Trap Doors Open for Oil

Monday 3 June 2019

When trap doors open in the oil futures market, it’s a sign of overextended risk positioning. The troubling outlook for oil demand growth has been building for several years now, since the 2014 crash when crude lost its grip on the $100 level. Since that time, the benchmark ETF for the Oil and Gas Services industry, OIH, has sent a consistent message that that oil will eventually become a no-growth business some years from now. Despite this longer-term probability, oil like all commodities has to contend with the daily ebb and flow of short-term dynamics. Accordingly, oil prices have traded in a fairly wide band, roughly $40 to $70, the past few years. But the return of trap-doors this past week, when oil fell several dollars at a time in step-down fashion, was the result of a market that’s mistakenly ignored more immediate problems with slowing growth.

One surprise is that many energy traders themselves seem surprised. Perhaps we did not appreciate the extent to which a number of bad and wrong ideas about oil had taken hold. Here’s one: that OPEC production cuts are supportive of prices. That’s the kind of thesis more often held by novices rather than veterans. And yet, here we are. To review, OPEC production increases are counterintuitively bullish for prices because they prove that more supply is needed to serve a growing market. OPEC production cuts are bearish for prices, for the opposing reason. But there’s an additional problem with OPEC cuts: they translate directly into OPEC spare production capacity—which is also bearish. This raises a question: what made energy traders hope the market would be unaffected when OPEC spare capacity moved from a 2018 average of 1.5 mbpd to a 2.0 mbpd level starting in 2019? No reason at all, it would appear.

The more perplexing case of market denial has been the failure to incorporate the growth crash in China’s vehicle market, and the fact that road fuel demand, which started declining in China last year, has picked up the pace of decline this year. Not to mention that US gasoline demand has opened up into a third year of no-growth, and now, according to weekly data, total oil demand in the US has also turned flat.

China’s total demand growth is still very much in positive territory, but continues to decelerate. While I remain confident in my forecast that China’s total oil demand will start to flatline early next decade, it’s encouraging that perennially bullish analysts on China have at least made one concession: China’s oil demand growth is not going to follow the 20th C example set by the US, and it will drop to a low, year-over-year growth level.

And that’s just the demand side. On the supply side, US oil production stood at 9.9 mbpd in January of 2018, 10.9 mbpd by July, and 11.9 mbpd by December. I won’t name names, but an energy focused fund manager on Twitter recently expressed exasperation that oil prices were falling again, given that “US oil production continues to stall.” As the kids like to say, LOL uhmm wut? Sure, US production has been stalling for several months now …above 12.00 mbpd! The rate of US supply growth now well exceeds notable previous examples, as when Russia rapidly poured on supply from 2001-2004 during a global economy recovery.

The scary prospect for the global oil industry, led at the moment by the United States, is that it’s got itself up to a ramming speed, right as the global economy has slowed down. Let’s be honest: the effects on global GDP from US-launched tariffs was a risk that first appeared on the scene over 18 months ago. And in slow procession a number of economies, Europe, and now China in particular, are beginning to reveal the impacts. Contrary to the view in oil markets that a supply problem was imminent, OPEC spare capacity, and now US capacity muscle-flexing, together show we would have an enormous problem with oil capacity surpluses, not deficits, were the global economy to stall for 2 quarters. Trap doors are a way for the oil market to correct its mistake(s), especially if we do undergo a period of weak global growth. The price risk in oil remains very much to the downside. And, unlike the 2014 crash which eventually recovered, oil’s current journey towards the $40’s —given all other trends in transport electrification—could turn from short-term holiday to long-term destination.

Solar has become so cheap, and many existing coal plants in the US Southeast so uneconomic, it would be profitable to close some coal plants and replace them with solar. The kicker: such a business proposition would still hold true, even when taking into account the losses from turning some coal plants into stranded assets. That’s the conclusion of Tyler H. Norris, director of Regulatory Affairs at the South Carolina Business Alliance and also director of market development at Cypress Creek Renewables. More interesting is that when Norris released his findings on Twitter, it prompted a useful response and discussion with Tom Echols, Commissioner with the Georgia Pubic Service Commission. Echols seemed to interpret the Norris findings as a suggestion to close all existing coal plants, which seems a misreading of the findings. That prompted the following exchange(s):

As the great retirement wave of coal plants continues, the US is essentially replacing them with a 1-2-3 punch of new natural gas, new wind, and new solar. We’re definitely not going to replace all the coal plants in the near term, but the argument to replace many is only getting stronger. Optimists theorized, just a few years ago, that existing coal plants would survive for a long time to come, impervious to cheaper options and settled comfortably, as they were, in the domain of incumbency. Alas, we are moving more quickly than even the optimists anticipated. Here is a link to Norris’ full deck.

In Los Angeles, Mayor Eric Garcetti has announced a new round of aggressive clean energy targets. In my view, however, they are insufficient to the task. In short, Los Angeles has pursed an excellent strategy so far to encourage energy transition. One of the first cities to establish a feed-in-tariff for solar, the city has laudably invested in rail transport, charging stations for EV, bike infrastructure, and now terrific plans to resurrect large assets like the Los Angeles River. Most notably, in contrast to the Bay Area, LA is fully aware new rail lines can leverage adjacent land blocks, bringing new housing opportunities into the system.

Underneath the surface of Garcetti’s new plan however is a studious avoidance of the inevitable. Now that road-pricing is taking off in a number of global cities, it must be stressed that simply relying on the adoption curve of EV is not going to bring Los Angeles quickly enough into line in any effort to curb emissions. So Garcetti can call his next initiative a New Green Deal for Los Angeles, but really, he is doing little more than free-riding now on existing state plans. To put this plainly, as the state’s largest metro area and host to the largest concentration of vehicles, Los Angeles should be running ahead of policy-flow from Sacramento. The stated efficiency goals for buildings, wastewater recycling, and tree-planting are all necessary. But they act, in this case, as a clever way to avoid the more politically difficult decision—the one that addresses the elephant in the room. Cars. LA Cars. All 6 million of them, for which Los Angeles now needs to introduce road pricing.

The growth rate of combined wind and solar generation has slowed down, in the United States. In 2016, combined wind and solar generation grew by 22.68%. In 2017, by 17.64%. But in 2018, they grew by 11.92%. And through the first quarter of 2019, again, by just 11.17%. While we can never extrapolate accurately from first quarter data, it’s a continuation, so far, of last year’s slow growth. US states like Arizona, New Mexico, Utah, Colorado, and Texas are getting started now in the solar game, but to match the first big wave of utility scale solar which began in California more than five years ago, these southwestern states are going to have to seriously pick up the pace. After all, that’s where the sunshine resources are. Truth is: states like Iowa and Oklahoma have done a far better job deploying wind power, than Arizona, Utah, or Texas have done deploying solar.

The offsetting good news is that combined wind+solar continue to make good share gains, in total US electricity generation. Even if the slow 11% growth rate were maintained this year, that would still push the combined generation totals from 371 TWh to 412 TWh. In a total US electricity system that has plugged along for a decade—not declining much and not growing much, around 4000 TWh—that means wind+solar are about to notch their first 10% share. That share growth can grow nicely, even as absolute growth has slowed, offers a lesson to all sectors—especially the auto sector—of what happens when a new technology appears at a time when the total addressable market itself is not growing.

Gregor Macdonald


The Gregor Letter is a companion to TerraJoule Publishing, whose current release is Oil Fall. If you've not had a chance to read the Oil Fall series, the single title just published in December and you are strongly encouraged to read it. Just hit the picture below.