Friday, January 16, 2015

Lining up a gnarly recession to start in fourth quarter 2016 or first half 2017

Much has been made of the oil price fall and how it might cause a recession. While the uncertainty caused by a fall in the most important import price to the economy does create a bit of a headwind, this is offset by the positive aspect of increased consumption and sentiment.

Ironically, however, we can project the possibility of a recession caused by oil prices - but it would be an oil price spike upward not downward.

What are you talking about Matt? You just wrote a post about how oil price is going to be pressured down over the next 6-12 months, possibly severely so. You just wrote about how oil stocks are going to be filled to busting in August 2015. Have you lost your marbles?

Ah, this case the seeds of the next spike are contained in the current fall. Here's the reason - eventually this fall in price will actually stimulate demand, probably starting in late 2015 and then really gearing up in 2016, barring any self-imposed contraction (I'm looking at you Europe). I predict that it will be China and the developing world that once again are the primary engine of demand growth.

There are two problems. The first is that to balance inventories, price won't recover much even when the market is significantly out of balance. This means we won't really have any price incentive to start drilling shale again until demand and supply are seriously out of whack - perhaps on the order of 2 MBD. The second problem is that shale supply will pick up a bit conservatively at first, after the price shock they are currently experiencing - and that even drilling full bore they won't be able to close the gap. The current drop in price is predicated on weak demand and steady supply gains. If instead we had steady demand gains and steady supply gains the market would be in balance. But we can't increase faster than "steady" and so long as demand increases steadily we will remain out of balance. What this means is that oil price will have to destroy demand, and to do that we will have to go well over $100.

So here are my predictions: Oil price will break $150 in the second half of 2016. We will have a world-wide recession starting in late 2016 or early 2017.

Why oil may be slower to come back than 2009

Oil is plunging in price, and one might be tempted to make comparisons to 2008-2009. During that time, oil fell from $145 in July 2008 to $35 in January 2009, only to recover back to $70 by July 2009.

As prices fell in 2008-2009, so did rig counts, as producers in the US pulled in their horns until they could lock in better prices. It didn't take long for those rig counts to start sneaking back up though as the price recovery was relatively quick.

The big difference is that this time OPEC isn't playing along. In 2008-2009 they cut production by 4 million barrels/day. This time they aren't cutting at all. Given we are over-supplied by almost 2 MBD there isn't a clear impetus for what will end that oversupply in the short term. In fact, chances are good that OPEC wants to keep prices low for a good long time to let the US shale industry wash out.

The basic problem is this - the market is almost two million barrels/day out of balance. This means every day, even with no more production growth, two million barrels need to find a home. Even if rig counts dropped to zero in the US, US production would only drop by about 350K barrels/day per month. And as of January, rig counts have only fallen about 15% - therefore production is still growing in shale even though price has now fallen to $50/barrel. Simply put, the dropping rig count is not enough to put the market into balance in the short term.

Finally, the "nuclear option" (pun intended) is if an (admittedly unlikely) agreement between Iran and the G5 comes in June. This would send one million barrels of oil back onto the market - just when it didn't need it the most.

My projection: I think the drill rigs will continue to fall in the US at a steady rate of 50-60 rigs/week. US production will stop growing in February and will then start to decline modestly. If prices are in the $30-$50/barrel range than drill rigs will continue to fall apace. At 900 rigs in April production will be falling at 100 kbd. At 400 rigs in July production will be falling at 250 kbd, while demand grows at 100 kbd throughout the year. I project stocks will build about 285 MBD between now and August - and that prices for storage will max out in June or July.

World supply ex US will be essentially unchanged. Libya is a wild card could be bullish or bearish. Iran is a wild card bearish but unlikely. If Iran starts pumping 1 MBD, then production wouldn't come into balance with demand until November and stocks would force the issue, resulting in shut-ins to balance the market. This second scenario, albeit unlikely would create huge contango in the market. Saudis/Kuwait/UAE might decide to cut but I doubt it - only below $20.

World demand may pick up but only slowly - when oil price falls it does stimulate the economy but the shock of lower prices will offset this for at least a couple of quarters (the economy responds negatively to uncertainty even if it is positive).