Submitted by Tyler Durden on 07/01/2022 19:30 -0400

The Current Oil Price Slump Is Far From Over

The oil price collapse of 2014-2015 began one year ago this month (Figure 1).  The world crossed a boundary in which prices are not only lower now but will probably remain lower for some time. It represents a phase change like when water turns into ice: the composition is the same as before but the physical state and governing laws are different.*

Figure 1. Daily crude oil prices, June 2014-June 2015.  Source: EIA.
(Click image to enlarge)

For oil prices, the phase change was caused mostly by the growth of a new source of supply from unconventional, expensive oil. Expensive oil made sense only because of the longest period ever of high oil prices in real dollars from late 2010 until mid-2014.

The phase change occurred also because of a profoundly weakened global economy and lower demand growth for oil. This followed the 2008 Financial Collapse and the preceding decades of reliance on debt to create economic expansion in a world approaching the limits of growth.

If the cause of the Financial Collapse was too much debt, the solution taken by central banks was more debt. This may have saved the world from an even worse crisis in 2008-2009 but it did not result in growing demand for oil and other commodities necessary for an expanding economy.

Monetary policies following the 2008 Collapse produced the longest period of sustained low interest rates in recent history. As a result, capital flowed into the development and over-production of marginally profitable unconventional oil because of high coupon yields compared with other investments.

The devaluation of the U.S. dollar following the 2008 Financial Collapse corresponded to a weak currency exchange rate and an increase in oil prices.  The fall in oil prices in mid-2014 coincided with monetary policies that strengthened the dollar.

Prolonged high oil prices caused demand destruction. This also allowed the expansion of renewable energy that could compete only at high energy costs. Concerns about global climate change and its relationship to burning oil and other fossil energy threatened the future interests of conventional oil-exporting countries. OPEC hopes to regain market share from expensive unconventional oil and renewable energy, and to renew demand for oil through several years of low oil prices.

OPEC increased production in mid-2014, and decided not to cut production at its November 2014 meeting   By January 2015 oil prices fell below $50 per barrel.

Most observers expected a sharp reduction in U.S. tight oil production after rig counts fell with lower prices. Production fell in early 2015 but recovered as new capital poured into North American E&P companies. This and the partial recovery of oil prices into the mid-$60 per barrel range gave expensive oil another day to survive and fight.

If capital continues to flow to unconventional oil companies and OPEC’s resolve stays firm, oil prices could average near the present range for many years. Oil prices will probably fall in the second half of 2015 as the ongoing production surplus and weak demand overcome the sentiment-based belief that a price recovery is already underway.

Oil prices must inevitably rise as unconventional production peaks over the next decade and oil-exporting countries increasingly consume more of their own oil. Politically driven supply interruptions will inevitably punctuate the emerging new reality with periods of higher prices.

For now, however, we have crossed a boundary and notions of normal or business-as-usual should be put aside.

A New Supply Source and Over-Production 

The main cause of the price collapse of 2014-2015 was over-production of oil.  Most of the increase came from unconventional production in the United States and Canada–tight oil, oil sands and deep-water oil. From 2008 to 2015, U.S. and Canadian production increased 7.65 million barrels per day (mmpbd). During the same period, non-OPEC production less the U.S. and Canada decreased 2.85 mmbpd and OPEC production increased 1.79 mmbpd (Figure 2).

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Figure 2 . World liquids production since 2008 and the relative shares for the U.S. & Canada, OPEC and non-OPEC less the U.S. and Canada.
Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

North American unconventional and OPEC conventional production increased almost 4 mmbpd in 2014 alone (Figure 3).

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Figure 3. U.S. + Canada & OPEC Liquids Production Since January 2014. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Through 2013, unconventional production growth was matched by decreases in OPEC production mostly from supply interruptions due to political events (Figure 4). The result was that prices remained high despite increases in unconventional production.

         
Figure 4. U.S. + Canada & OPEC Liquids Production Growth, 2011-2015. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

OPEC responded to defend its market share in mid-2014 by increasing production. Prices started falling in late June 2014 from $115 per barrel (Brent) and reached a low in late January 2015 of $47 per barrel after OPEC decided not to cut production at its November 2014 meeting.

Unconventional production slowed and fell in early 2015. Then, prices increased beginning in February and Brent has averaged $63 per barrel since May 1 (WTI average $59 per barrel). Over-production continues as different parties struggle for market share, for cash flow to survive, or both.

If high oil prices created the conditions for unconventional oil to grow and challenge OPEC’s market share, then prolonged low oil prices must be part of OPEC’s solution.  By keeping prices below the marginal cost of unconventional production (about $75 per barrel), OPEC hopes that expensive oil production will decline along with the fortunes of the companies engaged in these plays.

Decreased Demand and Demand Destruction 

OPEC is as concerned about long-term demand as it is about market share. Oil is the only major source of revenue for many OPEC countries and low demand, potential competition from other fuel sources, and the effect of a perceived link between oil use and climate change are existential threats.

Demand growth for oil has been declining since the late 1960s (Figure 5).  OPEC hopes to stimulate demand through low oil prices back to the peak levels that existed before the price shocks of the 1970s and 1980s.

