Oil Price Risks Collapse To Below $ 20 A Barrel

The bear market in commodities is already four years old, but there are risks that oil will make another final huge leg lower – contrary to anything consensus might imagine.

Although we don’t share Fed vice-chairman Fisher’s view on inflation (totally neglecting China exporting deflation and secular global debt deflation forces), he has a valid point in stating that the current oil shock is mainly supply-driven. Post-crisis, central bank Quantitative Easing has resulted in huge investment in overcapacity and thus de facto price deflation: a nice example of central banks aiming for one goal, inflation, and accomplishing the polar opposite.

 

US oil production surged to incredible levels at breakneck speed due to technological advances in fracking - all supported by a huge wall of investor money from zero interest-rate policies. And the OPEC cartel is effectively dissolved. The Arabs, as ultra-low-cost producers, will probably neglect the latest Venezuelan OPEC call in their quest for market share and basic revenues.

All the while, the broad investment community has tuned into the commodities channel over the past months. Many are looking for an oil bottom around $ 40 and a possible quick bounce a la 2008 / 2009.

There are a lot of good points made in favor of an end of the oil bear, for example by oil guru Andy Hall, to which we are quite sympathic (capex cut-off, absence of geopolitical price premium, demand picking up strongly in response to prices). Yes, the best cure for low prices is still low prices.

 

But this oil price slump is nothing like 2008 – yet. We are experiencing a short term oil supply glut and have yet to encounter a possible demand crush due to a new global recession. If such a recession were to hit before the current production overcapacity is washed out, the bottom of the already oversupplied oil market will totally fall out. Think undershoots to $ 20 in the oil spot market or perhaps even lower.

China is on everybody’s radar now, but the risks over there are still tremendously underestimated. It resembles the Japan of 1990 in many aspects. The Chinese were able to blast in a $ 600 billion stimulus program at the depth of the Lehman panic. But with debts exploding from 150% of GDP to 250% in the last six years, China is also starting to get ‘out of ammo’ regarding economic policy options – just like the rest the us. The marginal effect of every new yuan in fresh credit already dropped from 80% to nearer 25%.

An exceptionally strong current El Niño also points to a high probability of a warm North-American fall & winter. This could put additional pressure on natural gas prices, with possible spill-over effects to oil. Also worth a mention: the coming December UN Climate Change Conference in Paris. Pleas for a global carbon tax are ever-increasing after another record warm year. Even Big Oil itself calls for carbon pricing now. Shell, BG, BP, Enu, Statiol, and Total acknowledge that policy is inevitable and just want the current uncertainty to end.

To be clear: we are agnostic about the short term oil price. But we feel a global crisis could hit any time: now, or perhaps after a final concerted central bank blow-off phase. This crisis might also manifest itself as a slow-motion grinding crash, as boutes of hope are time and time again crushed due to disappointing economic growth from secular forces.

Either way: the tension in the oil market is set to rise further with increasing tail risks of an oil price blowoff - due to a supply disruption that the oil crash itself also might provoke (think escalation of Middle Eastern Sunni-Shia proxy wars / oil theft in Nigeria (current force majeure on Bonny)) – but especially of an oil price collapse (think global recession in current supply glut).

The same holds for equity & bond markets. Central bankers are walking a very thin line. They might embark on huge additional monetary stimulus to crank up asset prices once again, perhaps even resulting in a buying panic. Or they might commit to policy failures at some point and break market confidence down to the ground. Such policy failures are guaranteed to hit sooner or later.

Don’t allow yourself to be lulled into sleep should volatility settle down in the coming weeks. The financial markets are currently a much more dangerous place than at any point in the previous decades. Just how many times did you think about Greece in the past week? Don’t worry, you will again pretty soon.