Commodities | May 09 2008
By Greg Peel
An interesting comment was made on CNBC on Thursday evening. A technical analyst suggested that if you looked at a chart of the oil price without any numbers on the side, you’d buy it.
And buying it is exactly what the world is doing at the moment, much to the astonishment of many. Even as the Nymex day-session ended on Thursday in New York, the electronic session kicked in to push crude to over US$124.50/bbl. Oil is up US$10 in a week, even moving up on days when the US dollar is up, and moving up despite US weekly inventories showing a build. Can you buy it here?
Only at your peril, say the cynics. For half the world believes oil is in a ridiculous bubble – a bubble that shall soon surely burst sending the price of crude plummeting back to earth and reality. One reason oil has risen so far this week, they say, is because of an awful lot of media hype.
That “hype” centres on the now famous prediction from Goldman Sachs that oil would hit US$200/bbl. Even the traders in the Nymex pit concede the Goldmans report had fuelled a buying frenzy that allowed oil to rise in price even as the US dollar was rising. As Citigroup analyst Tim Evans argued, the news was driving the price rather than the price driving the news.
Evans went on to suggest that oil could “just as easily fall to US$40/bbl”. Supply, he suggested, was “comfortable”. So ridiculous did this statement sound that it was quickly dismissed by the market. They laughed at Evans just as heartily as they laughed at Goldman Sachs two years ago when those analysts suggested oil would go to US$105/bbl. Oil was around US$60 at the time. Well, they aren’t laughing now.
The fact that oil has now easily surpassed US$105 has provided the Goldman analysts with guru status. Thus if Goldman says it’s going to US$200, then to US$200 it will go. Buy, buy, buy, buy, buy.
There are two small problems here, which one might put down to “selective hearing”. Problem #1: Goldman never said oil would go to US$200/bbl. Problem #2: Tim Evans never said oil would go to US$40/bbl.
Goldman Sachs has a policy, when providing forecast prices for any commodity, of providing a “base case” forecast and an “upside” forecast. The base case is the forecast the analysts use in their models to thus value commodity stocks. The upside case is one the analysts offer as the extent a commodity might run to in the period were there to be some extenuating circumstances. Such circumstances, in oil’s case, could be many, with “supply disruption” of some sort being top of the list. What might happen, for example, if an angry Iran decided to blockade the Persian Gulf?
But the media wasn’t interested in Goldman’s forecast of US$110/bbl average. It only saw a news story in the US$200/bbl “upside” case.
And the proverbial hit the fan at Citigroup, an FNArena mole reliably informs us, when Tim Evans suggested oil could “just as easily fall to US$40”. The problem for poor old Tim is that he never said that at all. What he said was, “oil could easily fall by US$40″. A slight mis-hearing, and Evans became front page news.
Evans is not alone in believing oil could, or even should, fall to US$85/bbl. This is exactly what, for example, the Macquarie analysts are suggesting is the right price. It also happens to be where the oil price started 2008. Macquarie is in the “bubble” school of thinking, as are the analysts at GaveKal.
“We firmly believe oil is now trading ex-fundamentals”, says GaveKal, meaning it’s all about “fluff” and nothing about “stuff”. But GaveKal backs up its view with a compelling argument.
One of the favourite trades of players in any options market is to sell out-of-the-money calls when volatility is very high (as it is presently in oil). The idea is to pick a level where one believes the price will not reach before expiry, and collect the premium on offer by selling the calls at that strike. When oil passed US$100, notes GaveKal, all the option traders were selling the US$120-125 calls. The belief was that oil would trade up to ring the bell at three figures before falling back once more.
Well, they were wrong, and many would have watched in disbelief as oil kept on pushing its way up towards US$120. It hit this level a couple of times and retreated, and option traders’ heart rates also fell back. But then came Nigeria, and Goldmans, and all hell broke loose. When oil started running towards US$120 again it was time to cover those short calls. Now!
This goes a long way to explaining why oil would go up even as the US dollar is rising. For the bubble school has always assumed it would only take a bit of a turnaround in the weak dollar and oil would come crashing back – at least to US$105, perhaps to US$85.
In 2006 oil hit US$78/bbl on a savage run-up, fuelled mostly by the war between Israel and Lebanon. When the war ended oil quickly fell back to US$58/bbl. That was a fall of 25%.
If oil fell 25% tomorrow it would reach US$93/bbl. If it fell 20% – widely regarded as a figure that represents a “correction” (see US stock market, first quarter 2007), oil would be sitting at US$100/bbl. It is more than likely three figures would hold it, as this was the magic break-out point in the first place. The question is, however, what sort of blessed relief is US$100/bbl oil?
But as each day passes, nothing happens. Perhaps by the time you read this article, it will have. But what? What will be the pin that pricks the bubble?
Could George Bush be a prick? For George is shortly off to Saudi Arabia to plead for OPEC to please increase production before the US economy goes down the toilet and no one can afford to buy the oil anyway. OPEC is a very big part of the equation, for OPEC has steadfastly refused to raise its production quota, arguing that oil is presently trading on speculation alone and the supply/demand balance is such that OPEC need not produce any extra oil at this time. Supply is “comfortable”.
