Market watch

Classic price signals such as falling oil reserves, economic quagmire in the Organisation of Economic Cooperation and Development (OECD) countries and slackened growth in emerging markets all failed to quell the market on the way up to July, while geopolitical flashpoints, storms looming over the Gulf of Mexico and even production cuts by OPEC memeber states are now failing to stop its decline.

This raises a number of ‘inconvenient’ truths as to the self selecting nature of ‘fundamentals’ in play at any given time in oil markets.

Red rag to a bull, or is that bear?

During a stampeding bull market up to July 2008, traders failed to let news of sharp falls in US employment figures or weakened growth in Asia cool the market, as speculators piled into oil as a hedge against the weak dollar amid rising inflationary pressures.

The longer term cause of this upward run was the fact that financial investors were convinced that tight supply-demand fundamentals could be exploited as they built up a large net long position in crude oil futures from 2004 onwards.

Every scrap of geopolitical friction was seized upon to push prices up; the hijacking of a small Japanese oil ship passing through the Gulf of Aden prompted the market to hit $117/b while intractable conflicts in Iraq and Nigeria alongside fears of production cuts in Libya, all supposedly served to bring supply-demand fundamentals closer together.

Rumblings in Latin America were billed as a potential ‘Andean cataclysm’ rather than a largely predictable and well rehearsed contratante between Venezuela and Colombia.

Even failed Presidential candidate, Hilary Clinton, managed to move the market by firing a ‘virtual warning shot’ across Iranian bows.

Contractual instability for International Oil Companies (IOCs) operating in Russia and Central Asia also came as a supposed ‘surprise’ to the market in restricting Non-OPEC supply, which admittedly, still has more mileage than the death of Benazir Bhutto drawing supply-demand fundamentals closer together when pushing the markets to brink of $100/b in the closing hours of 2007.

Little wonder then, that despite a lack of any major change in market fundamentals (beyond Saudi Arabia working towards a record 12.5mb/d output by 2009) investment banks started to hint towards forecasts of $200/b.

Not to be ‘outdone’, Gazprom nudged estimates a little higher hitting $250/b, a figure that many analysts started to present as a self fulfilling prophecy as the markets approached the $150 mark in July 2008.

But just as the rising market wouldn’t let weak employment figures or dampened growth forecasts stop the oil markets meteoric rise, it is now highly unlikely that a declining market will let ‘minor’ inconveniences such as heightened contractual instability in oil producing states or major geopolitical flashpoints stem its decline.

Long standing OPEC stubbornness to increase output no longer appears to be a major problem, nor does entrenched difficulties in the Niger Delta.

The fact that Evo Morales has been fighting for his political life in Bolivia as Pervez Musharraf desperately clung onto his last vestiges of power in Pakistan has barely touched the sides as the oil price slipped to $112/b.

Iran’s threat in early August to block the Strait of Hormuz should Tehran be attacked, also failed to register, (a point which stands in stark contrast to the $6 spike following Iranian missile tests merely a month earlier).

Wall Street runs its course

This all points us towards our first inconvenient truth; namely, that speculation has added a sizeable chunk on the oil price in capitalising on tight market fundamentals.

Given that the latest ‘price signals’ in the Caucuses over the fraught existence of the BTC pipeline and broader access to Central Asian oil reserves that feed it, or storms in the Gulf of Mexico, have actually prompted the oil market to drop even further (hitting $106/b), provides unequivocal evidence that the market is currently being dictated by financial investors unwinding their net long positions to realise capital gains and release liquidity, rather than any shorter term price signals in play.

Such events, merely two months ago, would have made prices above $170/b entirely conceivable.

Instead, the market is now steering itself towards a ‘fundamental correction’ to the $85-95 per barrel mark, which remains a truer reflection of the oil
supply-demand fundamentals to hand.

Even the latest production cut from OPEC in Vienna (September 2008) failed to rally the market (closing at $102/b), underlining the degree to which speculation not only broke all the rules in forcing the market up, but is now having to reinvent itself on the way down in order to restore rationality.

OPEC is back on – just about

The re-entry of shorter term price signals to market sentiment ‘pegged’ to underlying fundamentals will, however, come as welcome news to OPEC, and in particular, Saudi Arabia, which prizes notional control over the oil market more highly than revenues.

But the downside for OPEC is that it will come under renewed scrutiny to increase output, particularly as non-OPEC supply continues to lag. Unfortunately, this brings us to our second inconvenient truth; OPEC is highly unlikely to put more oil onto the market any time soon.

This is either because most members of the cartel are already producing at maximum capacity, or more pertinently, because all producers (including Saudi Arabia) are enjoying elevated prices and are becoming increasingly confident that market demand will remain relatively inelastic.

Admittedly, Saudi Arabia might increase output on an ad hoc basis to cool the political ardour of Iran on geopolitical issues such as Lebanon or nuclear proliferation, but this will remain a short term play rather than a revision to flooded markets in the 1980s.

In effect, the days of ‘price moderates’ within OPEC could be over.

The upshot is that prices are unlikely to ease much into 2009-10, with further pressure expected by 2011-12.

Needless to say, such a scenario is getting ‘peak oilers’ very excited, but in reality, it is not so much the physical availability of resources that is in question, but amassing the necessary capital and political conditions needed in order to make major investments.

This brings us to our third inconvenient truth; the frequently quoted IEA figure that $22 trillion of investment will be needed in resource development, generation and infrastructure in order to meet global energy demand by 2030 remains as distant, as it is daunting.

This is not only due to cost inflation, but more importantly, increasingly unfavourable political conditions in producer states in order to allow for development of reserves.

‘Geopolitical peak’ is the real concern

This has a sharp resonance with the fact that IOCs are currently only able to vie for around 10% of global reserves, due to a heavy concentration of proven reserves (over 50%) residing in a small number of states.

Of these, Kuwait and Iran had tried to encourage IOC investment but the process has stalled because of domestic politics or international friction. Saudi Arabia refuses to allow investment from abroad in upstream oil, while Iraq remains particularly challenging for IOCs to make concrete commitments.

The other major opening is Russia, which has made a habit of cutting IOCs out of Production Sharing Agreements once the oil actually starts to flow, while major new finds in the Santos Basin (Brazil) are set to remain firmly in state controlled hands.

Whoever eventually ‘wins the Arctic’ could help to correct this balance, but at this stage, few would bet against national oil comnpanies taking the lion’s share of reserves.

A number of governments such as Venezuela, Angola, Algeria, Bolivia, Kazakhstan, Libya and Nigeria have also failed to resist the temptation to over-tax exploitation of natural resources further inhibiting investment.

Admittedly, a handful of producer states have left the door to reserves ajar, but invariably, the risk profile attached to them is simply too high for IOCs to take on.

This explains why Gazprom will try to fill Total’s boots in Iran, while CNPC, ONGC and Petronas surpassed Talisman in Sudan and CNOOC is conducting offshore drilling in Somalia. Similarly cavalier risk appetites from Asian NOCs can be expected in Iraq.

Even producer states that remain committed to increasing output (as opposed to active depletion policies) will still find it difficult to extract sufficient reserves out of the ground.

The point here is not to champion the relative merits of IOCs or NOCs, but to highlight the fact that without a seismic shift in political capping of reserves, we are likely to meet our final ‘inconvenient truth’; speculation will be the last thing the world needs to worry about as supply-demand fundamentals run headlong into the limits of a ‘geopolitical peak’.