The key to the puzzle

CGES | DECEMBER 2009 | SOURCE: Global Oil Insight

Churchill's famous dictum can easily be applied to the oil market by substituting 'the oil price' for Russia and 'the oil futures market and expectations' for Russian national interest.

From January '09 onwards it had become clear that the world was experiencing the worst recession since the 1930s. Along with falling GDP and plunging international trade came declining oil consumption, but the drop in oil demand was not universal.

The key to the puzzle

Oil use in the OECD countries will, we think, fall by almost 4% in 2009 and in the former Soviet Union by 6.5%, whereas it should grow this year by 2.6% in China and 1.3% in the rest of the non-OECD world.

Even so, we estimate that oil demand over all will decline by 1.8% (1.6 mbpd) in 2009 and yet the price of oil [Dated Brent] has spiked by 76% between January and November this year, a far steeper rate of increase than the 45% surge from January '08 to a record high of $134/bbl in July last year.

Falling oil demand and rising oil prices somehow do not go together, particularly during a recession and especially when global oil stocks, and — more to the point — inventory cover, have not been decreasing.

The plot thickens when we take into consideration the fact that refining margins have remained consistently low this year and average refinery utilisation rates have been well below 85% both in Europe and the US. It is difficult to argue that oil product markets were pulling up the price of crude oil when there was so much spare refining capacity lying idle.

More esoterically, we have had to resort to a dramatic 13-day increase in desired global inventory cover between 4Q08 and 2Q09 to explain the observed surge in the price of oil this year.

We believe that spot oil prices are driven by 'inventory disequilibrium', i.e. the difference between the oil stocks companies want to hold and the stocks they actually happen to possess, so to obtain a surge in the price of oil when oil stocks are rising requires a strong boost to desired stocks, which is difficult to justify at a time of recession and collapsing oil demand, unless there are other considerations.

What could these be? Given the huge size of the paper oil markets, including the OTC trades in non standardised products, it is to this part of the oil complex that we are compelled to direct our attention.

The oil market is no longer anchored on the so-called fundamentals of physical oil, which after all represents a very small fraction (around 5%) of the 'oil' traded on the exchanges daily. Furthermore, for some years now oil has been not just a commodity play, but a financial one also, in which investors buy and sell oil derivatives in the hope of earning higher returns than those provided by alternative investments.

Oil as a financial play is susceptible to money market considerations (the US Dollar carry trade, for instance), exchange rate pressures (movements in the Dollar versus the Euro and the Yen) and the behaviour of stocks and shares. Is it a mere coincidence that the price of oil and the Standard and Poor's 500 index both started to head north at around the same time in February this year?

How is upward price pressure in the oil derivatives markets transmitted to the spot market for oil? In other words, how can a financial play in oil affect the physical market for the commodity?

Expectations of a global economic recovery and a concomitant revival in oil demand lead to upward price pressure in the oil futures markets along the forward curve, widening the contango — other things being equal.

A rising contango encourages cash-and-carry hedging, by which oil companies and traders buy physical oil and simultaneously sell oil forward in the futures markets. In this manner upward price pressure builds in the physical market while forward prices weaken in the paper market, reducing the contango.

Over time, the forward curve should flatten, thereby reducing the incentive to buy (and store) physical oil and thus the pressure on spot prices, unless another wave of upward pressure appears along the forward curve, kicking off the whole process once again. Does not OPEC have a role to play in all this?

Surely the world's residual supplier must be able to influence the price of oil? Of course it can and indeed does, but through the filter of expectations in the futures market, which is subject to many influences — oil and non-oil. The key to the puzzle can no longer be found solely in the world of physical oil.

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