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  • 7/26/2019 EM - Deconstructing Oil


    Ecstrat 28thOctober 2014

    Emad Mostaque | John Paul Smith emad@ecstrat.com |jp@ecstrat.com 1

    Deconstructing Oil

    At the turn of the year I had the curious positions of predicting that jihadists would over-

    run western Iraq1and the oil price would fall to $90 (Brent).

    Unfortunately Iraq has fallen apart and while the oil price spiked as Iraqi violence increased,

    but has since fallen below $90, finding some stability at the $85 level ($80 for WTI)

    This note considers why oil fell as it did, where it may go from here and broader impact,

    with the key takeaways as follows:

    1. Structural issues with Brent have caused pricing abnormalities that are reverting


    ISIS has significant regional impact, but is a minimal threat to supply. For now

    3. OPEC largely irrelevant, Saudi Arabian influence also declining on global flow changes

    4. Supply disruptions have likely peaked, particularly in Libya and Iran

    5. Shale is not the swing barrel, lower prices are setting the scene for higher prices

    Certain geopolitical developments have been left out due to their sensitivity, better

    discussed directly with clients rather than in a note.

    My oil model, a hybrid that has been very successful thus far (Fig 1) has flipped back to a

    buy for both Brent and WTI, with a target in the next few years of $130 per barrel.

    The near-term downside risk is to around $77 level if we see a resumption of the broad risk

    asset sell-off, but it is unlikely to stay at these levels, with a band of $90-100 likely next year

    (dependent on how bad China gets)

    Fig 1. Public model recommendations and the dated Brent oil price (+172% rel)

    Source: Bloomberg, Emad, Religare, Noah. Rel performance by going ow or uw oil at position changing points

    1Business Insider Most Important Charts of the Year December 18th2013 #1:


  • 7/26/2019 EM - Deconstructing Oil


    Ecstrat 28thOctober 2014

    Emad Mostaque | John Paul Smith emad@ecstrat.com |jp@ecstrat.com 2

    Rubbish Models

    The fact that our econometric models at the Fed, the best in the world, have been wrong

    for fourteen straight quarters does not mean they will not be right in the fifteenth quarter.

    Alan Greenspan, 1999 testimony to Congress

    Before analyzing how oil prices got to where they are today and where they may end up infuture, it is important to construct a reasonable model and understand the key assumptions

    that may influence the price.

    As the above quote shows, modelling is terribly difficult and after all the hard work and

    effort we put into our models, we do on occasion overstate how great they are, blinded by

    their intricate construction to the fact that rubbish in generally still leads to rubbish out.

    Indeed, when modelling multivariate real-life situations such as oil, the economy or stocks,

    one can assume that any model you build is highly unlikely to give any lasting edge over the

    competition unless it is fundamentally different, which is generally a lonely place to be.

    Demanding oil

    Most oil models tend to be quite similar, based on oil demand. The theory is that one can

    extrapolate demand growth from a mixture of GDP growth, demographic trends and

    looking where countries are on the oil consumption per capita curve, thus inferring

    demand growth, which in turn leads to supply growth to match it.

    If one then plots the cost of extracting various types of crude, you can figure out the

    marginal barrel for a level of crude and how much that costs and infer the price of spot

    crude from there dependent on more bottom-up factors such as inventory levels

    Fig 2. Change in Consensus 2014 GDP Forecasts

    Source: Bloomberg

    Fig 2 shows how difficult forecasting even GDP growth a year out can be, with other factors

    on oil such as energy intensity of usage for even well-known markets such as the USA

    similarly opaque and difficult to judge.

  • 7/26/2019 EM - Deconstructing Oil


    Ecstrat 28thOctober 2014

    Emad Mostaque | John Paul Smith emad@ecstrat.com |jp@ecstrat.com 3

    Thus most forecasts tend to be extrapolations of spot, with current consensus forecasts

    moving in line below $100 and even $90 despite no major shifts in expectations of either

    demand or supply, a familiar, herd-based pattern in prediction.

