PORTFOLIO POINT: Investors wanting to punt on crude could check out exchange-traded oil funds.
This latest bout of market turmoil has seen crude prices off some 20%. It’s a big move, and has prompted a re-evaluation of the dynamics driving the market, especially if, as many believe, Chinese growth is now slowing. I demonstrated a couple of weeks ago that professional traders had retained a net long position throughout this turmoil, and recent data shows that while these positions have been pared back, the speculators are still very long. Is this simply misplaced optimism or is there something more in it?
The problem for retail investors is that price action has been so volatile lately. It is difficult to know with any certainty what the price action is telling us. You can get a sense of the increased volatility in Chart 1 below.
Chart 1: Crude oil price volatility (moving average std. deviation)
Ever since the GFC, daily price movements have been much more volatile when compared to the late 1990s and early 2000s – and that’s taking into account the incidence of the second Gulf War and the September 11 attacks. Now we’re just afraid of things that might occur, and price action is far more volatile.
Certainly, there are concerns over Europe imploding and a China slowdown, and these are legitimate concerns. But how important are these concerns really for the medium-term price action? Well, this is where we need to maybe revisit some analysis of the fundamentals. The first thing to note is that the fundamental dynamics – production and consumption – are much less volatile than the oil price. Check out Chart 2 from BP’s statistical review.
Chart 2: World oil consumption (thousands of barrels per day)
You can see from the chart that global oil consumption grows at a comparatively constant rate. It is, by and large, characterised by linear growth, pockmarked with a few minor bumps along the way reflecting the economic cycle or things like the OPEC oil embargo in the early 1970s. Note the almost insignificant bump in 2008 – consumption barely declined at all. Overall, the average annual growth rate over the last 20 years has been 1.4%, with consumption falling about 2% in 2008 and 2009 combined.
It’s a similar story for oil production, and the chart is almost exactly the same – just note that there is a difference between supply and demand in these figures due to the fact that the production numbers don’t include biofuels and such things, whereas the consumption figures do. Otherwise, the disparity between consumption and production is met by changes in inventories.
Chart 3: World oil production (thousands of barrels per day)
Anyway, the point is that production is relatively stable as well, growing at an average pace of 1.2% over the last 20 years. The so-far minor difference in growth rates between production and consumption is currently being met by biofuels, ethanol and the like. But the point I’d like to highlight is that while the disparity may be minor now, it does appear to be growing. Since 2004, for instance, the disparity between growth rates has increased from 0.2% over the 20-year period to 0.4%. Over the last two years, that has increased to almost 1%. There is very clearly a widening gap between production and consumption, albeit minor at this stage, and no doubt met by the ever-increasing use of biofuels.
This is where we start getting into some of the analysis that many of us will remember was popular through the 2006-08 period. You don’t hear about it much these days, but it is as relevant as ever – more so when you look at some more recent trends. Chart 4 gives an update of the situation.
Chart 4: Crude oil consumption growth in China and India
That’s exponential growth for China, and India has got some solid growth rates as well; both nations are well above the world average. Oil consumption in both China and India has been rising by an average of about 5.5% over the last five years, or about four times the world average.
The really important point to note, though, is that this momentum barely changed through the GFC; consumption continued to increase. Now at that time, Chinese economic growth certainly did slow, from 14% in 2007 to 9.6% in 2008, and admittedly growth is expected to be weaker than that in both 2012 (8.2%) and 2013 (8.8%) according to the IMF. But let’s face facts: as far as oil consumption is concerned, growth rates around 8-9% are still very strong. In other words, even a Chinese slowdown will be supportive of the oil market. And as for Europe? Well, it currently represents a larger proportion of the market than China – about 18% (ex Russia) against China’s 10.2%. That said, Europe has provided no contribution to the increase in global oil consumption or demand.
China and India, in contrast, provided over 40% of the increase in demand. China alone has been responsible for 30-50% of the increase in global demand at various times. So, in terms of the marginal demand, Europe matters little – even during times when demand fell. Consequently, Europe’s current recession matters little for the crude market.
We also can’t forget that China’s rapid lift in oil consumption has some way to go yet. Chart 5 (from BP) shows that per capita consumption in China is up there with Africa, a situation that is unlikely to last with the current trajectory. If per capita consumption was more in line with Europe (and current growth rates suggest they’re heading that way), we’re looking at very serious increases in annual consumption levels.
Chart 5: Oil consumption per capita
Now, another important issue to consider is the idea that there is some sort of supply glut going around. This has also apparently influenced the decision of traders to reduce their net long positions recently. Looking at the statistics, I’m not really sure that is the case though. Chart 5 below from the International Energy Agency shows total oil stocks as at March 2012. The chart shows they’ve actually declined from a recent peak and are insufficient to last much more than a month or two. There is certainly no glut.
Chart 6: Total oil stock levels, OECD
So it seems that many of the arguments that we saw back in 2006-08 are as valid as ever. Yet oil prices are some 45% below their 2008 peak. Unquestionably, much of that gain was speculatively driven, or even driven by real money managers, as investments increasingly moved into alternative assets – commodities and the like. How much of that increase was speculatively driven? Well, that’s a topic that’s subject to considerable debate. Some say none of it. Suffice to say that the issue remains unresolved. But even if, like me, you think that speculative and real money demand played an important role, and you think about the dynamics that drove this speculative or real money investment into crude in the first place, well none of it has changed. Indeed, some of the drivers have become an even more powerful force.
Consider that interest rates are historically low and the major central banks are printing money. The forces driving the hunt for yield are very strong then – stronger than in the 2006-08 period. Consider also that real investor cash deposits are high – we saw this especially in the Australian context last week. That’s an enormous pool of funds to be used when risk appetite lifts further. It would appear then that all the planets are aligned for either a strong rebound in oil, once the European issue is settled, or a long-lasting fatigue.
So, how should investors play it? Well, the low correlation of price movement between Australian energy companies like Woodside Petroleum (WPL) and crude (AUD or USD denominated) – it ranges between 0 and 30% – means my preference is for an ETF. I know there is one trading in the AUD market, BetaShares’ crude index, so it’s worth checking out.