Oil markets, where next?

Last year the oil price surged to record breaking levels. However, just as it reached its peak at $145 a barrel, the credit crisis took hold. Amidst the collapse of Bear Stearns and Lehman Brothers, the bailout of AIG and the sale of Merrill Lynch to Bank of America, the oil price started a depreciation that would shed four fifths of its value. Prices bottomed out at $40 a barrel at the beginning of this year where they steadied themselves before a modest advance to where they ended July at just under the $70/bbl mark. But where will the oil price head next?

Philip Verleger told Bloomberg that he thinks that oil prices are still too high, and that he sees oil falling to $20/bbl. He argues that three reasons depict that there should be a dip in the oil price; demand, supply and inventory capacity.

Demand is weak and stabilising, but there is little evidence of an upturn in the recovery in energy demand. US oil demand is still decreasing and the high rate of unemployment means that less people are driving to work and fuel consumption is easing further. People are also buying more efficient cars which again drives down fuel consumption. Oil demand might continue to contract for years to come as the world economy suffers.

Supply is relatively inelastic, which means that changes in demand have a marked affect on energy prices. Besides supply and demand, there is also inventory capacity and storage costs to consider . We are currently 5% away from the previous peak in world inventories and should reach capacity by this September. This will have a negative effect on the demand for oil, as we will already have enough of the fuel to get us through the winter even if half the world’s refineries shut down. Storage costs are also important at the moment. Since there is so much oil in storage, a rise in storage costs will force people to mark down the price they are willing to pay for oil.

I believe the fundamentals are there for a striking fall in the price of oil but it seems the markets are far more bullish than I am. Take wednesday’s inventory data for an example. Oil inventory data was released which showed a massive increase of 5.1m barrels in crude stocks, much higher than the consensus estimates of a fall of 1.3m barrels. As expected, prices plunged by $4. That to me is where prices probably should have stayed for while but then the bullish speculators took over. The price trimmed its losses later in the session (to just $2.72) and completely recovered on Thursday as Chinese officials declared that it would continue to operate a loose monetary policy.

So why is the market so bullish? There are many who believe that the oil market is being overrun by speculators. As things stand traders can use nearly unlimited credit to swing prices in either direction, and that’s causing false valuations of oil. Jim Cramer called the market a “farce”. The CFTC has taken notice of the complaints and may look into changing position limits (the number of futures positions a trader can have open), this action would try and keep individual traders from placing orders so large that they move the market. Of course, intervention like this is strongly opposed by the financial community. Jeffrey Sprecher, chief executive of ICE, a commodities exchange, said “While well intentioned, these measures often fail to achieve their desired objectives or, worse yet, lead to unintended consequences.”

Another important question is whether the national governments will intervene in the oil market. The US keeps strategic reserves, and could push the oil price up if it wishes by adding to them. China has also started to keep strategic reserves. Indeed the oil price hike last year may have been exacerbated by increases in strategic reserves by these governments. Gordon Brown and Nicolas Sarkozy have voiced their distaste for large oil price fluctuations in an op-ed in the Wall Street Journal. They said “we as consumers must recognize that abnormally low oil prices, while providing short-term benefits, do long-term damage. They diminish our incentives to invest not only in oil production but in energy savings and carbon-free alternatives. It is a thorny issue, but complex markets need not be volatile or damaging to the wider global economy. We are convinced that producers and consumers alike would benefit from greater transparency, greater stability and greater consensus on the market fundamentals. After two years of destructive price volatility, the time has come for both sides to work together to build on our common interest.”

Brown and Sarkozy make a good point. Lets not forget that if prices were to fall to as low $20/bbl, it could have devastating effects to the global economy. Take BP for example, they have already announced a collapse in profits and would struggle to keep up its capital spending  programme and dividend payments as their cash flows diminishes from such a low price. BP needs an oil price of $60/bbl to keep cashflow neutral and a fall to $20/bbl would leave BP with a gaping whole in its finances, which could criple UK GDP.

Following CFTC action, the FSA has called a meeting with major oil companies, banks and hedge funds to review oil market regulation in the UK. The meeting, held on 5th August, will unlikely result in new reglations just yet as any action needs to be well thought through. Large price fluctuations, rogue trading and government intervention are unhealthy characteristics in any market.

So, fundamentals indicate that oil could be priced at a deep discount to its current value; however, it seems commonplace in today’s markets for fundamentals to go somewhat ignored. Where will oil prices head next? We wait and see.