How Oil Could Kill the Qantas Rally

How Oil Could Kill the Qantas Rally

On Wednesday, the Daily Reckoning Australia took you to Italy.

Well, we’re racking up the frequent-flyer miles this week. Today, we’re going to Mexico.

Alas, we have no time for a Mariachi band or a dip in the sea at the Playa del Carmen. We need to keep things strictly business.

That’s because, on 1 July, Mexicans go to the polls in the presidential election.

Most people don’t care who runs Mexico.

But they should start caring.

Lopez Obrador, the candidate leading in the polls, is a leftist with a sympathy for the days of total nationalisation of the Mexican energy industry.

That’s giving some of the major oil companies slight discomfort.

They have committed big dollars to the Gulf of Mexico, and that includes BHP Billiton Ltd [ASX:BHP]. These companies plan to increase capital expenditure unless something changes drastically — such as the election of Mr Obrador.

The last thing the world needs right now is another worry about oil supply. Or another reason for major oil companies to hold back on investment.

Mexico is the smallest producer in North America, but it’s not insignificant, producing about 1.9 million barrels a day.

In any case, demand for oil appears strong in the face of trade wars and a wobbly Italy.

One of these signals is that the oil market is in what’s called ‘backwardation’. This refers to a situation in which the spot price of a commodity is higher than the forward price.

In the futures market, contracts expire on different dates. For example, a refiner can order oil for delivery in six months’ time but lock in a price today.

The market goes into backwardation when the spot price of oil — what it costs to buy now — is higher than the price for contract months further out.

July oil futures settled at $67.17 a barrel in New York overnight. But for September it was $66.68 a barrel.

So you can see the ‘front’ month is trading above the ‘back’ month. This suggests a strong demand for oil.

Not only that, but oil is holding around its highs despite the strength in the US dollar.

Airline stocks have a big worry

That means oil demand is still strong even though, for instance, it’s getting more expensive for Europeans with the buying power of the euro slipping.

The World Bank released its Commodity Markets Outlook report recently. It noted that Indian demand for oil was up 11% in the first quarter, despite the rupee being one of the worst performing currencies this year.

If you own energy shares, there’s the prospect of good profits. But there’s the natural flipside to this as well.

For example, costs are going up for consumers. You’ve seen it with your petrol bill. But it’s not just motorists filling up at the pump feeling the heat.

Global shipping giant Maersk whacked a surcharge on its customers because its fuel bill is up 20% this year.

What’s more, the chief of the International Air Transport Association revised down his outlook for airline profits.

I flagged a cautious note on Qantas Airways Ltd [ASX:QAN] recently on the back of this. Regardless, the stock is holding up well for now.

US shale can’t help here 

Here’s what worries me:

Jet fuel is what’s called a ‘middle distillate’.

Different grades of crude oil produce jet fuel better than others. Heavy, sour crude is best for diesel and jet fuel.

The catch is that most of the supply gushing out of the United States is shale oil, which is light, sweet crude.

This is why the collapse of Venezuela is so important.

It’s not just that the world loses the barrels Venezuela produces. It’s that it loses the type of heavy crude that it exports.

US refiners use the heavier crude to mix with the lighter American grade.

You have to remember the refinery system in the US was built on the assumption that they would be importing the majority of their oil from the Middle East.

US exports of crude were banned until 2015. This explosion in US energy has surprised everyone, including the US.

The dire situation in Venezuela means these US refiners have to find those heavier barrels elsewhere.

This is why we might see different oil benchmarks trading at wildly varying prices. There’s already quite a price difference between Brent crude ($77) and West Texas Intermediate crude ($67).

Brent is regarded as the ‘world’ price of oil, though this benchmark is now basically redundant.

There are two reasons for this.

One is that the Brent oil and gas field in the North Sea is in decline.

The second is that the US is now the global ‘swing’ producer. That’s a term used to describe a supplier that controls global deposits and possesses large spare production capacity.

All told, exports of US oil are likely to keep booming and ultimately dictate the global price. The infrastructure just needs to catch up.


Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia