The Hindu Business Line : Oil prices: Correction on cards

An evaluation of the oil and gas futures and options markets indicates that supply is sufficient to meet current demand and the oil price increase seems to be overdone with speculative interests in abundance.

— Vipin Chandran

Physical markets do not seem to be displaying distress in demand.

Sunil Kewalramani

After oil hit its recent record of $135 a barrel, consumers and politicians have started venting their anger in various ways. This seems to indicate $135 was a ‘Tipping Point’, at least temporarily. Veteran Hedge fund manager George Soros, while finding the increase in oil prices analogous to a bubble, feels a crash in oil markets in not imminent.

On June 4, 2008, India and Malaysia became the latest Asian countries to increase the price of subsidised fuel. Consumers in India will now pay an average Rs 50 a litre for gasoline, or about $4.45 a gallon, well above the average $3.79 a gallon that US drivers are paying.

In Malaysia, petrol prices have risen by 78 sen (24 Cents), a 41per cent jump from RM 1.92 per litre. Indonesia has hiked fuel prices by an average 29 per cent.

Dotcom analogy?

There are indeed parallels between the late stages of the dotcom mania and the current oil boom. Both mega trends were rooted in a powerful economic shift; the dotcom boom was associated with several technological breakthroughs and new killer applications that change the way we live and do things, the oil-led commodity boom is attributed to the emergence of China and India as economic powerhouses, and the decoupling of the emerging economies from the developed world.

From January 2006 to mid-April 2008, more than $90 billion of incremental investor flows went into assets managed by commodity indexes. For every $100 million in new inflows; the price of West Texas intermediate, the US benchmark, increased by 1.6 per cent.

An evaluation of the oil and gas futures and options markets seems to be indicating that supply is sufficient to meet current demand and the oil price increase seems to be overdone with speculative interests in abundance. I believe we are nearing a steep correction in oil prices. Let’s see why:

Spot vs futures

Physical markets do not seem to be displaying any signs of distress in demand. Whereas crude-oil futures prices have repeatedly hit record highs in recent months (Brent crude at the time of this writing is trading at $132 a barrel on the Intercontinental Exchange in London, up over 80 per cent since last year).

Yet today, traders dealing with physical cargos of crude oil see the spot market so awash with oil that some producers such as Iran are starting to hoard it in hopes that greater demand for crude will lift spot prices as well.

They cite seasonal closure of refineries for maintenance and a poor return on refining operations for the lack of interest in buying spot cargoes. According to the OPEC’s departing governor, Hossein Kazempour Ardebili, around 25 million barrels of his country’s heavy, sour crude oil are being stored in offshore vessels in the Persian Gulf.

According to him, there are no buyers because the world market has more than enough oil to meet its requirements.

The lag

Since prices for gasoline and other refining products have not risen as much as prices for crude oil, refiners have had little incentive to hurry their maintenance processes, and those able to operate at normal levels are opting to reduce production. Global cracking margins — the profit refiners earn from processing crude into high-quality end products —have fallen to less than $7.50 a barrel this month, approximately half the level at this time last year.

To lend credence to this view, some of Europe’s biggest refineries have been taken offline in recent months, including the region’s largest — Royal Dutch Shell PLC’s giant 4,20,000 barrel-a-day Pernis refinery. The Netherlands plant underwent partial maintenance for more than a month starting end of March 2008.

The widely traded Forties is now selling at a discount of 75 cents a barrel to a benchmark North Sea mixture, swinging from a premium of about 15 cents a barrel a year ago.

The “Peak Oil Theory” (the theory that global oil output has already peaked and can only decline from here) is behind much of the oil price increase. On one side of the fence are billionaire oilman T. Boone Pickens, oil banker Matthew Simmons, and many others suggesting that the world is reaching Peak Oil now. On the other side of the fence, as indicated in this figure, are Cambridge Energy Research Associates (CERA) headed by Pulitzer prize writer Daniel Yergin, and others such as Exxon Mobil, who are not predicting a Peak in global oil production until circa 2040 followed by a gradual decline.

Back to Fundamentals

Over the past 10 years, global oil reserves have increased by 140 billion barrels to 1,200 billion barrels. If you add Canadian oil sands to the total, the increase was 300 billion barrels.

Over the same time span, the increase in world oil demand has been a benign 45 billion barrels. If supply and demand aren’t entirely behind the recent price increases, speculation has played a key role. Over-the-counter commodity derivatives held globally grew sevenfold, to $7,000 billion in the three years to June 2007. If we assume that about 50 per cent of the open positions on commodities are accounted for by oil, the exposure as of the last data point equated to 48.5 billion barrels of oil, or about 20 times the size of the New York Mercantile Exchange.

Some light, sweet crude-oil grades — typically prized by refiners for their easy conversion into high-quality diesel and gasoline — have also come under pressure. While light, sweet crude futures prices have shown little signs of slowing, their price structure is starting to hint at an easier short-term supply outlook.

Slipping into ‘contango’

To the greatest extent in the history of oil futures trading, oil prices are now in continuous contango — that is, oil futures get progressively more expensive each year into the future. (Contango is when the futures are trading above the expected spot price at a future date. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them in line with the expected future spot price). A contango structure usually indicates that oil-market players expect crude-oil supplies to be less scarce in the short term than they will be in the future. Evidence seems to be suggesting that supply is sufficient to meet current demand.

The above contango structure and dramatic shift from backwardation to contango in the oil futures market, in the space of just six weeks, are also an indication that a correction in oil prices could be on the cards in the near future.

The author is CEO, Sunil Kewalramani Global Capital Advisors. Feedback can be sent to globalequity@sunilkewalramani.com

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