Figure 5. World Liquids Demand Growth.  Source: BP, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Demand destruction followed periods of high oil prices from 1979-1981 (Iran-Iraq War) and from 2007-2008 (demand growth from China).  2010-2014 was the longest period in history–33 months–of oil prices above $90 per barrel in real dollars (Figure 6). Since 2011, demand growth has fallen to only 0.5% per year so far in 2015 (Figure 5).

Figure 6. Crude oil prices more than $90 per barrel in 2015 dollars. Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Prolonged low oil prices may restore growth to the global economy accomplishing what the central banks have failed to do since 2008. If successful, interest rates should rise and this may restrict the flow of capital to unconventional E&P companies. Most of the capital provided to these companies comes from high-yield (“junk”) corporate bond sales, preferred share offerings, and debt. In a zero-interest rate world (Figure 7), these provide yields that are are much higher than those found in more conventional investments like U.S. Treasury bonds or money market accounts. If interest rates increase with a stronger economy, capital may flow to more productive investments that offer yields that are more competitive with higher risk tight oil offerings.

Figure 7. Federal funds interest rates January 2000-June 2015 and Brent crude oil price.
Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Over-Production Continues

The over-production that began the oil price collapse continues and has gotten worse. The global production surplus (production minus consumption) has gone on for 17 months and has grown from 1.25 mmbpd in May 2014, just before prices began to fall, to almost 3 mmbpd in May 2015 (Figure 8).

Figure 8. World liquids production surplus or deficit and Brent crude oil price. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

We may take some comfort that the rate of increase has slowed but it is difficult to explain the increase in prices over the last few months based on supply and demand.

The production supply surplus that is largely responsible for the current oil-price collapse is not a trivial event that will likely go away soon unless production is cut either by unconventional producers or OPEC. Earlier production surpluses in May 2005 and January 2012 were higher than today but were short-lived and related to specific non-systemic factors (Figure 9).

Figure 9.  World liquids relative production surplus or deficit and Brent price in 2015 dollars, 2003-2015. 
Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The present supply imbalance is structural and persistent. The only comparable episode in recent history was the production deficit immediately before the 2008 Financial Collapse that lasted 11 months. It was driven by growing Chinese and other Far East demand and by dwindling oil supplies following the peak of conventional production in 2005.

For now, OPEC appears committed to continued over-production to achieve its goals. Its production increased 1.4 million barrels of liquids per day during the last year (Figure 3) and some analysts suggest it might increase by an equal amount again in coming months.

Meanwhile, U.S. production has not fallen much so far. Production from the main tight oil plays fell about 77,000 bpd in January 2015, was basically flat in February and increased 51,000 bpd in March (Figure 10). This is partly because companies are high-grading well completions in the best parts of the plays. It is also because of the backlog of drilled but uncompleted wells that are being brought on production at a fraction of the incremental cost of drilling new wells.

Figure 10. Oil production from tight oil plays in the U.S. Source: Drilling Info and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

But the most significant factor is that capital flow to U.S. unconventional plays has increased. Figure 11 shows that almost $17 billion in equity offerings flowed to U.S. oil companies in the first quarter of 2015, more than in any other period since 2010. The percent of E&P equity rose to over 10% of overall issuance from an average of about 4-5% over the last decade. This can only be explained because there are no alternative investments with comparable yields and that investors believe that they are buying assets that are somehow viable at current oil prices.

Figure 11. Capital available to U.S. E&P companies in the first quarter of 2015. Source: Wall Street Journal.
(Click image to enlarge)

Tight oil companies have made the case that through increased efficiency and lower service costs that their economics are better at lower oil prices today than they were at $90 per barrel prices a few years ago. First quarter (Q1) financial results do not support this claim.

In fact, tight oil companies are losing more than twice as much money in Q1 2015 as they were in 2014. On average, companies that were spending $1.40 for every dollar they earned from operations last year are now spending $3.20 for every dollar earned (Figure 12).

Figure 12. First quarter (Q1) 2015 vs. full-year 2014 capital expenditures-to-cash flow from operations ratio.
Source: Google Finance and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Follow The Money

The strength of the U.S. dollar provides a simple and generally reliable way to cut through the complex factors that govern oil prices. A negative correlation exists between the strength of the U.S. dollar and the price of oil (Figure 13). This correlation is particularly strong beginning in about 1997.

Figure 13.  U.S. Federal Reserve Board broad dollar index and CPI-adjusted Brent and WTI crude oil prices.
Source:  Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The relationship is key to understanding the current oil-price collapse. Figure 14 shows the daily exchange rate of the U.S. Dollar and the Euro in relation to Brent and WTI crude oil prices.  The onset of price decline coincided with a stronger U.S. dollar beginning in June 2014 that may be related to the end of quantitative easing and to an improving U.S. economy.  The recent increase in oil prices in 2015 corresponds to weakening of the dollar that may reflect disappointingly weak first quarter 2015 U.S. GDP growth.

