Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

You should be pretty scared right now. Even a cursory glance at the news, or 30 seconds of listening to a presidential candidate, will inform you that terrorism is rampant, the Middle East is unraveling and that we're all basically done for.

Yet there you are, selling oil at $30 a barrel. 

Peace in Our Time
WTI crude oil prices show no sign of geopolitical risk
Source: Bloomberg

The geopolitical risk premium, an omnipresent if mercurial figure in the oil market over the past decade or so, has vanished. Consider that the past three months have witnessed the terrorist attacks in Paris, a Russian jet being downed by Turkey, the burning of Saudi Arabia's embassy in Tehran, Islamic State targeting Libyan oil tanks, and Venezuela entering a post-election political standoff.

In response, oil has tumbled by a defiantly insouciant one-third. Even Tuesday's news that some U.S. Navy sailors were being held in Iran barely registered (they have since been released).

This lack of fear is, well, alarming. The chief exhibit here isn't oil's spot price but the futures curve:

A Brighter Future
Geopolitical risk has vanished along the Brent oil futures curve
Source: Bloomberg

In October, Brent crude futures for this year averaged $53 and change. Now, they don't average above $50 a barrel until 2020. The oil market isn't merely saying there's no risk to supply now; it isn't pricing in a problem right through the next president's first term.

Betting on a quiescent five years in the Middle East hasn't been a good wager for most of my lifetime, and the odds look even longer than usual now, as the U.S. stands back and Iran and Saudi Arabia face off. Meanwhile, low oil prices are deterring investment pretty much everywhere else.

Downing Tools
Oil rotary rigs in operation haven't collapsed in the Middle East but have everywhere else
Source: Bloomberg
Note: Regional rig counts indexed to 100

All else equal, that means the market share of Middle Eastern producers should increase. In its latest short-term outlook, released on Tuesday, the Energy Information Administration projected non-OPEC supply to fall this year for the first time since 2008. With OPEC's own effective spare capacity thin, the risk of a supply shock is rising. 

Perhaps the market simply can't see past the humongous glob of oil blocking the horizon. As I explained previously here, commercial crude oil inventories are at very high levels. Using current projections by the International Energy Agency, they look set to keep climbing to more than 70 days' worth of OECD demand by the middle of the year, compared with less than 60 days for most of the past five years. The likely return of Iranian barrels compounds the issue. And even if something really drastic happened, like a total collapse in Venezuelan output to zero for a year -- which didn't even happen during that country's general strike in 2002 and 2003 -- working off the glut would still take time. 

Battle of the Bulge
Even under an extreme scenario of supply cuts, it would take time to work off the world's glut of oil inventory
Source: International Energy Agency
Note: Assumes no cuts in OPEC output and Iranian supply rising by 600,000 barrels per day by year-end

Even so, these projections do indicate supply and demand starting to rebalance sometime in the next year. So is something else keeping the fear factor out of oil futures?

Maybe it's just a different kind of fear.

In October, BP's chief economist gave a speech on the "New Economics of Oil". In this brave new world, shale resources' vast reserves, short lead times and low upfront investment upend the notion that OPEC's own underground riches are bound to rise in value over time as everyone else's wells run dry. Adding to this is pressure on the demand side in the form of political and technological momentum to limit the burning of fossil fuels.

If you're a big producer and think BP's economist is even half right, then you might want to monetize as much oil upfront as possible. That puts Saudi Arabia's decision to keep pumping oil at high rates -- and even consider an IPO for its national oil company Saudi Aramco -- in a new and gloomy light for oil bulls. Sure, cutbacks and bankruptcies will savage the E&P industry. But as and when capital returns, shale production would likely crank back up.

If that scenario promises some sustained pressure on the supply side, this chart also points to big problems on the demand side.

Sticking Together
The latest sell-off in oil has mirrored the turmoil in China's financial markets
Source: Bloomberg
Note: Performance indexed to 100

Granted, Chinese stock-market gyrations have about as much to do with the real economy as the country's official data do. And December trade numbers revived some animal spirits on Wednesday. Even if China's economy isn't headed for a hard landing, though, it is clear the champion of the commodity supercycle is in need of a breather. The country's fixed asset investment binge has led to overcapacity and declining returns on incremental spending, as this chart from Michael Parker at Sanford C. Bernstein shows.

Less Bang for the Buck
Excessive investment inevitably leads to diminishing returns, even in China
Source: Sanford C. Bernstein

China doesn't need to collapse to hit commodities, it just needs to throttle back. The Bloomberg Commodity Index just notched up its fifth year of losses, with only cotton registering a gain out of 22 constituents. Crude oil came in last.

Weakening currencies in several emerging markets, including China, suggest it would be unwise to rely on the rest of the emerging markets necessarily picking up the slack. Yet non-OECD countries are expected to account for 96 percent of the growth in global oil demand this year, based on the IEA's current projections. And those could be in for a revision, with the World Bank having just cut its forecasts for global economic growth, in large part because of concerns about struggling emerging markets.

In a similar vein, energy economist Phil Verleger, citing Larry Summers' work on the theme of secular stagnation, has in several recent reports offered a reminder that the assumptions underpinning forecasts of growth in oil demand shouldn't be taken for granted.

For example, Summers puts the probability of a recession in the U.S. within three years at 63 percent once the country is already three years into a recovery. We are currently more than six years in. Verleger, meanwhile, calculates that since 1970, U.S. annual economic growth has tended to run between 1.8 and 2.6 percentage points higher than the country's oil demand growth, in expansions and recessions, respectively. The implication is that the U.S. looks overdue for a slowdown. And if economic growth were to slip to 2 percent or less, then oil demand in the world's biggest market could actually fall.

More doom-mongering? Possibly, but you could say the same about predicting a Saudi Arabian collapse, which looks like a more extreme scenario than, say, economic growth forecasts turning out to be too optimistic and oil demand being flatter than anticipated. If the market has lost sight of geopolitical risk, it may be because there are more mundane monsters overshadowing the oil market.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net