Why oil is still a steal

28th May 2010

The first is the fact that the oil price is permanently bounced around by geopolitical considerations, by the state of US buffer stocks, and by a whole lot of other temporary considerations such as ‘triple witching hours' (when derivative expiry dates coincide).

And the second fact is that the world's oil consumption needs really don't switchback in anything like the same way.

Indeed, they're probably changing much less than you think.

Since 2005, global oil demand has grown by just 1.5% a year, according to the US government. And, by no particular coincidence, global production has risen by exactly the same amount, from 80 million barrels per day to 86 billion.

Not even China and India have tipped the balance drastically – yet.

So why in heaven's name did the oil price suddenly double to $135 in mid-2008 and then drop back to $45 before establishing a new ‘working range' of $70-90 over the last year?

And why exactly did April's $85 average price drop back by 20% to $70 in late May?

Dammit, don't they know the American ‘driving season' has started?

What's going on here?

A brutal year so far

That's a tougher one than it sounds. And if nothing else, it underlines the heavy financial risks to a private investor in getting too heavily exposed to the chaotic conditions of the oil market.

The textbook response is to argue that the fall in oil prices is all down to our old friends, short-term economic fears and political worries.

Economic fears will often ensure, as now, that, as soon as the market reckons that global demand might shortly drop a bit, the futures markets go into a tailspin and take the exchange-traded funds with them.

That in turn depresses the spot price of physical oil, and hey presto, you have a self-fulfilling prophecy on your hands. (As in second-half 2008.)

The political fears overlap are largely congruent.

The markets are concerned that the troubles in the euro zone might spill over into political conflict of a kind that could soon paralyse Western Europe's economy by stopping new investment.

They fret that China's state-ordained clampdown on lending will cripple the ability of its 1.3 billion people to buy stuff, and export stuff too. And that North Korea's bone-headed determination to confront the South may plunge the region into military uncertainty and possibly war.

All true. And we can add to that the additional worry that risk investors around the world are pulling in their horns because they fear that they might soon need to liquidate their assets.

(Or because they don't really have enough trust in each other to tolerate the increased counterparty risk from all those derivative trades.)

Either way, the beneficial spiral of confidence between the physical oil market and the futures market has gone sharply into reverse.

The system is, as they say, de-leveraging.

Normal service will be resumed…

Well, yes, for the time being. But can you honestly think of any good reason why any of these things are going to bring about a 20% reduction in global oil consumption over the next few years?

And if not, what's with the 20% price change since April?

Has the ‘fair price' of oil really plummeted?

Put your hand on your heart and tell me that you think it's all about de-leveraging, and that the commodity business won't ever return to business as usual. Or, alternatively, that the world's economy is about to go permanently down the tubes to the tune of 20% or more…..

Then look at the ‘peak oil' arguments that tell us how the combination of shrinking global reserves and increasing global demand will shortly tip the price balance drastically.

Look at the imminent cessation of new offshore drilling in the US, and the dismal environmental progress with oil shale and ‘alternative' fuels from tar sands, and tell me that we won't be fighting each other for old-fashioned oil before long. Hopefully, only in the marketplace.





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