    It may well be that we overestimate our ability to judge the impact of small moves in

    localized factors on the overall oil market, with oil elasticity very strange due to EM

    subsidies and developed markets being significantly well off (just about) not adjust.

    It seems that the oil price is more influenced by stories and perceptions of reality, from

    peak oil to shale oil to the Arab Spring as opposed to more quantifiable data. There are key

    levels for consumption and production adjustments and at which the price will react.

    It is also worth questioning the quality of data in the market, as it seems that the market

    moves more often on sentiment than reality, with 500,000 barrels of oil disappearing from

    Sudanese exports of negligible impact versus maintenance on fields with less than 100kbpd.

    Figuring out which barrel is more important than another is tough.

    My approach is a hybrid of supply and demand-based constraints with elements of

    behavioural analysis bolted on. It is not very pretty, but has thus far been effective, with

    some of the key elements from it being the approach to understanding how oil pricing

    structures may contribute to instability, which is covered in the next section, and how key

    market participants may act versus common perceptions.

    A Tale of Two Benchmarks

    The way that oil and oil-related products are priced has changed in the last few years.

    WTI (West Texas Intermediate) crude used to be the center of the oil pricing universe.

    Other crudes and derived products would price as differentials to the spot price of WTI

    observed at Cushing, Oklahoma based on blend quality, local supply/demand and so on.

    The spot price also set the basis for the futures curve that could be used to hedge supply

    and demand. 3-5 years out, this approximated the marginal cost of production for oil as

    otherwise suppliers or consumers could lock in prices for guaranteed profit.

    When the spot price is above future prices (contango), oil is encouraged to come to the

    market and when it is below (backwardation), oil goes into storage and production is idled.

    As we entered the financial crisis of 2008, WTI became increasingly affected by local factors

    as flows from Canadian oil sands and shale led to huge inventory builds.

    As such, the center of the oil pricing universe moved to the North Sea and the Brent blend,

    also known as BFOE (Brent, Forties, Oseberg and Ekofisk) crude after its four major fields.

    Derived products (such as gasoline) and even US coastal blends like LLS started pricing with

    Brent as a basis, as can be seen in Fig 3.

  • 7/26/2019 EM - Deconstructing Oil


    Ecstrat 28thOctober 2014

    Emad Mostaque | John Paul Smith emad@ecstrat.com |jp@ecstrat.com 4

    Fig 3. Who uses Brent vs WTI, source OEI, ICE

    Source: OEI, ICE

    However, structural elements of how Brent is calculated combined with investor behavior

    may have led to distortions in the oil price that are only now normalizing.

    Futures and financialisation

    In the mid-noughties, institutions started to allocate huge amounts of money to

    commodities via index funds that predominantly used futures contracts, lured by the

    promise of endless Emerging Market growth and Malthusian outcomes.

    The debate continues on the impact of these financial flows, but the theory was that it

    should be minimal as these funds typically invested via futures and didnt hold these

    contracts to expiration, meaning spot prices should be determined by the physical market.

    This was especially true of the largest component of these indices, WTI, where one had to

    take physical deliver on maturation. Thus institutions expressed their commodity bets byowning futures and rolling them into further out futures before expiration, earning a nice

    roll yield as commodity curves tended to be in contango , selling high and buying low.

    Brent has a slightly different structure as outlined in Fig 4.

    Fig 4. Brent Pricing Structure

    Source: ICE

  • 7/26/2019 EM - Deconstructing Oil


    Ecstrat 28thOctober 2014

    Emad Mostaque | John Paul Smith emad@ecstrat.com |jp@ecstrat.com 5

    This is more complex, but there are three key elements of interest here:

    1. You dont need to take physical delivery of Brent but can cash settle, indeed the

    physical market is 1,000 times smaller than the futures market in volume

    2. Forties is the most important