Figure 14. U.S. dollar/Euro exchange rate, Brent and WTI prices. Source: EIA, Oanada and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The standard explanation for the relationship between the dollar and oil price is that global oil transactions are carried out in U.S. dollars. When the dollar is weak against other currencies, oil prices are higher and when the dollar is strong, oil prices are lower. In other words, a stronger U.S. economy and currency may reduce oil prices and vice versa. While the observation is accurate, the explanation is more complex.

Oil and other commodities are hedges against economic risk and uncertainty. Oil prices increase and decrease as risk perception rises and falls. High oil-supply risk or “fear premiums” generally manifest as short-lived, upward price spikes that are quickly integrated into forward price expectations. Following the initial shock of oil-supply risk, U.S. Treasury bond and related “flight-to-safety” investments tend to lower oil price trends as the U.S. dollar appreciates.

Supply and demand balance operates as a first-order cycle against which economic uncertainty and geopolitical risk fluctuate as second- and third-order cycles. When a  first-order supply imbalance coincides with second- or third-order economic or geopolitical factors, an upward or downward price-cycle may develop. Higher energy costs are a weight on the economy that may lower currency values.  Conversely, lower energy costs may lift the economy and currency values.

The U.S. is the world’s largest economy and the U.S.dollar is the world reserve currency. This makes the U.S. dollar a fairly reliable reflection and measure of all of these factors.

The 2014-2015 oil price collapse may be understood then as a supply surplus that occurred at a time of a strengthening U.S. economy (low economic uncertainty) and relatively low geopolitical risk (Figure 15).  The additive effect of these three cycles was a sharp decline in oil prices.

Figure 15. World liquids production or surplus, Brent price and U.S. dollar index.
Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Are Low Oil Prices Long or Short Term?

Oil price collapses in 1981-1986 and 2008-2009 are the only analogues for the present price situation (Figure 16). So far, the current price collapse seems more similar to 1981-1986 than to 2008-2009.

Figure 16. The 1981-1986 and 2008-2009 oil price collapses in the context of OPEC and
non-OPEC oil  production, oil consumption and Brent crude oil price in 2014 U.S. dollars.
Source: BP, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

1981-1986 was a long-term event. The price collapse itself lasted for 5 years but oil prices remained below $90 per barrel in real dollars until 2007, almost 27 years.

2008-2009 was a short-term event. Prices began falling in July 2008 and reached a low point in December 2008. Prices recovered and reached $90 per barrel in April 2010 and $100 per barrel in March 2011. Then entire cycle from $90 per barrel and back again lasted a little more than 2 years.

The oil price collapse of the 1980s was similar to the present price collapse because the primary cause was a new source of supply. Non-OPEC production exceeded OPEC production in 1978 as new supply from the North Sea (U.K. and Norway), western Siberia (Russia), the Campeche Sound (Mexico) and China came on line. Unlike the present, the new supply was inexpensive conventional oil.

Oil prices had increased in 1979-1981 to more than $90 per barrel in real dollars because of supply interruptions at the beginning of the Iran-Iraq war. This caused approximately 4.3 mmbpd of demand destruction. Lower demand and continued supply growth from non-OPEC countries caused a production surplus beginning in 1982.

Oil prices fell from $106 per barrel in 1980 to $31 per barrel in 1986. OPEC cut 10 mmbpd of production between 1980 and 1985 with no effect on falling oil prices. In 1986, OPEC decided to increase production to protect market share, abandoning its role as “swing producer.”

Although neither the volume of new supply or the amount of demand destruction during the current price collapse are as great as 1981-1986, they are more similar than to 2008-2009.

The 2008-2009 oil price collapse was part of an overall crash of the entire global economy. High oil prices in 2007 and 2008 were due to a large and persistent production supply deficit because of high demand from China and the Far East, and dwindling supplies following the peak of conventional oil production in 2005 (Figures 15 and 17). The surplus had nothing to do with new supply but was completely due to decreased demand from a collapsing global economy. The surplus only lasted for 6 months and never approached the level seen in 2014-2015 (an OPEC production cut  in early 2009 limited the length of the surplus and possibly its magnitude).

Figure 17. World liquids production surplus of deficit (12-month moving average) and Brent oil price. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

High oil prices preceding the 2014-2015 price collapse began because of supply interruptions resulting from the Arab Spring. Brent price reached a maximum of $129 per barrel in April 2011 at the height of the Libyan Civil War. These events corresponded with a period of U.S. currency devaluation following the 2008 Financial Collapse and an extraordinarily weak U.S. dollar (Figures 13 and 15). The additive effects of a supply deficit, economic uncertainty and geopolitical risk resulted in high oil prices.

Case histories neither predict the present or the future but offer guidelines. These two case histories simply suggest is that the present period of low oil prices is more similar to that of the 1980s and 1990s than to that of the 2008-2009 period. That similarity means that the current phenomenon is likely to be a relatively long-term event.

Conclusions

The availability of capital to fund unconventional production is the key to how long low oil prices will last going forward. If the flow of capital continues, then the production surplus and lower oil prices will also continue, assuming that OPEC is able to maintain higher production levels and that demand growth remains relatively low.

