Understanding The Oil Markets — 2010 Version

I'm starting to think that the oil markets in 2010 are just a more chaotic version of the markets as they were in 2007. You will recall that in 2007 oil the price was rising, demand was outstripping supply, OPEC said the markets were well-supplied, and would not raise output quotas and the Venezuelans were saying $100/barrel was a fair price for oil. Most of this has happened just in the past week. Consider these two statements made in a recent Bloomberg report—

• Global oil demand has exceeded supply by more than 900,000 barrels a day on a seasonally adjusted basis since May, Goldman Sachs Group Inc. said in an e-mailed report today. Goldman expects the world oil market to remain in deficit in the first half of next year, it said.

• OPEC maintained its output quotas, forecasting demand growth will slow as the global economy struggles to recover amid ample supplies. Oil supply and demand are “in balance,” and $70 to $80 is “a good price” for oil, Saudi Arabian Oil Minister Ali al-Naimi said at the group’s meeting in Quito, Ecuador, on Dec. 11.

Who are you going to believe? Well, you should never believe Goldman Sachs, given their constant efforts to drive up the oil price to support their index-trading money-making machine. But you should never believe OPEC either, given their constant efforts to drive up the oil price by withholding oil from the market. If $70 to $80 is a "good price" for oil, why did OPEC maintain their quotas just as the price touched $90/barrel on the NYMEX last week? One thing we do know is that OPEC producers are breaking their quotas left and right—

OPEC is breaching its production limits the most in six years, signaling the world’s biggest suppliers are ready to pump more crude next year as oil rallies toward $100 a barrel.

The Organization of Petroleum Exporting Countries excluding Iraq pumped 26.78 million barrels a day this year, exceeding the quotas by an average of 1.934 million a day, the highest level since 2004, according to data compiled by Bloomberg. Crude rose 12 percent in 2010 as demand recovered, trading at about $90 for the first time in two years. Options to buy at $100 next December are near a five-month high.

And then there's the UK consultancy Wood Mackenzie, who said worldwide oil demand posted a new record in the 3rd quarter just past—

HOUSTON, Dec. 8 — Worldwide oil demand for this year’s third quarter will set a record at 88.3 million b/d, said Wood Mackenzie Ltd., Edinburgh, in its latest analysis.

According to the report, provisional data shows that global oil demand for the recent quarter will almost certainly exceed the previous highest quarter—the fourth quarter of 2007—when demand averaged 88 million b/d.

Just 3 years from the onset of the great recession, global oil demand has recovered to the pre-recession peak seen in 2007, the report said. The analysis finds that world oil demand in 2010 will likely reach an annual average of 86.7 million b/d, 100,000 b/d more than in 2007.

Further, WoodMac expects worldwide oil demand in 2011 to exceed pre-recession levels, averaging a new all-time high of 88.1 million b/d. Oil demand in 2012 will climb to almost 90 million b/d, according to the forecast.

I'm not sure what WoodMac counts as oil. Aside from ethanol, does this very large 88.3 million figure include Crisco, extra-virgin olive oil, whatever Willie Nelson puts in his bus, palm oil, nearly-extinct-fish oil and illicit whale oil? It's not clear, at least not to me. Who knows? — maybe WoodMac is long crude oil, or at least their clients are.

And finally there is the price: as money flows into "hard" assets (like commodities) following on QE2 and other free loose money policies, the price of oil is negatively correlated with the Dollar Index. If financial considerations are driving the market, the price isn't a reliable short-term guide to the global supply and demand balance.

Or so it would appear. What does the current price really mean? Does it mean the world is well-supplied, as OPEC claims? On the other hand, if Goldman Sachs and Wood Mackenzie are right, why isn't the price $110/barrel? Or $120/barrel? Or some other completely unaffordable number?

In short, standard reporting on what's going on in the oil markets tells you next to nothing about what's really going on in the oil markets. And that's why I had a same-as-it-ever-was moment last week as I tried discern the larger trends we need to worry about. It's just like 2007 in 2010, and of course we still remember—we still do remember, right?—what happened in mid-2008.

Fortunately, there is some terra firma for us to stand on. Oil demand in the developed world (i.e. the OECD nations) is basically flat, and considerably lower than it was in 2007. All the new demand for oil is coming from emerging markets, especially China—

China's implied oil demand in November rose 13.7 percent from a year earlier to a record of nearly 9.3 million barrels per day, Reuters calculations based on preliminary official data showed on Monday [today].

And from Bloomberg as cited above—

China, which last year overtook the U.S. as the world’s biggest energy user, boosted net imports of crude by 26 percent in November from a month earlier as refineries ramped up processing rates to ease a diesel shortage. Net purchases were 20.3 million metric tons, or 5 million barrels a day, the highest since September’s record 22.9 million tons, data from the Beijing-based General Administration of Customs showed.

Refineries processed 36.65 million metric tons in November, or 8.96 million barrels a day. That exceeded the record of 8.76 million barrels a day in October.

 
Data from Reuters. Look at the difference between China's domestic production (green line) and crude oil processed (blue line) to calculate China's imports. 1 metric ton = 7.3 barrels.

Here's some advice: if you want to know what's going to happen to oil prices over the next year or two, pay attention to what's happening in China. Forget OPEC. Forget Goldman Sachs. Forget Wood Mackenzie, and forget the countless other bullshitters out there who claim they have some insight into the oil markets. As far as oil demand and prices go, it's all China, all the time.

And that's why the video below should be of some interest to you if you're wondering what's up with oil. This is Jim Chanos (hat tip, Mish) talking to CNBC about what's going on in China's increasingly shaky economy. This is the kind of thing you need to know because as goes Chinese oil demand, so goes the oil price—

The overdependence on new real estate in China, when the demand isn't there, will cause the nation to eventually "hit a wall," hedge fund manager James Chanos told CNBC Friday.

“Construction is 60-plus percent of GDP, compared to exports of 5,” said Chanos, who is the founder and president of Kynikos Associates.

“The problem is that consumption as a percentage of Chinese economy has declined in the last 10 years, from 40 to 35 percent. It’s all real estate,” he said. After the US, China has the world's second largest economy...

China has built new cities that are now essentially empty, he added. Despite the overbuilding, said Chanos, construction continues at a good clip, with 12 million to 15 million residential units this year. The units, priced similar to those for US residents, are intended for Chinese who earn about $3,500 annually and are in the bottom 20 percent of wage earners. Ironically, many of the Chinese who've moved to cities from the country are construction workers, he noted.

“When construction is 60 percent of your economy, and you are building lots of things that people don’t need, the state may let this get out of control,” he said.

 

Comments

[Morocco Bama]

Nice analysis, but of course, the discussion of oil cannot preclude the currency in which oil transactions are denominated, and the implications to the dollar, and the U.S. economy, when the switch out of the dollar is final. I stumbled upon this article from 2009 about that. It's not a bad analysis. I'm not saying I endorse it wholesale, but I do agree with some of the points raised. It's worth a read and pertinent to that topic. Also, the comments are insightful and thought-provoking.

http://www.ianwelsh.net/what-not-buying-oil-with-dollars-means/