Achieving price equilibrium

JEFF BARRY, WARWICK ADVISORS CORP., HOUSTON

IN HIS EDITOR'S COMMENT in March, OGFJ's Don Stowers said he seldom hears a convincing explanation as to why crude oil prices decreased last year and why they will increase to a forecasted level this year. That resonates with me, if only because some of the people making these predictions have an agenda. I do not have an agenda, but I am inspired to offer my explanation. My assessment is based on observation and various experiences in the global market.

THE DECREASE (2014)

Starting in early 2014, the Federal Reserve Bank stated its intent to end Quantitative Easing (QE) later in 2014. (I believe that after discounting various fluctuating political risk premiums, the main reason that crude oil prices exceeded the US$80-US$85 range was the QE program.) While not specific on the end-date, investors (hedge funds, et al) started taking this seriously, and by February, those investors in WTI contracts (traded on NYMEX) began an orderly liquidation of their contracts. This is observable from Cushing inventories steadily decreasing from the mid 40s (million barrels) in February to almost 10 by October. There was a gradual decrease in WTI prices from this operation, but nothing notable.

However, in October, the QE actually stopped and the investors in Europe (also feeding off the QE) were shocked (or didn't get the memo earlier in the year) and began an extraordinarily rapid liquidation of Brent contracts (traded on ICE). Some might call this panic selling. Whatever the name, the result was a drastic decrease in the crude oil price in Europe. That reflected on the NYMEX with WTI.

The aforementioned are observations. What follows is the experiential hypothesis. As the commodity price was on the downward trajectory, the panicked (and embarrassed) Brent contract sellers in Europe began to put out stories that the Saudis had to decrease their production to put the supposed imbalanced supply and demand balance back into balance.

As the Saudis were involved in their own situation with Iran and Iraq, I believe they were taken by surprise by the concept that they now had to step in and solve a problem that was not an oil markets problem, but in reality a money markets problem. I also believe the Saudis were further surprised when they refused to decrease their production and were characterized to be at war with all shale oil and gas producers in the US. This "war" was amplified in the US by media already against shale fracking. The story was not only repeated in multiple variations, but became accepted as reality - the conventional wisdom.

More interestingly, the Saudis (and others in Europe) picked up on the story in November and December, further embellishing it. But when there were no media-demonstrable results from American shale producers reducing oil production, complaints from Oman to Nigeria, and the appearance of the Saudis losing the "war on American shale" in February and March, they started walking backward their leadership in war on shale. (I could provide entertaining comments on the ridiculousness of the war on shale story, but I am focused on the commodity price question.)

Was the global supply and demand balance out of sorts at the time or were there other factors for reasonable consideration? My conclusion is that "out of balance" money market investors panic-sold crude oil contracts to raise cash. They were embarrassed and created a story that grew on its own. Physical supply and demand fundamentals were not involved at the time.

It is also important to note that although E&P companies were peripheral to the main event, they have used it to bring down operational cost structures, an area of complaint for the past few years. I acknowledge that "everyone" has a crude oil price predictive model with hundreds of variable inputs. We all have friends who can go on and on about their models, but these quantitative formulas do not take into consideration the qualitative aspects of panic and embarrassment along with ridiculous explanations and amusing excuses that always seem to follow.

THE INCREASE (2015)

The economic situation in Europe is bleak, and the thinking is confused. By my observation, productivity is moribund. No matter what numbers are published, consumption of generally everything is slow, including transportation fuels and natural gas (used in heating, electricity, and industry). One example: the cost of electricity to people in Germany is astonishingly high compared to other industrialized countries.

What to do? Well - the European Central Bank (ECB) stepped up (right in the middle of the Saudi war on shale) in February and announced its European QE program -- €60 billion of newly-created cash infusions per month into banks until they hit €1 trillion. The QE of the ECB started about the third or fourth week of March 2015. I believe that in three or four months, investors accessing cash from the banks disbursing the QE will start migrating a growing portion of such cash into the largest and most liquid commodity on the planet, crude oil. Brent contracts will have more buyers than sellers, and Brent contract prices will increase. Within a few weeks after these increases in Europe, Brent price increases will start reflecting into WTI contract prices on the NYMEX.

I believe the money markets will drive crude oil prices to my equilibrium price level of ~US$79, a price I believe can continued until there is clarity on the Chinese consumption question.

The conventional wisdom is that the money markets are just reacting to physical crude oil supply and demand imbalances and constraints. (Where were the supposed imbalances and constraints in October and where are they now in April?) I disagree with the conventional wisdom as I see the instability in the money markets from QE programs causing upward and downward pricing movement of crude oil and other commodities. Moreover, instability in the money markets also drives the value of the US dollar versus other currencies in affecting crude oil prices. My conclusion is that the ECB's QE program will ultimately increase the commodity price of crude oil through Brent and WTI trading contracts in the third quarter of 2015 to US$79 (±US$4).

REAL ISSUES

There are three real issues/questions (still not addressed by the financial news media):

• First, understanding why the Saudis, Iraqis, and Iranians are continuing their price discounting battle in favor of the Chinese government.
• Second, understanding why the Russian government does not reduce its collective production from 10.5 MMbbl/d to 9.5 or 9.8 MMbbl/d and see if the commodity price jumps to the US$70s or US$80s and assume a bigger global leadership position as a contra to OPEC.
• Third (and most important), no one really knows how much crude oil is being refined and consumed in China, and Chinese crude buying and refined products consumption patterns might be a key to understanding the discounting in the Middle East along with future crude oil prices.

There have been and continue to be implications developed within the international news media using their sanctimonious rear view mirror superficiality that charges many in the independent E&P sector with poor management, over spending, over production and other malfeasances. However, I find that in reality independent upstream and midstream company managements are positively reacting to perfidious actions of central banks and their instrumentalities in the financial markets rather than to fundamentals of global and American oil and gas consumption and supply issues. Oil and gas company managements must remain flexible in addressing erratic changes in the financial markets that ultimately affect commodity prices.

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