Eventually, price will win and unconventional production will fall. The market will rebalance and prices will rise. If oil prices stay low for long enough, demand will increase to support those higher prices. I doubt that prices will increase to levels before mid-2014 barring politically driven shock events. $90 per barrel appears to be the empirical threshold price above which demand destruction begins.

It is more difficult to predict how the second- and third-order effects of economic uncertainty and geopolitical risk may affect supply and demand fundamentals and, therefore, price.  These are the wild cards that could change the  outcome that I describe.

The most likely case is that oil prices will decrease in the second half of 2015 and that financial distress to all oil producers will increase. The hope and expectation that the worst is over will fade as the new reality of prolonged low oil prices is reluctantly accepted.

We have had a year of lower oil prices. Based on available data, I see no end in sight yet. The market must balance before things get better and prices improve. That can only happen if production falls and demand increases. That will take time.

We have crossed a boundary and things are different now.

US DOLLAR SHORTAGE - Fed a Reluctant Dollar Bull

"The Fed is a reluctant Dollar bull," explains Goldman Sachs, noting that Yellen inadvertently revealed the FOMC's expectation that coming policy changes will boost the greenback. Broadly speaking the rest of the sell-side has herded along into the strong US Dollar camp with only Unicredit (rate shift may slow recent very strong USD momentum) and Morgan Stanley (suggesting USD corrective activity) backing away from full dollar bull though most suggest adding to dollar longs on any dip as the most crowded trade in the world gets crowded-er.

Goldman Sachs: The Fed Is A Dollar Bull

1. Price action around the last FOMC was jarring. The drop in the Dollar in the immediate aftermath of the meeting was greater than during the “no taper” surprise in September 2013 (Exhibit 1) and conviction that the USD can rally from here has taken a beating.

We have a different take and continue to see large upside for the Dollar. Our reasoning is simple. On the surface, there is no denying that last week was a dovish shift, no doubt in response to the sharp rise in the Dollar in the run-up to the meeting. But what does that shift really signal? In our minds, it is an implicit admission that the normalization of monetary policy – a return to data dependence and lift-off – will boost the Dollar. Last week’s actions thus inadvertently revealed the Fed’s expectations for the greenback, which are that coming policy changes will likely boost the Dollar. In a sense, last week was reminiscent of the SNB’s decision to de-peg in January. That action implicitly signaled an expectation that the Euro could weaken a lot more, making the peg increasingly unsustainable. That “forecast revision,” made in the run-up to the ECB's QE, has of course been borne out. Like the rest of us, central banks have implicit currency views, though in the case of the Fed we have to infer those from actions rather than words. Last week’s switch from “patient” to “not impatient” signaled that normalization is coming, but a reluctance to do so in June, for fear that Dollar strength will get out of hand. The Fed is a reluctant Dollar bull.

2. Of course, it is quite possible that the pace of Dollar appreciation slows from that seen since Chair Yellen’s Humphrey-Hawkins testimony (Exhibit 2). But that is hardly a heroic statement.

The Dollar has seen outsized gains versus the majors recently, which – as discussed in our last FX Views – reflect Dollar positioning that was too pessimistic (it felt to us like the market was expecting a repeat of the kind of weak data we saw a year ago) and rising focus on “patient” coming out of the FOMC statement. It is perfectly normal for the Dollar to consolidate after such a move. Indeed, following large moves, the USD has tended to trade sideways for several weeks at a time. This time is no different most likely, i.e. this is not the end of the bull-run for the Dollar.

3. There is no doubt that the hurdle has risen for labor market data, which Chair Yellen highlighted in giving the FOMC “reasonable confidence.” But it is also important to remember the bigger picture. The bulk of the Dollar rise has been the Euro and Yen weakness, a reflection of regime change at the BoJ and ECB that pushed the 2-year differential sharply in favor of the Dollar (Exhibit 3).

This is why, in our minds at least, the Dollar has been resilient to relatively mixed data in recent months. As such, the hurdle for the Dollar is not really all that high after all. There is an additional facet to this. Last week, Chair Yellen talked back the removal of “patient,” downplaying a June lift-off by saying the Fed would “not be impatient.” Forward guidance, in other words, did not quite leave this time around. Its full removal is another Dollar positive catalyst, which we believe should see the 2-year differential converge further towards the forwards, boosting the Dollar (Exhibit 4).

4. We know we may sound like perma-Dollar bulls. We are not. There will be a turning point, but in our minds that will come once we have gone a lot further towards normalization.

Markets will inevitably front-run monetary policy normalization, so the turn will likely come before the Fed funds target reverts to its historical average.

But is that moment at hand, before the Fed has been able to fully let go of forward guidance, let alone lift-off? We think not.

