Raw Input. High stocks temper crude oil prices bl-premium-article-image

G Chandrashekhar Updated - October 13, 2014 at 08:50 AM.

Should output be cut in Q1 next year, prices will move towards $100 a barrel

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Much to the relief of many consuming countries around the world, crude oil prices have fallen sharply over the last three months or so. Brent crude has declined as much as $22 a barrel from the highs seen in June. Analysis of market trends suggests three or four drivers that triggered the fall.

For one, while supplies are improving, demand is moderating. As a result, the first half of the year saw a stock build-up of over 125 million barrels. The inverse relationship between the stock and price of any commodity is well-known. Sensing a possible supply overhang, speculators substantially liquidated their long positions on the commodity bourses. Indeed, both Brent and WTI speculative long positions have fallen more than 50 per cent since June. The exit of speculative longs has put pressure on prices.

Supply risk overdone

Experts have also come to believe that frequent alarms about supply risk have led to fatigue.

Geopolitical instabilities usually drive crude prices up because of the risk of supply disruption. Now, investors are no longer paying — or no longer willing to pay — a large premium for that perceived supply risk. Whether such a stand is sensible is, of course, debatable. Finally, dollar strength and the shrinking liquidity as the US winds down its bond purchases, are adding to the pressure on prices. No wonder, analysts are all reducing their price forecast for crude oil.

In the short run, a modestly tightening supply-demand balance should support prices. From the beginning of this year, the focus of the market has been on the steep production increase in the US. At the same time, demand growth in key markets including China and India has been slow. Although China continues to be a significant mover and shaker of the global commodity markets including energy, confidence in the economy is fading.

Evidence of weakening in demand is provided by the International Energy Agency which, in January, forecast a demand growth of 1.4 million barrels per day for 2014, but has now revised it down to 0.9 mbpd. Disappointing demand growth and surprisingly high production have forced prices down.

Geopolitical issues

To be sure, political uncertainty is still high in key producing regions, including West Asia and Latin America. Experts estimate that nearly a fifth of global production comes from regions with high risk. Will there be a production cut to support prices? Historically, non-OPEC producers have been averse to cutting output to rebalance the market. So, the burden falls on OPEC producers. With prices falling, OPEC can potentially reduce production. If such cuts are delayed, stocks will rise further. Given the possibility of a production trim, it is likely the recent sell-off is overdone.

At the same time, a strong dollar, reduced liquidity in the US and slowing global economic growth have dampened the demand growth outlook for the rest of the year and well into the first two quarters of 2015. In the last three months, the greenback gained 7.5 per cent vis-à-vis the euro. A stronger dollar makes oil more expensive in other currencies and hurts structural demand growth.

Limited upside

On the NYMEX, crude oil closed at $86 a barrel on October 10, down from $92 a month ago and from $103 a year earlier. Rather than from the demand side, price adjustments can come from the supply side. Until the market is rebalanced through production cuts, the upside in prices may be rather limited.

Should output cuts come through as expected in Q1 next year, then prices will move towards $100 a barrel. If geopolitical instabilities escalate, prices can potentially breach $105 a barrel.

In India, crude oil is a critical driver of inflation as it is a universal intermediate. India’s inadequate domestic output and dependence on imports to the extent of 80 per cent makes the country vulnerable to global market volatility and is compounded by the dynamics of the rupee. For India, lower crude price is a fortuitous situation. Maybe it is time to even start building modest quantities of strategic reserves.

Published on October 12, 2014 15:19