The strange case of the price of crude oil
Don’t expect the price of crude oil to reach the great heights it achieved in 2008, says this U.S. advisory, because the rules are changing.
Oil, oil everywhere, but not enough to pay the bills.
You probably noticed the price of crude oil surging up again yesterday. But over in the Middle East, it’s not moving high enough, fast enough.
Saudi Arabia, in particular, is trying to dig its way out of a steep financial hole. And the goings-on in oil-rich Iran are causing more than a little unease as well.
Crude oil is the one commodity that still makes the greatest waves — at the gas pumps, in investment portfolios or in global politics.
Yet the price of oil is marching to a different drummer now. Its rapid rise in 2008 was built on the shifting sands of speculation. Don’t expect it to do the same thing again.
That’s the contention of Review & Outlook, an advisory issued by a Boston money management firm. We can always count on this advisory for a challenging analysis of the economy and the markets.
While it is not sold on the future of oil, the advisory is not averse to gold. It highlights Newmont Mining (NYSE-NEM; TSX-NMC), the big gold producer formed eight years ago by the merger of Canada’s Franco-Nevada, Australia’s Normandy Mining and Newmont Mining of the U.S.
Indeed, the advisory is being cautious, and won’t be adding to its equity holdings “until such time as we judge equity market risk/reward to have returned to more favorable levels.”
And nothing says risk/reward louder than oil.
Lost demand
In Saudi Arabia, two major business groups defaulted on loans in the $20 to $30 billion range. Real estate prices have plunged. Two big private funds wrote down investments. Banks in the United Arab Emirates were forced to write down loans from Saudi Arabia.
And oil revenues have not been there to save the day.
Oil prices may have risen in recent months, but “it will still take time to make up for the millions of barrels of lost demand,” the CEO of Saudi Aramco said recently on the PBS Nightly Business Report.
The combustible combination of Saudi financial needs and international energy markets, says this advisory, have turned even the world’s largest crude oil exporter “into something of a passive price taker, watching gyrations in markets and hoping for higher prices that have not come.
“Indeed, profound changes in oil markets have upended the old pricing mechanisms and have increased volatility and unpredictability.”
Distorting the market
Consumers have discovered discipline, willingly or not. When oil reached $150 a barrel in the summer of 2008, oil consumption fell. So did industrial production. Small cars and smart cars came into fashion.
In an economy that is still finding its feet, it’s hard to imagine robust energy demand, says the advisory. Oil imports may have risen in China over the summer, but not in the western world.
But then, why should oil soar when it had no business to climb as far as it did in the first place? Its rise to dizzying heights a year ago was not based on a firm fundamental foundation.
Before the credit crisis, commodities were all the rage in the growing global economy. A variety of exchange-traded funds cropped up to “easily and cheaply” hold everything from cotton to copper to natural gas to oil.
But trading in ETFs has had the effect of distorting the market, exceeding the position limits that the Chicago Board of Trade sets on futures contracts. Deutsche Bank has already had to shut down its “double long” leveraged oil ETF. More ETFs may follow it into oblivion.
And investors (read, big institutional investors) will find they can no longer avoid position limits.
An unwelcome event
It has become increasingly clear that oil’s rise from $100 to $150 “was largely fuelled by pooled money entering this market for the purposes of asset diversification,” says the advisory. Investment banks helpfully arranged swap agreements that effectively sidestepped the rules.
In short, there was a great deal of manipulation going on that had nothing to do with the good old law of supply and demand.
Politicians have snapped to attention. “It is one thing for the price of sugar to shoot up due to speculative action,” says the advisory. “It is quite another for politicians to witness petroleum shooting up to the point where consumers stay at home or take the bus.”
So regulation has come to the swap market. Notice has been served that the 2008 run-up was unacceptable.
“As a result,” says the advisory, “commodity prices have been shaped by fundamentals much more than in recent years.”
There are still many unpredictable elements that can affect the price of oil — like the nuclear aspirations of oil-rich Iran.
But don’t expect the price of oil to rise based on the prospects of global reflation, emerging market growth, market bubbles caused by ETFs, or even “peak oil” theories, says this advisory. No matter what the cheerleaders in the business press and elsewhere claim.
In fact, the only thing that might send oil soaring is an unwelcome event like the detonating of a nuclear device in Iran, concludes Review & Outlook. So be careful what you wish for.
But we’re all perfectly justified in wishing for three happy days over the Thanksgiving weekend. We’re back on Tuesday.
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