*  *  *

And the rest of the sell-side seems to agree... though positioning varies... (via Bloomberg)

Barclays (strategists incl. Dennis Tan)

• Moved estimate for timing of Fed’s first rate hike to Sept. from June following changes to FOMC’s projections; expect target range for federal funds rate to reach 50-75bps in Dec., vs 75-100bps before
• Don’t expect medium-term downward trend in EUR/USD to change after dovish Fed surprise; use rebound as opportunity to establish short positions at a better entry level
• Local data likely to weigh on pair this wk on expectations of slightly firmer U.S. CPI (look for headline reading of +0.3% m/m, core CPI of +0.2% m/m ) and softer euro-area flash PMIs (expect flash composite  PMI of 53.5)
• Forecast U.K. March CPI inflation to fall to 0.0% y/y, RPI inflation to drop to 0.8% y/y; may provide some upward pressure to EUR/GBP
• Yuan rebound may be short-lived, sell on rally

BNP Paribas (strategists incl. Vassili Serebriakov)

• The Fed eliminated “patient” but sounded dovish; case for USD appreciation remains intact
• BNP re-enters long USD/JPY at 120.50, targeting 125 with a 118.50 stop
• Recommends buying a 3-mo. EUR/GBP call, financed by a 1-mo. put with expiry before the May 7 U.K. elections, given likelihood of a hung parliament
• All eyes on U.S. and U.K. inflation data in wk ahead
• Goes long EUR/SEK at 9.20, targeting 9.60 with a 9.0550 stop
• SEK appreciation appears to be raising Riksbank concern;  with further easing probable, risk-reward favors SEK shorts

BofAML (team incl. Athanasios Vamvakidis)

• Strong USD will lower real GDP growth and inflation, delaying first rate hike to Sept., or even later
• This could slow USD appreciation in short term, but expect mkt to continue taking advantage of any USD dips to buy more
• Increased concern about negative scenarios in Greece, which could trigger further EUR downside
• Recommends buying a 3m EUR/JPY put spread, as a continued fall in EUR/USD could weigh on risk sentiment given its positive correlation with equities
• Remain constructive on peripheral spreads with carry trades expected to get further boost from QE and TLTROs

Credit Suisse (team incl. Ray Farris)

• USD sensitive to weak data surprises in light of last wk’s Fed press conference as they could further support expectations that FOMC will wait for longer before hiking
• Remain fundamentally USD bullish; use consolidation to add longs at better levels, especially vs EUR
• EUR-specific drivers likely to be on the back burner for the time being; remain EUR bearish, think slow-and-steady increase in Greek bond yields could be a harbinger of increased volatility, potential credit risk down the line
• Turned bearish on GBP, on view low inflation and election risk will increasingly weigh on currency
• Expect Japan core CPI ex VAT hike to continue moderating, to 0.1% y/y; bias remains for USD/JPY topside towards CS’s 3-mo. forecast of 125
• Risk is still for a weaker CNY and CNH trajectory with outflows likely to remain high in the coming mos. and CNY trade-weighted index at a record high

Societe Generale (team incl. Olivier Korber)

• Dovish Fed switch could trigger USD profit-taking in coming wks; EUR/USD should ultimately reach parity even as road will be bumpier from here
• Relief rally in EM assets on back of Fed to be short-lived; ready to fade rally, remain tactically bearish on GEM
• In EM FX, still want to sell TRY, while call for steeper curves in a number of local rates markets, especially Poland and Korea
• Sudden end of former Swiss FX policy has severely challenged credibility of potential future SNB actions, including FX interventions; limits scope of CHF weakness
• CHF strength and deflation raise the possibility of a liquidity trap
• Initiate long NOK/SEK spot position; revived monetary-policydivergence should lift pair toward 1.10

Morgan Stanley (team incl. Hans Redeker)

• Removing the word “patient” from FOMC statement has increased Fed’s flexibility to tighten whenever it sees the need to act
• Yield and interest-rate differentials have become less dollar-supportive, suggesting USD corrective activity
• USD exposure reduced, tightened stops on remaining USD long positions
• Trades such as long JPY/KRW and long CLP/COP provide relative value
• Greece and local French elections next weekend are EUR-specific risk events, limiting euro rebounds
• CAD/JPY shorts offer value, with the steep fall of oil prices undermining the CAD outlook
• Further commodity-price weakness isn’t fully priced in

UniCredit (strategists incl. Vasileios Gkionakis)

• FOMC’s downward shift in interest-rate projections may halt recent very strong USD momentum
• Therefore, most important U.S. data – CPI and durable orders - unlikely to re-ignite strength across the board
• Euro-area data have potential to push EUR/USD even higher
• Preliminary March EMU PMI surveys should post fourth consecutive increase for both manufacturing and service
• Together with a stronger German Ifo Business Climate for March, likely to offer EUR/USD more fuel
• Any further deterioration in Japan Feb. inflation will keep the market warm to the possibility of additional stimulus
• High level of uncertainty around general election, dovish BOE likely to weigh on the GBP; CPI release might add some pressure

*  *  *

So, The Sell-Side would like you to buy Dollars (from them) on every dip...

And then Stan Fischer  explained...

• *FISCHER SAYS DOLLAR WON'T KEEP RISING FOREVER.

Wait what?!

*  *  *

Reflecting on today's significant weakness in the Dollar, the Goldman traders noted...

USD weakness continues today but unlike last week the move today was on much lighter flows.