GaveKal agrees with OPEC. The world currently has 2 million barrels a day spare production capacity, GaveKal argues. This is set to double next year to 4 million according to the most recent International Energy Agency assessment. Moreover, US demand for oil is currently dropping faster than the US Energy Information Administration had previously forecast. And this is having a bizarre effect. Try and work this one out:
US refinery capacity utilisation has reportedly fallen to 85.4% this year from 87.6% last year. Whoop-de-do, I hear you think, that’s hardly monumental. But what’s going on at the refineries is another supposedly important part of the US$125 equation. Refineries are currently undergoing regular maintenance ahead of the US summer “driving season”. Okay, that much makes sense, less refining – higher gasoline price. But refineries also suggest they have pared back capacity due to falling demand for products such as gasoline, diesel and heating oil. The end result is lower product inventories, higher product prices, and a crude price being dragged up as well.
In other words, lower demand is resulting in a higher oil price. Go figure.
In the meantime, crude inventories are backing up. US inventories rose last week for the very reason that refineries aren’t demanding as much input. GaveKal reports that over in Iran they have so much crude production backing up that they’ve had to hire tankers just to sit in the harbour and store up to 28 million barrels of oil. On this basis, you would really, really have to think that the oil price must surely crash soon.
But then there’s Nigeria. Why is Nigeria so important?
Nigeria produces an oil with the romantic name of Nigerian Bonny Light. Danske Bank points out that Nigerian oil is “pivotal” to world production as it is the sweetest of the sweet crudes and highly sought after by US refiners preparing for summer driving season gasoline demand. Nigerian rebels have been attacking oil pipelines for at least two years now. Every now and again there’s a lull, and then the attacks recommence. The problem at present is, as Barclays Capital suggests, that “the continuation of violence in Nigeria appears inevitable given the lack of mediation between the rebels and the government”.
This last week Royal Dutch Shell was forced to dramatically reduce production in Nigeria as rebel attacks on pipelines intensified. Exxon-Mobil had already been forced to come to an arrangement with local unions in order to end an 8-day strike that saw 30% of production shut down. It is a volatile situation in the Niger Delta, and a resolution does not appear forthcoming.
If Nigeria is to 2008 what Israel-Lebanon was to 2006, then one might suggest it will be peace in Nigeria that can set off oil’s correction. If it were only that easy. Nigeria is part of the “supply” problem.
On the other side of the fence from the bubble school sit the fundamentalists. The fundamentalists do not buy the bubble argument. Sure- there is speculation going on in oil just like there always is, but it is not speculation that is driving oil well above US$100/bbl. It is simply, they argue, rising demand meeting falling supply.
Barclays Capital is one of the strongest proponents of this argument. This week the analysts put up their average 2008 oil price forecast from US$102/bbl to US$116.90/bbl, thus rising to join the top of the list (not counting Goldman’s upside case, of course).
What ever you want to argue about OPEC, Barclays points out that which many others draw upon as well – “non-OPEC supply remains weak and continues to underperform dramatically relative to consensus expectations”. The most recent addition to the list of underperforming non-OPEC producers is Russia, where oil production has fallen to well below forecast estimates. Russia was to many a Great White Hope as far as providing additional production capacity for the world, but this has not happened. By falling short of estimates, Russia, among others, is challenging IEA supply increase forecasts.
What also hasn’t happened is any meaningful fall in OECD demand. Barclays suggests “the decline in OECD demand that started way back in 2005 has not accelerated significantly and has not been consistently large enough to bring global demand growth back to much below one million barrels per day”. This is despite arguments above that US demand has indeed fallen more than had been expected due to the weakness in the US economy (and the price).
The other standard argument, believed by some but not all, is that global demand for oil should also fall as (a) prices rise and (b) the weak US economy resounds across the globe. However, that oil demand growth remains “robust in key pockets”, says Barclays, particularly – you guessed it – China, India and the Middle East. When you think about it, it’s pretty hard for oil demand to fall when around two billion people are buying their first ever car. Chinese demand alone, notes Barclays, is “well on course” to be stronger in 2008 than it was in 2007.
Barclays final argument is that despite traditional expectation, the introduction of extra production capacity anywhere on the globe has not meaningfully materialised as a result of the oil price rising to a point that makes many different sources now economically viable. What has thus followed is the perception of the oil price at which supply comfortably meets demand has been constantly drifting up in analyst assessments. Nor have alternative energy sources, such as biofuel, made much of an impact.
There are issues surrounding alternative sources which are providing impediments. For example, the ethanol argument is reaching a critical point now that third world countries are experiencing food riots. At what point do governments step in and halt the biofuel bonanza? Environmental issues are another concern which, for example, are hampering the great Canadian oil sands solution and ensuring, to date, that US sources such as what is known to be under Yellowstone National Park, what is known to be under the pristine wilderness of Alaska, and what is supposedly the source of “25% of the world’s undiscovered oil reserves” (I could never quite get my head around that one) in the Artic Circle remains securely where it is.
Add all this together, and Barclays suggests, “While the current dynamics remain in play, we do not believe that analysts can even make the statement that fundamentals imply that prices should be lower”.
And Barclays’ analysts are not alone in that belief.
To return to the opening paragraph of this article, let’s not forget our old friends the technical analysts. Barclays technical analysts said only this morning that they are looking for “further gains towards US$130/bbl”.
One final point. If there is a speculative bubble going on in any commodity, it is always reflected by the “front month” of that commodity’s futures contract being at a significant premium to subsequent time periods. In the case of oil, so flat has the backwardation become that forward prices out to several years are all over US$100/bbl. That is not a forward curve that suggests anything less than an ongoing supply/demand imbalance.
So there you have it – both sides of the argument. Where is the oil price headed from here? I have absolutely no idea.
