPEC’s oil production reached a 3-year high in July, and nothing has changed since then.
The commodity markets have cheered Venezuela’s urging OPEC member nations to host an emergency meeting, but Saudi Arabia, the organization’s largest producer, refuses to cave. The general consensus is that Saudi Arabia’s resolve is real, having learned from previous crude oil cycles, and that the oil-rich nation won’t cut production alone—meaning that it demands coordinated action from US producers.
The problem is that US independents cannot, by law, engage in coordinated action to prop up the crude oil price markets. In the US, that’s called explicit price collusion, and Saudi Arabia appears to be demanding just that for any cooperation. Broad-based capital spending cuts across the upstream energy complex suggest US oil production may slide next year, but even that might not be enough to stem the price declines.
As a side note, if the Justice Department is investigating potential airline price collusion, given the resilience of fares in the wake of dropped refined product prices, we can only posit that the wave of capex cuts by participants in the domestic oil and gas space may face eventual scrutiny as well, especially if crude oil prices “miraculously” rise back to $70 per barrel, ultimately hurting end consumers.
2. China demand is fading.
Almost everything out of China (FXI) speaks to a coming Armageddon. We’ve outlined our view that spillover impacts from the China stock market crash and lost consumer wealth in the trillions of US dollars will impact the country’s property market, resulting in profound implications on China’s Big 4 banks, and we continue to hold this view. We do not believe the US banks, including Citigroup (C) and JP Morgan (JPM), are immune to such an impact. Investors keep forgetting that the London Whale incident occurred after new financial oversight regulations were implemented.
In this piece, released September 1 by ShanghaiDaily, for example, the average cost of new homes (in Shanghai) “plunged 15.7 percent week-over-week to 26,806 yuan (US$4,192) per square meter” during the last week of August. “A return to budget-tight home buyers to the market” caused a “structural shift,” driving the significant mean-selling-price weakness during the last week of August. Yet, in this piece, released by ShanghaiDaily September 2 (the next day), the same “structural shift” that caused the massive mid-teens price decline in Shanghai somehow translated into Shanghai being the country’s leading price “gainer…with a rise of 3.77 percent for new homes.”
Housing price data in China remains far from clear, in our view, but we would note that a 15% decline in the mean-selling-price is much more “believable” than nearly a 4% gain amid a stock market collapse of 40%+. Chinese housing markets remain influx, from our perspective, if not under pressure that may only mount in coming periods.
With the Big 4 banks in China already experiencing an increase in bad loans as a result of weakened credits in the mining and construction space, any price deterioration in the property markets could come back to bite in a big way. The latest reading in the country’s purchasing manager’s index spoke to contracting manufacturing activity—a situation that when combined with eroding consumer confidence and evaporating wealth has, in our view, created a whirlwind of concern that can only lead to reduced demand from the country for commodities and crude oil, specifically. South Korea export data, released yesterday, indicated that weakness in China has already spread beyond its borders, and Australia’s second quarter GDP growth slowed considerably on weak China exports. The Aussie dollar just hit levels against the US dollar not seen since the depths of the Financial Crisis.
China’s military parade to commemorate the end of World War II will start tomorrow, and that’s news that many market observers are applauding. With the Shanghai markets closed Thursday and Friday, it’s the only sure way to stop a decline in the Shanghai Composite, which continues to capture the world’s attention. According to Bloomberg, however, “shares on mainland exchanges are still more than twice as expensive as their identical counterparts in Hong Kong,” suggesting that further slides in equities on mainland exchanges cannot be ruled out.
3. EIA Inventory Data Still Not Comforting
The crude oil markets seem to be rallying in part on views that weekly US field production of crude oil has peaked, which may be a good thing, but levels are still the highest they’ve been in at least the past 35 years. US commercial crude oil inventories continue to hover between increases and decreases week to week, with the latest August 28 reading suggesting a build of 4.7 million barrels, but one thing remains inescapable: “US crude oil inventories remain near levels not seen for this time of year in at least the last 80 years.”
It is our view that market observers continue to ignore that crude oil prices were as low as ~$12 per barrel as recently as 1998, and the marginal cash costs to bring a barrel of oil equivalent to the surface approximates $14, the average of what E&P’s pay, according to Moody’s. Full cycle costs may be in the low-$40s, but with the current supply glut not witnessed in decades coupled with Asia demand slowing and ripple-effects occurring in the US, where new bond issuance has “evaporated,” a revisit to the days of the late 1990s as it relates to a price of a barrel of crude oil cannot be ruled out. Moody’s sounded the alarm regarding a weakened pace of corporate bond issuance last week, as businesses seem to have become risk-averse in light of the extreme market volatility. To us, the implications on business investment are material, and that means pressure on US gross domestic product.
The dividends of even the “strongest” bellwethers Chevron (CVX) and ConocoPhillips (COP) can’t possibly be considered safe if we come close to the 1998 lows. A bout of nostalgia of $100+ per barrel crude coupled with a dash of recency bias may be all that’s driving the recent price rally in the black liquid from the high-$30s. There’s no reason why we won’t hit $50 or $60 per barrel again before we hit $20, but the bias to crude oil prices, in our view, remains lower.