We were net better sellers of USD across the board but I think some of that is position reduction given the high level of realized vol we’ve seen. EURUSD has had at least a 125bp move day/day the last 4 sessions. Will be interesting to see if the USD rally can reignite once things calm down because recent FED speak continues to emphasize that a rate hike could come mid-year.

 

DRIVER$ - USD & Energy

USD

The $9 TRILLION Crash Gains & Pains

The financial world focuses far too much on stocks. The stock market, despite being at record highs (meaning record market capitalizations) remains one of the smallest, and least sophisticated markets on the planet. Consider that stocks, even at current lofty levels, have a global market capitalization of slightly over $60 trillion.

In contrast, the global bond market is well over $100 trillion. And the global currency market trades OVER $5.3 trillion per day.

It is currencies, not stocks, where the most significant moves occur. The currency markets are the largest, most liquid markets in the world. They are always first to move when things change. Stocks are the DUMB money compared to currencies.

So who cares?

Everyone should care, because, globally, the world is awash in borrowed money… most of it in US Dollars.

When you BORROW in US Dollars you are effectively SHORTING the US Dollar. So when the US Dollar rallies… you have to cover your SHORT or you blow up.

I’ve written before about this problem. Last month I projected that the US Dollar carry trade (borrowing in US Dollars to finance other investments) was the largest carry trade in the world. At that time I believed the US Dollar carry trade is believed to be north of $3 trillion.

I was WRONG… WAY, WAY WRONG. It’s MANY MULTIPLES LARGER THAN THAT.

Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned.

SOURCE: the TELEGRAPH.

The US Dollar carry trade is north of $9 trillion… literally than the economies of Germany and Japan COMBINED.

And the US Dollar is rallying… HARD.

The fact that Oil is imploding at the same time this happens is not coincidence. Oil producers and explorers were financing their projects using what? BORROWED DOLLARS.

This is going to begin seeping into emerging markets and other assets soon. Imagine what the world would look like if $9 trillion worth of shorted Dollars had to be covered? Imagine the SELL PRESSURE this would induce in all other assets.

Just like 2008.

OIL - WTI

QE allows more borrowing from the future than would be possible if market interest rates really had to be paid. This allows financiers to temporarily disguise a growing problem of un-affordability of oil and other commodities.

The problem we have is that, because we live in a finite world, we reach a point where it becomes more expensive to produce commodities of many kinds: oil (deeper wells, fracking), coal (farther from markets, so more transport costs), metals (poorer ore quality), fresh water (desalination needed), and food (more irrigation needed). Wages don’t rise correspondingly, because more and more labor is needed to provide less and less actual benefit, in terms of the commodities produced and goods made from those commodities. Thus, workers find themselves becoming poorer and poorer, in terms of what they can afford to purchase.

QE allows financiers to disguise growing mismatch between what it costs to produce commodities, and what customers can really afford. Thus, QE allows commodity prices to rise to levels that are unaffordable by customers, unless customers’ lack of income is disguised by a continued growth in debt.

Once commodity prices (including oil prices) fall to levels that are affordable based on the incomes of customers, they fall to levels that cut out a large share of production of these commodities. As commodity production drops to levels that can be produced at affordable prices, so does the world’s ability to make goods and services. Unfortunately, the goods whose production is likely to be cut back if commodity production is cut back are those of every kind, including houses, cars, food, and electrical transmission equipment.

Conclusion

There are really two different problems that a person can be concerned about:

1. Peak oil: the possibility that oil prices will rise, and because of this production will fall in a rounded curve. Substitutes that are possible because of high prices will perhaps take over.
2. Debt related collapse: oil limits will play out in a very different way than most have imagined, through lower oil prices as limits to growth in debt are reached, and thus a collapse in oil “demand” (reallyaffordability). The collapse in production, when it comes, will be sharper and will affect the entire economy, not just oil.

In my view, a rapid drop in oil prices is likely a symptom that we are approaching a debt-related collapse - in other words, the second of these two problems. Underlying this debt-related collapse is the fact that we seem to be reaching the limits of a finite world. There is a growing mismatch between what workers in oil importing countries can afford, and the rising real costs of extraction, including associated governmental costs. This has been covered up to date by rising debt, but at some point, it will not be possible to keep increasing the debt sufficiently.

The timing of collapse may not be immediate. Low oil prices take a while to work their way through the system. It is also possible that the world’s financiers will put off a major collapse for a while longer, through more QE, or more programs related to QE. For example, actually getting money into the hands of customers would seem to be temporarily helpful.

At some point the debt situation will eventually reach a breaking point. One way this could happen is through an increase in interest rates. If this happens, world economic growth is likely to slow greatly. Oil and commodity prices will fall further. Debt defaults will skyrocket. Not only will oil production drop, but production of many other commodities will drop, including natural gas and coal. In such a scenario, the downslope of all energy use is likely to be quite steep, perhaps similar to what is shown in the following chart.

Figure 5. Estimate of future energy production by author. Historical data based on BP adjusted to IEA groupings.

Related Articles:

Low Oil Prices: Sign of a Debt Bubble Collapse, Leading to the End of Oil Supply?

