Oil traders aren’t usually thought of as philosophers. There is so much information to process that it’s often difficult to look beyond this week’s news and data. This year the forces of supply and demand have been close to balanced. Oil prices are up a bit, currently around $57 per barrel, which puts them near the middle of their range in recent years. 1 1 Close As of the close on November 13, 2019, December ’19 WTI crude oil futures were at $57.12 per barrel. The average closing price of the front month futures contract price from January 4, 2016 to November 13, 2019 is $53.91. Source: Bloomberg. Implied volatility has been muted by historical standards. 2 2 Close It had been the ONE place where volatility was high! Despite this, oil company stocks have lagged broader market indexes. A number of oil-related stocks are below where they were five years ago. This underperformance may indicate that markets are looking beyond the current price of oil and are taking a longer-term, more philosophical view. Perhaps energy investors are seeing the forest through the trees or, in this case, the offshore wells through the waves.
Futures markets are discounting slightly lower prices over the next few years followed by a long stretch where oil is around $50 per barrel. 3 3 Close Looking at WTI crude oil futures as of November 13, 2019. Source: Bloomberg. The term structure in the front months, known as backwardation, is not uncommon for the oil market, nor is flat pricing further out in the curve. Beyond the first couple of years, futures markets often come up with a terminal value for a commodity, and then price that into perpetuity. After a certain point in the far part of the curve, liquidity dries up and the prices become less meaningful because they don’t really reflect the views and information of a wide cross section of market participants. 4 4 Close In many cases the long-dated futures and swaps are used to hedge complex structured trades. There just isn’t much visibility beyond the first few years.
This doesn’t stop the philosopher-traders from coming up with grand theories about the long-term future of oil. In the mid-2000s, many people feared the imminent onset of “peak oil.”
Some would argue it was a 1970s idea. Like disco, it came back in the 2000s, except with oil supply forecasts instead of bell-bottoms.
Peak oil is the point at which so much of the supply of oil has been depleted that production starts to drop and eventually heads towards zero as the last barrel is extracted from the earth. Back then, it appeared that even if global peak oil had not been reached, some areas such as the U.S. had reached regional peak oil. Production in the U.S. had been falling since the 1970s. Shale reversed that decline, and now with U.S. production at record highs, talk of peak oil has quieted.
Cultural critics may never resolve the debate as to whether art follows life or life follows art. In a similar fashion, it’s hard to tell whether oil prices follow these theories or if these theories are discussed because people want an explanation for current prices. If crude oil costs over $100 per barrel as it did in 2008, it’s easy to talk about peak oil. Now that it’s under $60 per barrel, we’ve seen a pivot toward a different type of peak oil. It’s possible that the peak in oil may be in demand, not supply. Alternative technologies such as electric cars will replace oil with other energy sources, and oil consumers may continue to become more efficient. Whereas people may have thought that there would be no more oil in 100 years, now some folks might be saying there will be no more use for oil instead. 6 6 Close This is an extreme view, but the future is hard to predict so people like to make strong statements.
There is evidence that investors are concerned about the long-term prospects for oil demand. For example, last week Brazil held an auction for rights to drill the abundant oil off its coast. Only two companies submitted bids and one was … Petrobras, the Brazilian national oil company. 7 7 Close It was sort of like Forbes magazine endorsing Steve Forbes for President. We’re waiting to see who Bloomberg news endorses. , 8 8 Close Reuters: “Big oil stuns Brazil in back-to-back auction flops,” 11/7/19. It may be that a flawed auction system deterred foreign companies from participating, but even so it is not a sign that folks are chomping at the bit to drill in the ocean.
Oil-related currencies have done poorly this year. The Colombian peso is down more than 5% against the U.S. dollar, and the Norwegian krone has fallen against both the dollar and the euro. 9 9 Close The Chilean peso has done worse, but there is some political intrigue there. Source: Bloomberg. Norway has a hawkish central bank and has mostly enjoyed strong economic data, so it likely hasn’t been driven by the domestic economy. 10 10 Close The Swedish krona has done even worse, but economic data there has been weaker than in Norway. Many traders think of the Norwegian krone as a proxy for oil, because extraction is such a large part of the economy there. This, combined with the poor performance of oil-related stocks, makes it seem as though markets are at least cautious about holding oil assets.
Many of the largest producers of oil are looking to diversify into other areas. Norway has used its sovereign wealth fund as a way of moving savings out of oil and into other areas. Saudi Arabia is looking to diversify its economy. Shale companies, after years of expansion, may finally be pulling back on their own spending as investors look for higher returns on capital in the near term. It is possible that recent emphasis on sustainable investment has reduced investment in oil companies, but the trend seems to go beyond just mandated reallocation.
Not all oil investment has suffered. Big oil companies are still trading at multiples that are not far off from the average in the S&P 500, so it’s clear some investors are willing to pay for energy earnings. But there has been a shift away from energy as a sure bet whether it’s in shale, deep water, or more traditional plays. If you are still a peak oil believer or you are skeptical of alternative energy, there are plenty of ways to express these views. That’s what happens when something falls out of favor: it creates possibilities. It may also create some value now and then.
What We Are Watching
Bank of Canada Speeches: Deputy Governor Wilkins (Tuesday) and Governor Poloz (Thursday)
In comparison to a number of other major economies, Canadian growth has looked relatively healthy in recent quarters. Labor market data has shown strong hiring and low levels of unemployment, and housing market indicators have picked up. Nonetheless, the Bank of Canada struck an unexpectedly dovish tone at its last meeting in October. While policymakers left rates unchanged at 1.75%, the post-meeting statement noted that “the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” In the post-meeting press conference, Governor Poloz went on to announce that policymakers thought about shifting to “a more accommodative monetary policy as a form of insurance against [downside] risks.” 11 11 Close Bank of Canada: “Monetary Policy Report Press Conference Opening Statement,” 10/30/2019. These comments boosted Canadian fixed income and led to weakness in the Canadian dollar. This week, Deputy Governor Wilkins and Governor Poloz are both scheduled to speak. Market participants will be looking for further clarification of how close the BoC is to a potential rate cut.
FOMC Minutes (Wednesday)
At its October meeting, the FOMC delivered its third rate cut of the current “mid-cycle adjustment” while leaving the impression that it was likely done easing. The FOMC minutes coming out this week will provide a detailed account of the committee’s deliberations. Two participants dissented from the rate cut decision, and the rationales behind these objections will likely feature in the minutes. Looking ahead, the market will focus on any discussion of the criteria that would prompt the Fed to re-start the easing cycle. Chair Powell has noted that monetary policy is “in a good place,” implying unchanged policy rates in the near term, though the bar for rate cuts appears lower than for hikes. Discussions supporting this asymmetric balance of risks would likely support risky assets, steepen the yield curve, and weaken the U.S. dollar.
Eurozone PMIs (Friday)
Euro area growth has been slowing for several quarters. Manufacturing has been one of the main drivers of the slowdown, particularly in Germany, where the industrial sector has experienced notable weakness. This week’s Preliminary Purchasing Managers’ Indices (PMIs) will be one of the first looks at the current state of manufacturing in the euro area in November. The PMI release will also include survey data for service sector companies, which have seen weaker growth as well but have thus far avoided contraction. With concerns around global trade and Brexit declining over the past several weeks, economists surveyed by Bloomberg expect this week’s PMI surveys to show a slight improvement in both manufacturing and services. If the PMI data were to surprise to the downside, it would likely lead to a selloff in European equities and rally in German bunds as growth concerns could increase.