Oil edges back amid market turbulence

Oil prices edged back up to $100 (Dh367.8) per barrel on Thursday as the losses seen early in the week as a consequence of the financial market turmoil were largely reversed on poor US inventory data.

Nymex crude edged briefly above $100 per barrel once again as the $10 per barrel losses last week have slowly been reversed due in part to the damage caused by Hurricane Ike in the US Gulf of Mexico.

With new supply hitting the market and demand growth slowing rapidly, oil prices are looking for a floor. However, although there is a surplus in the market, until inventory data confirm this through evidence of significant stock builds, price falls below $100 per barrel seem premature.

In the short term, the price fall last week was overdone, and prices are likely to continue rising in line with what current fundamentals warrant. However, stock builds are likely to come through in coming weeks, and this will push prices lower over the fourth quarter, testing Opec's ability to defend prices in a falling market.

Crude prices touched three figures briefly yesterday as oil markets rallied following the release of bullish inventory data from the US government's Energy Information Administration (EIA), showing a sharp fall in commercial oil and oil product inventories.

Front-month Nymex crude prices continued to rise Thursday from the lows of just over $91 a barrel seen earlier last week, ending the day on $97.88 a barrel, an increase of $0.72 a barrel on the previous close. The EIA report was a key factor in pushing prices back up to the $100 a barrel level.

The latest weekly US inventory report released on Thursday, coming just days after Hurricane Ike ravaged the US Gulf Coast, showed a 6.3-million-barrel drop in US crude inventories for the week ending September 12, in addition to a 3.3-million-barrel fall in gasoline (petrol) stocks and a 0.9-million-barrel decline in distillate inventories. The data was gathered in a period where shipping was affected by Hurricane Gustav, but does not include the disruptions due to Hurricane Ike.

This week's data are likely to show even larger falls in inventory given the widespread damage and shut-ins caused by Ike.

The Ike aftermath

As markets digested those numbers, there were also further reports of widespread fuel shortages in the US as the disruption caused by the storm ripples out to the retail market. Reports indicate that many parts of the south-eastern and mid-Atlantic coast of the US are facing widespread shortages of fuel due to the refinery disruptions. The shortages have contributed to the rebound in prices, but financial market turmoil remains an important price driver. The widespread losses on equity markets in the midst of a turbulent week for the international financial system initially prompted widespread selling of crude futures.

As markets tumbled, expectations for economic growth and demand plummeted, and with capital being diverted into safe havens in the shake-out, oil markets felt the effect of the panic. Prices plunged by almost $10 a barrel last Tuesday as fear took hold.

However, following the bail-out of the American insurer AIG and a concerted effort by central banks to pump more liquidity into international markets, some of the gloom has receded. Equity markets have bounced back somewhat as regulators ban short selling and this is also contributing to oil rise.

The gains may, however, prove to be temporary, as the serious problems that have caused massive write-downs are not yet solved. Volatility has been exceptionally high, and is likely to remain so in coming days and weeks.

The impact on oil prices may be less severe now that the initial shock has worn off, but any more dramatic events could still push prices lower in short-term movements. In other words, as the dust settles, oil prices will remain volatile.

The link between the US dollar and oil did break down earlier in the week - on Monday and Tuesday both the dollar and oil fell. The link between a falling dollar and rising oil prices has cracked this week, but given the exceptional circumstances in the markets, the link has not been permanently shattered.

The bigger picture

The volatility in oil prices this past week conceals the underlying feature of what is now happening in oil markets - finding a new floor. With new supply finally reaching the market in larger volumes and demand growth likely to slow significantly, spare capacity will, for the first time in several years, almost certainly grow significantly. This will restore the supply cushion, and reduce the impact of geopolitical risks and supply disruptions that have dominated the steady move up from $40 a barrel in 2004 to almost $150 a barrel in July this year.

The price rise may well have been exaggerated by the exceptional growth of speculative capital in futures markets, but the main driver for the rise was a lack of supply and consistently strong demand. Prices rose incessantly in order to find a ceiling price that would finally curtail demand growth. At $147 a barrel in July there were signs that the price was approaching a level that was stoking inflation and forcing many to reduce consumption, though whether this actually did represent the true ceiling is difficult to say, as the market ultimately retreated as a result of weakness caused by the credit crunch rather than oil prices per se. Nevertheless, the price peak came just as new supply was due onstream and with demand weakening. July was a turning point.

Market dynamics

As the market changed, the dynamics in oil prices are now adjusting to the growth rather than the reduction of spare capacity. Opec will be truly tested in the new environment, and the search for the ceiling is giving way to the search for a price floor. So where is the price floor? Historically we saw prices sitting just above $20 a barrel, the marginal cost of non-Opec production. Opec did succeed in defending prices at a level closer to $30 a barrel in the early part of the commodity bull market, but much of this was ultimately due to the unexpectedly large surge in demand.

Things have changed, however, since the start of the decade. Marginal costs have risen significantly as non-Opec output has reached a plateau. It is deepwater offshore oil and oil sands production that now make up the marginal non-Opec barrel.

Tight fiscal regimes

Costs since the start of the decade have also risen, and governments have tightened fiscal regimes. To invest in major new projects, companies will need a long-term price above $70 a barrel to make the investment worthwhile. Any fall below this level will threaten new production and invariably slow the rate of investment. Prices could of course overshoot on the downswing, but in the current cost environment, this could not happen for very long before supply was trimmed back once again.

A price range of $70-$80 a barrel probably represents a hard floor for these reasons. Opec is likely to seek to defend a price slightly in excess of this level. A price target in the $80-$90 a barrel would be acceptable given current economic conditions, but Opec would prefer a price in excess of $100 a barrel during economic growth cycles. The past 12-18 months suggests this is a price that would allow continued economic growth.

Outlook and Implications

If the price floor is indeed around the $70 a barrel mark, and Opec will seek to defend prices above $80 a barrel, then the fall back to $90 a barrel this week was premature. Although supply and demand data do indicate a growing surplus in the market, inventories are a lagging indicator, and as yet there is no evidence of a sizeable build coming through. Prices are retreating on demand weakness and a looser market, but until this is confirmed with stock builds, there remains too much uncertainty to press down on prices to the extent we have seen.

A level of $100 a barrel seems to be more in line with current fundamentals, perhaps slightly higher given recent disruptions in the US GOM. However, if the short-term price drivers indicate a higher level, over the coming 6-12 months, it is difficult to see prices doing anything other than gradually falling.

With demand growth estimates still being revised down, there is more downside than upside risk in the market (though the situation regarding Iran is still a significant risk).

As inventory data confirm this, prices should once again seek a price floor. At this point Opec's ability to defend prices in a falling market will truly be tested.

- The author is an oil analyst with Global Insight, London.