WSJ Gets it Wrong on “Why Peak Oil Predictions Haven’t Come True”

Eight Pieces of Our Oil Price Predicament

ENERGY - Conequences of $68/bl Oil

Oil Crash 12-01-14 Richard Duncan

The price of oil is crashing – and with good reason. Supply is surging, while demand is weak. Moreover, within just a few decades, new technologies, including solar and probably hydrogen fuel cells, will make oil completely obsolete. Anyone born after the middle of this century will probably never know the smell of gasoline.

The price of oil fell by $10 a barrel last week. It’s now down 40% since June. This oil price plunge will have a significant impact on the global economy, so it is important to consider both its causes and its potential consequences.

THREE MAIN CAUSES

1. SHALE OIL: There are three main causes. First and foremost is shale oil. Thanks to the shale oil revolution, the United States is now producing almost 9 million barrels per day, the most in 30 years. By the end of next year, US production will be approaching 10 million barrels per day. So, even with most Iranian oil off the market due to sanctions, and with Iraqi oil production at somewhere near a quarter of what it could have been had there been peace in that country during the last decade, global output is increasing sharply. According to the International Energy Agency (IEA), global supply was 93.8 million barrels per day (mb/d) in September this year, up 2.8 mb/d from one year earlier.
2. WEAK GLOBAL DEMAND: The second reason is that global demand for oil is weak. Demand from China is growing much more slowly than had been anticipated due to the economic slowdown there. US demand for oil is actually declining – in large part due to government regulations requiring improved fuel efficiency standards for cars. Furthermore, global economic growth is weak and there has been a very sharp slowdown in the growth in global trade. The IEA estimates global oil demand will be 92.4 mb/d this year and 93.6 mb/d in 2015.
3. GEO-POLITICAL CLASH: In addition to supply and demand factors, I believe there may also be a third reason for this oil price crash: the desire of the United States to punish Russia for supporting pro-Russian separatists in the Ukraine. Russia is one of the world’s largest oil producers. Russian government finances depend heavily on oil sales. Therefore, the drop in oil prices is a severe blow to Russia. I believe it is well within the power of the United States government to push down the price of oil by selling oil futures short. The lack of transparency or oversight within the $700 trillion Over-The-Counter derivatives market would permit the US government to do this without being noticed. Since this tool is available to US policymakers (and perhaps this is just the kind of situation that explains why the government has not imposed transparency on this market), no one should be surprised that they would employ it.

CONSEQUENCES OF $68/BL OIL

Now, what about the consequences? Ultimately, the consequences will depend on two things:

• How far the price of oil falls and
• How long it remains low.

Since we don’t know the answers to those questions, let’s focus on the consequences if the oil price stabilizes where it is now, at $68 per barrel for Brent.

1. CONSUMER "TAX CUT": Consumers will be better off. Lower gasoline prices will be like a tax cut for the middle class, who will be able to spend more on other goods.
2. SMALLER US TRADE DEFICIT: The US trade deficit will become smaller as the cost of oil imports falls (although this will be partially offset since Americans are likely to use their savings from a lower gasoline bill to buy more consumer goods made overseas). A lower trade deficit will boost GDP.
3. SHIFT IN CENTRAL BANK STANCES: Lower oil prices will mean more downward pressure on consumer prices and a greater risk of deflation. The fear of deflation is likely to cause the Fed and the Bank of England to delay their plans to increase interest rates, while it may force the European Central Bank and the Bank of Japan to accelerate their asset purchases.
4. LOWER SOVEREIGN BOND YIELDS: In most countries, government bond yields have already fallen in response to the increasing disinflationary/deflationary pressures that will result from lower oil prices. Government bond yields in a number of European countries fell to record lows last week.
5. SOVEREIGN FISCAL PRESSURES: The finances of the oil exporting countries will suffer. The currencies of Russia, Norway, Venezuela and Nigeria have already fallen significantly, reflecting the deterioration in those countries’ economic prospects.
6. PRODUCTION BREAKEVEN COSTS: Lower oil prices are likely to put some high cost producers out of business. Canadian oil sands look particularly vulnerable. Some of the marginal shale oil producers in the US may also go to the wall. As bankruptcies occur, defaults on energy junk bonds are likely to rise significantly. At this stage, I don’t believe that the losses in the junk bond market will be significant enough to cause a new financial sector crisis. Nor do I believe that so many wells will shut down in the United States that US oil production will begin to fall. Production costs have been falling rapidly and are likely to continue falling. Oil prices will have to fall considerably further before most of the new shale oil production becomes unprofitable. Of course, the possibility that oil will fall much further can’t be ruled out. It was $20 per barrel not all that long ago.
7. REDUCED CAPITAL FLOWS: Finally, the reduction in the US trade deficit will mean a reduction in capital inflows into the US. (Capital inflows are the mirror image of the Current Account Deficit, since every country’s balance of payments must balance.) The reduction in capital inflows will reduce the upward pressure on US asset prices that has come from this source in the past.

