Q1 2015: WTI Oil

The New Year opened with prices in freefall, and continued that pattern the better part of January. A review of Q1 needs to go back to the 2nd-half of 2014, as a combination of factors became a perfect storm for black gold. Foremost, supply was rising at a breakneck pace. This, combined with slower global demand made a lethal formula. Meantime, a revaluation of the U.S. Dollar was accelerating and, as almost all oil is priced in Dollars, the effect was powerful. The final straw that broke the proverbial camel’s back was OPEC’s decision in November, led by Saudi Arabia, that formally stated in a communique: market share trumped price discipline. With U.S. production at levels not seen since the early 1970’s, before the first of two Arab oil embargos, the dominos were ready to come tumbling down. And, indeed, they did!

From a triple-digit price, the decline gained momentum below the $80 mark. OPEC’s statement on Thanksgiving Day in the U.S. shocked markets lulled by the assumption of Saudi Arabia doing what had become custom; cutting back production. The largest OPEC member played the role of swing player, not just on the global stage but within the cartel itself. Not this time in so many words was the response from the Kingdom. Prices were slashed another 10% to close-out November. December proved more volatile, with prices on the benchmark moving much lower, to the low $50’s.

As 2015 dawned, reality had set in. Oil rigs, the initial casualty of cutting back output were shut down in large numbers. However, technological improvement in efficiency has kept supply rising. And so, evermore supply, especially at the U.S. hub in Oklahoma needs to be countered with a slowdown elsewhere, or an increase in global demand. The former does not seem to have hit a crescendo yet. OPEC as a whole, and Saudi Arabia in particular, increased production in Q1. In numbers, an official quota of 30.5 is being surpassed by nearly a million barrels daily. The second point holds more promise, as global growth may be on the verge of not only plateauing, but rising. Not only in Europe, but also in Emerging Markets, as numerous central banks, given a window of opportunity with declining inflation, slashed interest rates to promote growth. So, if greater growth is realized, demand for fossil fuel would increase. That’s what economic models suggest!

To that backdrop, in late January prices bottomed-out above $40. A bounce, based mostly on the market discounting the supply / demand equation, coupled with the steepness of the second fall, from $73 after OPEC’s decision, allowed prices to levitate all the way back above $50. In other words, back to breakeven for 2015. Then came March, and another wave of selling as oil inventories at Cushing, Oklahoma made headline news reaching an 80-year record stretching back to the midst of the Great Depression. Again, prices tanked, hitting marginal new 6-year lows, but stopping just short of $40, a very important historical and psychological price for oil. Near quarter-end, after a slight softening of the U.S. Dollar combined with dovish words from the U.S. Fed, interpreted as keeping rates at the zero-bound well beyond mid-year, prices rose above $50. Thereafter, WTI has stayed range-bound, though at the upper-end, above $50 a barrel.

Looking ahead, what will the rest of this year bring? Industry analysts are already eyeing over the horizon into 2016, with the thinking it may take as long as 18 months for a return to equilibrium. That is an open question for now. Much may depend on the following: if global growth picks-up, then at what rate, so the percentage increase may be key. Can EM growth pick-up if China’s GDP moves below 7%? In the developed markets, will Europe post its best growth since the financial crisis set-in 7 years ago? Will U.S. demand increase with much lower prices at the pump as a proxy as the summer driving season draws near? All to be answered, though not over the next 3 months.

In Q2, the dominant story is likely to be one of supply. Will the increase in supply slow down? If it does, that in itself could act as price support. What happens if prices head to a new cycle low, meaning below $40. Many in the industry and investors remain concerned the final low has not been seen. That may keep prices on the defensive for longer, making significant new highs difficult to reach and sustain. However, the other side of the coin: most analysts have circled Q2 as the quarter most likely to see a rock-bottom price in oil. So, if Q2 ends without a new low, and supply stops setting records, it may be enough to raise markets’ expectations of a true floor on WTI.

Disclosure
This communication contains our current opinions and commentary, and does not represent a recommendation of any particular security, strategy, investment product or manager. The views expressed here are subject to change without notice. This commentary is distributed for educational purposes only and should not be considered as investment advice or an offer of any security or service for sale. Information contained herein has been obtained from sources we believe to be reliable, but we do not guarantee its completeness or accuracy. No part of this letter may be reproduced in any form, or referred to in any other publication, without WE’s written permission.