Thursday, December 1, 2011

Goldman Sachs' Bullishness on Oil Prices

Zero Hedge reports on Goldman Sachs' top ten trades for 2012, and this one caught my eye:
6. Long July 2012 ICE Brent Crude Oil futures for a target of $120/bbl (opened at $107/bbl) and a potential return of 12%, stop at $100/bbl

As the downside risk from the European debt crisis has intensified, so has the oil market’s incentive to draw down inventories ahead of the threatened global economic recession. In particular, in its attempt to price in the potential that the European debt crisis may trigger a new global economic recession, the oil market continues to set crude oil prices too low to clear the tight physical markets, leading oil inventories to reach exceptionally low levels for the time of year. In the first three quarters of 2011 (latest available data), OECD total petroleum inventories drew by 225,000 b/d more than normal. This implies that despite Brent crude oil prices, which averaged $111.50/bbl over the same time period, current demand still exceeded the available supply. We estimate that Bent crude oil prices would have needed to average $130/bbl to restrain demand in line with supply. Further, in the absence of the IEA coordinated release of 35.5 million barrels of government inventories this summer, Brent crude oil prices would likely have needed to average $140/bbl to keep demand in line with supply.

Of course, the market had ample inventory cover from 2011Q1-2011Q3, and so the market could balance by drawing inventories rather than restraining demand. However, with inventories now exceptionally tight outside of the US, and US inventories drawing rapidly, we believe that this draw on oil inventories cannot be sustained and oil demand must be restrained either through the feared sharp decline in world economic growth, or higher crude oil prices.

Consequently, while the downside risk from the European debt crisis has increased, the upside risk to oil prices has also increased as the low level of inventories and currently tight supply-demand balance is leaving the oil market exceptionally vulnerable to supply disappointments or better-than-expected demand. Interestingly, while the oil market has spent much of 2011H2 drawing parallels to 2008H2, the more relevant parallel may prove to be between 2011H2 and 2007H2, when extremely tight physical markets set the stage for crude oil prices to rise by almost 50% in 2008H1 to a record high over $145/bbl even though the US economy had fallen into recession, much as we think the European economy is doing now
I made the following graph of the days of supply in OECD private stocks (stocks divided by consumption):

The EIA data goes through July and the IEA gets us one more month.  I'm struggling to see Goldman's argument that stocks are at "exceptionally low levels" relative to history.  Anyone want to help out in comments?

I also note that there's a flaw in this analogy:
the more relevant parallel may prove to be between 2011H2 and 2007H2, when extremely tight physical markets set the stage for crude oil prices to rise by almost 50% in 2008H1 to a record high over $145/bbl even though the US economy had fallen into recession, much as we think the European economy is doing now.  
If we look at the price history:

In 2007 H2 prices had been rising steadily all year.  In 2011 they've been slowly falling since March.

Right now I find their arguments unpersuasive.


buck smith said...

Great analysis, Stuat. Maybe they are thinking about strategic reserves (Non-private), but I think you are right to look at private stocks. Or given that it is G-S maybe they are trading against their published recommendation. ;)

Kenneth D. Worth said...

With regard to inventory levels, they don't seem to correlate at all to price. Days of supply rose through the price spike of early 08 and then kept rising through the crash of late 08 and then kept rising even more through the price recovery of late 09.

I think a lot of "inventory" in the oil market is not like stuff in a warehouse somewhere, but rather oil on tankers waiting to be delivered, in pipelines going somewhere, in storage waiting to be run through a refinery that might be off-line at the time, etc.

But you're right, Stuart, I'm not at all sure where they got the idea that inventories are exceptionally low for this time of year. Perhaps the real reason for the bullish call is China's recent actions to stimulate growth and doubts about future supply expansion. Who knows?

Don said...

Hi Stuart,

These links may help...

Note the above dates and shape of curve i.e. it is inverted aka backwardation which is one of the hallmarks of tightness and bull mkts.

Now look at the next link.

Notice the similarity (both have higher nearby prices resulting in a downward sloping curve) of the two?

Now, in the second link, continue to press the left arrow beside the month indicated until you get to Jan 2010 which is as far as you can go. Then press one of the days inside that month. Notice the shape of the curve i.e. up. This is contango, or a "normal" mkt whereby storage and interest costs force outer contracts to be more expensive.
I think what Goldman is seeing (but not revealing to us unwashed : ), is exactly this inversion. It is often very bullish.

Hypnos said...

How about an armed conflict with Iran initiated by Israel in which the strait of Hormuz is blockaded for a month and maybe a tanker or two sunk just outside Saudi Arabian ports?

For the life of me I cannot understand the current European fixation with slashing Iranian oil imports. A nuclear Iran poses absolutely no threat to Europe whatsoever (I honestly do not think it poses a threat to Israel either, and I sincerely consider Ayatollah Khamenei to be substantially saner than either Nethanyau or the entire Republican presidential field).

But the Iranian situation is the potential wild card here.

Stuart Staniford said...

Hypnos: I agree there's some small but not completely trivial near-term risk of a military conflict with Iran in which case oil prices will go into low earth orbit. But that's not the case Goldman is making.

Anonymous said...

Here's how it works, it's quite simple.

In 1979 the Iran-Iraq war greatly reduced the world's crude oil production causing a sharp rise in price in the 1980s. The money that came into the oil industry stimulated production causing the price to fall in the 1990s.

By 2004 that no longer works since world crude oil production rates hit a limit that cannot be overcome. By 2008 there were again massive price increases however this time no addition expansion of crude production has been achieved since it no longer possible.

Now there are two circumstances:

1) Economic stimulus including quantitative easing, interest rates on loans, reserve requirement for loans, Operation Twist, etc. cause the price of oil to rise.

2) Economic recession (defined as the time interval between economic stimulus efforts) causes the price of crude oil to go down.

Kobayashi said...

Or GS knows or calculates with other eventualities and probabilities but does not want to reveal those (as they may be deemed insider infos). Rather, it finds something (which most investors will not question if comimng from GS) to base its recommendation on and is now legitimately able to alert its clients to the business opportunity. I know this sounds a bit cospiratorial (although if you read the bloomberg article on Paulson's leakage of insider info to hedge fund manager, it may have happened again), and I don't personally think they are privy to any real insider info, but they probably assign a greater probability to an Iran intervention or some other disruptive event than most other investors.