By John Richardson, ICIS Consultant
Oil and petrochemical markets have behaved from mid-February until today as if the world is about to return to the way it was in the first half of last year.
Here is the thinking behind this behavior:
What happened from around September 2014 onward in the crude market, until mid-February of this year, was only a temporary “supply side” problem and not a demand problem. The supply problem was that the world had underestimated the rise of shale-oil production. Most people also thought that the Libyan output would be lower than it has been. Most importantly, the vast majority of analysts did not anticipate that OPEC, led by Saudi Arabia, would prefer to defend market share, rather than the oil price.
“Temporary” ended up being a lot longer than most had expected. Granted, the assumption held that supply of oil would eventually start to match the new price and cuts in production would have to result in a price recovery – if not to $100, at least to levels much-higher than we saw in January.
Sure enough, February saw a rally in oil prices, and in the case of Brent greater stability around $60 a barrel. Since then we have seen restocking by many petrochemical buyers responding to both the rise in crude oil and its newfound stability.
No purchasing manager for a plastics converter or a big consumer-goods manufacturer wants to be accused of failing to buy raw materials today, especially when the consensus view indicates that raw materials may be well more expensive tomorrow.
This is the biggest factor behind the rise in Asian petrochemical pricing since mid-February. Supply factors in some of the petrochemical markets themselves are also having an influence. For example, most notably at the moment is polyolefin.
But what this rally really comes down to is end-users changing their dominant approach from “hand-to-mouth” to “buying ahead of further oil-driven petrochemical rising prices.” Of course there is nothing wrong with this strategy. Traders, producers and buyers of petrochemicals have been absolutely right to follow this short-term trend. Most traders, producers and buyers of petrochemicals will also be right if they demonstrate extreme caution as we get closer to Q2. The reason is that the second quarter could well see another sharp retreat in oil prices. Some analysts think that a longer oil supply could drive prices down to $30 a barrel, perhaps even $20 a barrel.
But in H2 of this year, one assumption is that; oil pricing will rebound – not to $100 a barrel granted, that’s probably over for good – but to around today’s level.
This assumption rest on the notion that what could happen in the second quarter will again be temporary because of high U.S. inventory levels, the end of cold weather in the U.S. and lastly refinery turnarounds. But first of all, you need to ask yourselves this question: Why exactly did oil prices recover in February?
The rally appears to have been driven by oil traders who made use of misleading stories about US rig counts. Although the number of rigs in operation in the US has fallen, production has continued to increase. “Oil investors are making money, buying and storing oil because of the difference between the current price of oil and the price of delivery in far-off months,” wrote the Associated Press in this March 4 article.
You then need to take into account these arguments:
First, oil supply will not be turned off as quickly as many people think. In the U.S., for example, a few dollars above variable cost margins on a barrel of oil are better than no dollars at all when you have large debts to service. Saudi Arabia is also playing the “long game” as it tries to win back market share. This reduces the chances of an OPEC production cut.
Next, demand is the thing. Yes, a lot more money is now in the pockets of consumers because oil is cheaper, but when deflation takes hold, people spend less rather than more money. It is very hard to make the case that deflation today is not a major global problem. Once again it must be stressed that this is not “business as usual” in China. The problems with China’s economy will take many years to fix. The global consequences of this reform process are huge.
Lastly, on the subject of supply again, supply of energy is vastly above demand because the central bank stimulus so badly distorted our view of real, underlying, demand growth. As energy-company debts left over from this critical mistake are restructured, this will also add to global deflation.
So what is the right price for oil?
The chart above, from this ICIS article by fellow blogger Paul Hodges, is helpful in trying to answer this question. It shows that the long-term average price of crude since 1861 until 2013 was actually just $30 a barrel, inflation adjusted. You would be unwise to not at least build $30 a barrel into your scenario planning. You would be very, very unwise to not plan for extreme volatility in oil prices over the next few months and years as the world adjusts to its New Normal - whatever you think that New Normal is.