Oil prices continue bouncing down the stairs to lower levels

Brent Dec14a

Brent oil prices have reached the “$70/bbl and probably lower” level that I forecast in August.  So we now need to think about where they go next.  Luckily, the chart above can still guide us, as it has done since September 2010.

As readers will remember, I first forecast the collapse on 18 August.  I then followed this post with a detailed analysis and specific price forecast on 27 August as follows:

How low will prices go?  We can have no idea, as prices have never been this high for so long.  Nor can we rule out a further massive stimulus effort by the central banks at some point.  But ‘technical trading’ logic would suggest they will fall to at least the 200-day exponential moving average, currently around $70/bbl, and probably lower (red line)”.

Unfortunately, conventional wisdom completely missed this move, believing that prices would always stay at $100/bbl.  Many companies and investors have lost large amounts of money as a result of wearing these rose-tinted glasses.

There are 2 parts to the question of ’What Happens Next?’:

  • Why is this happening?
  • What will tell us when the price move is ending?

The “Why” question is easy to answer:

  • China’s stimulus policy has ended.  Instead, President Xi is moving to his New Normal concept.  He intends to improve income levels for ordinary people, not to create wealth effects for a minority via a property bubble
  • The US Federal Reserve’s Quantitative Easing (QE) policy has paused.  Investors are preparing to ‘dash for the exits’ just before interest rates rise, as they know prices for financial assets are well out of line with fundamentals

So the stimulus policies that pumped air into China’s demand bubble, and the US financial asset bubble, have stopped pumping.  And a child knows what happens to bubbles when you stop pumping more air – they deflate very quickly.

The unwinding of China’s ‘collateral trade’ was the initial catalyst.  As I warned in June, this is now opening the fault lines in the debt-fuelled ‘ring of fire’ created by central bank stimulus.

The “What” question relies on the chart for an answer.  We are still in the Great Unwinding phase of these stimulus policies, so we cannot yet rely on supply/demand fundamentals to guide us.  Instead, as the chart shows:

  • The ‘triangle shape’ extended for 5 years before prices finally fell (red, green lines)
  • Prices then collapsed rapidly through support at $90/bbl and $70/bbl (purple)
  • $70/bbl was also the 200-day exponential moving average price (red)
  • My August forecast has thus been realised, and prices have indeed carried on falling

Rubber ballWe are now in a classic falling formation, bounded by the blue line.  I think of this as being like a rubber ball bouncing down stairs.  The ball falls off one stair, bounces to the next, and never quite manages to bounce back to the higher stair.  Then it bounces down to the next stair, before eventually reaching the bottom.

Market traders instead call this a “Lower highs, Lower lows” pattern, where sellers continue to dominate.  Buyers appear at the lows, but they give up as more sellers appear and sell into the rally.  So we will only know when the selling is finished when the price finally makes a ”Higher high” again, and bounces back onto the stair above.

In terms of supply/demand fundamentals, however, little has so far changed.  There have been no major production cutbacks or demand increases.

As expected, Saudi Oil Minister Ali al-Naimi, wants the market to decide, saying Wednesday,  ”Why should we cut production? Why?”.  Equally, many developing countries have been busy removing subsidies that supported demand.

It is therefore hard to see what will stop prices continuing to fall towards $50/bbl.

What happens then will be the key question.  Geopolitical disruption cannot be ruled out.   Russia, for example, might cut gas supplies to try and boost energy prices.  But  otherwise, the key to the future will continue to be China.

Asian producers and traders now have large inventories of almost every oil-related product.  Buyers have simply stopped buying in recent weeks as prices have collapsed.  So the question is whether China’s demand will now increase in January, before markets close for Lunar New Year in mid-February.

A lot of money is now riding on this issue.  If these hopes prove false, and the Western winter stays mild, there would seem little to stop prices heading back towards historical levels of $25/bbl – $40/bbl.

This would be good news in the long-term, as this would be an ’affordable’ price for the global economy, at around 2.5% of GDP.  But it would be very bad news for all those investments based on the two myths that (a) oil will remain at $100/bbl forever and (b) China’s demand will increase exponentially as it becomes middle-class.

In turn, a sustained price fall will mean deflation becomes inevitable in the Eurozone and Japan, irrespective of any further QE initiatives.  Financial markets will also be impacted as a new ‘Minsky moment’ develops, and investors suddenly realise (as in 2008), that they have overpaid for their assets and rush for the exits.

As I will discuss tomorrow, the International Energy Agency warned on Friday that OECD stocks “may bump against storage capacity limits” in H1, adding that we may see “social instability or financial difficulties”.  This highlights why I have long feared the Great Unwinding will be a very bumpy road.

I wrote about this potential ‘worst case’ back in June.  One can still hope we might avoid this outcome, but the risk is getting greater all the time.

The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

Benzene Europe, down 53%. “Falling global prices, sluggish demand and a bearish outlook for upstream oil and energy numbers saw the market dropping significantly below $800/t this week, the lowest since mid-2009.”
Naphtha Europe, down 44%. “Market fundamentals remain bearish on a supply overhang, with little support from downstream European and Asian petrochemical markets”
Brent crude oil, down 39%
PTA China, down 33%. ”Sentiment was mostly bearish because of consistent declines in the upstream crude futures markets”
¥:$, down 16%
HDPE US export, down 12%. “Traders said domestic export prices still are essentially offers because foreign prices are so much lower”
S&P 500 stock market index, up 2%

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