This has been an exciting few weeks in the oil markets and the drama could increase during the weeks ahead. But just imagine the extraordinary upheavals that will occur (in the markets and in geopolitics) when the realization eventually sets in that new technologies will make oil practically worthless sometime before the middle of this century. That realization still appears to be some time off, however. Between now and then, we are likely to see a number of other big swings in the price of oil, both up and down.

ENERGY - Conequences of Reduction in Liquidity Flows

SUMMARY

• FLOWS REDUCTION: $316bn hit to the cartel’s revenues which previously:
  • Boosted liquidity,
  • Spurred asset prices and helped to
  • Kept borrowing costs down,
  • The $316bn figure would be much higher if other big oil exporters including Russia, Norway, Mexico, Kazakhstan and Oman are taken into account.
• 40% fall in Brent crude since mid-June will reverse trend and for the first time in 20 years Opec nations will be sucking liquidity out,
• ASSET BUYING REDUCTION: In 2012 Opec petrodollar flows into liquid investments such as US Treasuries, high-grade corporate bonds and equities stood at $500bn. Next year, they could drop below $100bn if prices average $78 a barrel,
• US$ LIQUIDITY SQUEEZE : The US is importing less oil than it used to, meaning fewer dollars are being sent abroad: some analysts have said this could lead to a shortfall in dollar liquidity,
• SHIFT IN INVESTMENT PATTERNS: The main impact of the reduction of petrodollar flows will be less on liquidity than on investment patterns. What a sovereign wealth fund might put their money into will be different to what an asset manager might favour.
• FORCED ASSET SELLING: If stressed oil producers are forced to sell assets to fund gaps in their domestic budgets, that “could in theory be a good deal messier”

Flow of OPEC Petrodollars Set to Dry Up 12-03-14 FT

The flow of Opec petrodollars into global financial markets is set to dry up as the collapse in the oil price delivers a $316bn hit to the cartel’s revenues.

Big oil producers have pumped the windfall they enjoyed from soaring oil prices over the last decade into a huge range of global assets, from US Treasuries and high-grade corporate bonds to equities and real estate.

Qatar, for example, bought the Harrods department store and Paris Saint-Germain, France’s top football club, while Abu Dhabi’s sovereign wealth fund bought a stake in the glitzy Time Warner building in New York.

The flow of petrodollars into the global financial system boosted liquidity, spurred asset prices and helped to keep borrowing costs down.

But the 40 per cent fall in Brent crude since mid-June will reverse this trend, as the shrinkage of the oil producers’ cash pile removes a pillar of support for global markets.

“This is the first time in 20 years that Opec nations will be sucking liquidity out of the market rather than adding to it through investments,” David Spegel, global head of emerging market sovereign and corporate research at BNP Paribas.

BNP estimates that if oil production remains at its current level and oil prices stay at about $70 a barrel for the next year, Opec nations will receive $316bn less in oil export revenues than if oil prices were at their three-year average of $105.

George Abed, director for Africa and the Middle East at the Institute of International Finance, said at their peak in 2012, Opec petrodollar flows into liquid investments such as US Treasuries, high-grade corporate bonds and equities stood at $500bn. Next year, they could drop below $100bn if prices average $78 a barrel, he said.

This “comes on top of other trends that seem to be sucking liquidity out of the global system”, he said.

One of the key factors in the slowing flow of petrodollars is the surge in US oil production. The US is importing less oil than it used to, meaning fewer dollars are being sent abroad: some analysts have said this could lead to a shortfall in dollar liquidity.

The $316bn figure would be much higher if other big oil exporters including Russia, Norway, Mexico, Kazakhstan and Oman are taken into account.

Oil prices have fallen amid a surge in US shale production and weakening oil demand in China. Brent slipped further last week after Opec decided not to cut output to shore up prices.

George Magnus, economic adviser to UBS, said the main impact of the reduction of petrodollar flows will be less on liquidity than on investment patterns as wealth is transferred from oil-producing countries to consumer nations such as Japan that benefit from a lower oil price.

“What a sovereign wealth fund might put their money into will be different to what an asset manager might favour. We should expect a lot of churn,” he said.

Jason Shoup, analyst at Citigroup, said that the decline in petrodollar growth was “likely to equate to less demand” for bonds.

The shift could also have some bearing on when borrowing costs for governments, companies and consumers start to rise. With consumers spending more, the withdrawal of the Federal Reserve’s quantitative easing programme could become “that much more palpable,” he said.

However, Alan Ruskin at Deutsche Bank downplayed the impact of petrodollars on US markets as less Opec money has been flowing into the country in recent years.

In a note to clients, he said the size of annual inflows of petrodollars into US dollar and asset markets was “modest relative to total cross-border flows”. But if stressed oil producers are forced to sell assets to fund gaps in their domestic budgets, that “could in theory be a good deal messier”, he said.

Although some countries with huge foreign-exchange reserves such as Saudi Arabia are better able to withstand the pain from lower oil prices, others such as Venezuela will only suffer more if crude prices fall. Pierre Andurand, a prominent oil hedge fund manager, said that oil prices could drop to $60 a barrel next year.

GEO-ECONOMICS - Petro$$ Crisis and Energy Price (Demand) Collpase