Why 100-Dollar Oil is Rational

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At the present time, because "currency wars" are the new Call of Duty for finance ministers and central bankers worldwide, it could be risky to predict oil prices attaining US$ 100 a barrel before year end. If the rash of competitive devaluation and depreciation of leading moneys continues, especially the US dollar and the euro, with the Chinese Yuan still receiving the same treatment, a tilt back into global economic recession is in no way impossible. And any dip in global economic growth will slay oil prices, like other commodities and equity values.

Growth of world oil demand stays difficult to forecast, but is surely positive because the global economy is growing. Due to the European debt crisis, there is a strong potential for renewed speculation against the euro, with a quick knock on to falling us exports (due to a stronger dollar) and further hesitant growth of the US economy. Under almost no circumstance can we give any credibility to claims by the Obama administration that growth could attain 3% or more by early 2011 on an annual basis, but oil demand of the US is unlikely to fall.

The 30-nation OECD group still takes more than 50% of world oil and over 55% of world oil export volumes, keeping the OECD outlook important for oil prices.

Not only the US economy will underperform the rest of the year, but Japan and South Korea also face soft or weak economic growth outlooks, but these risks and doubts are often exaggerated or over-weighted in global analysis of oil demand drivers, and growth of world oil demand can become under-estimated. For world oil demand, we can be sure, emerging economy growth generates sure and consistent growth.

BACK TO BACKWARDATION

Sentiment-driven oil pricing driven by non-fundamental factors outside supply/demand is usually stronger when we have what are called "contango" prices for any kind of commodities, and financial assets. That is current prices for spot delivery are lower or much lower than future prices, for delivery some weeks, months or years ahead. Conversely the opposite price profile (called "backwardation", when spot prices are higher than future prices), is normal for oil market trading and preferred by OPEC. When future prices are much higher than spot prices, in 'strong contango' the market is unstable and likely to change, which has been the situation until recently in 2010.

The quick and large bidding down of near-term future and spot prices by oil traders, with Nymex prices losing over 20% through as little as 15 days several times this year to date, the clear fact is that long dated forward prices resisted. This is because the market understands the basic fundamentals of future structural undersupply and a structurally weak US dollar.

We can note that very long dated futures, for example 2017 or 2018 contracts, stayed near US$ 90 a barrel throughout most of the period this year to date (May-September) during which near-dated contracts were able to fall far below this price. Reasons for this are an interesting list of economic, financial, monetary and oil industry fundamentals.

Firstly the global economy, as IMF forecasts go on showing, and driven by the success of the Chinese and Indian economies, may grow by 4% to 4.5% in 2010 despite the European and US sovereign debt crises, and the always-high US trade deficit. World oil demand has stopped contracting and will most surely grow for the full year 2010 - not contract as it did in 2008-2009. Whenever global oil demand rises for more than a few quarter-year periods at a time, supply problems have to start being taken seriously: any shortage, even short-term, can drive prices up very fast. Falling prices become rare and are quickly corrected by traders buying again.

Secondly as we know, since midyear the Euro declined quite fast, by 15% or more, against the US dollar followed by the reverse sequence. Today in November it is possible that FX traders play the same movie again, and talk down the euro after talking it up. This time however it is unlikely oil traders will use this as a signal that the dollar price of oil can slip back: oil exporter country confidence in both the dollar and euro has been eroded in 2010. Gold and precious metal prices, and the soft commodities will increasingly serve as the reference pricing base for oil.

More serious and long-term reasons concern oil sector fundamentals. This specially concerns deep offshore production, Canadian tarsand oil, and synthetic oil production from processes such as GTL (natural gas to oil conversion), and the biofuels. All of these are high cost, or very high cost alternatives to conventional onshore oil, and need oil prices well above US$ 85 a barrel - on a sustained basis - to have an economic rationale and to attract investors, especially where capital costs for production equipment and infrastructures are rising fast.

Real supply alternatives are in fact and mostly small scale, take a long time to develop, and are high cost. Outside the export supply from OPEC states, IEA data claims that non-OPEC supply totals at least 52.4 Mbd (million barrels a day), while other estimates, for example by Bank of America Merrill Lynch place the non-OPEC supply at around 52 Mbd. OPEC export supply requirements, for balancing world demand, can be calculated using this type of data.

Under any hypothesis excluding a return to global economic recession and falling oil demand, pressure on oil prices will tend to rise. One way to measure the arrival of more rational and realistic views, by oil market traders in the next few weeks, will be the shift from contango to backwardation, through a steadily rising price level for spot and short-term future contracts.

Oil prices of US$ 90 a barrel are now both rational and sustainable, but in a context of currency war and competitive devaluation, this price level is almost surely going to be surpassed, in a generalised process I call Petro Keynesian Growth which will lever up all commodity prices.

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About Andrew McKillop

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