By Gregory Meyer in New York
Oil markets had become almost boring until recently. After years of breathtaking moves, prices seemed frozen between $70 and $80 a barrel. Producers and consumers, long at loggerheads, were in an uneasy peace.
Veteran oil watchers knew it couldn’t last. Yet many of them were caught off guard when crude tumbled instead of rising.
After touching 2010 highs in early May, the main crude oil benchmarks both sank below $70 a barrel on fears the eurozone debt crisis would spill into the broader economy.
The fall contradicted bullish Wall Street forecasters who point to demand that is rising again after two years of global decline.
Signs of weakness were first visible at Cushing, Oklahoma, a landlocked city of 9,000 people and 50m barrels of oil storage tanks.
The obscure locale is the official delivery point for the benchmark US oil futures traded on the New York Mercantile Exchange. As Cushing filled to record levels, the price of spot Nymex crude plunged relative to other blends.
Some analysts brushed off the inventory gains, saying Cushing’s isolation detaches it from broader oil markets. Goldman Sachs, which recently forecast $96 US crude by late summer, said the place was subject to “idiosyncratic issues”. Barclays Capital, which predicts oil well above $80, expects prices to rebound “with the Cushing distortion diminishing and the strength in demand biting into the current elevated levels of demand pessimism”.
Soon enough, the main European yardstick also dropped below $70 a barrel. Investors dumping risky assets did not spare oil, illustrating its growing status as a portfolio component. As they flocked to the dollar as a haven, dollar-denominated oil suffered.
This came despite evidence of stronger demand, not only in surging economies such as China, but plodding ones like the US.
Volatility has also jumped after months of greater calm. The worries seeping into most markets helped push up the Chicago Board Options Exchange Crude Oil Volatility index – which measures options on a fund tracking crude oil futures – 50 per cent in May.
One day recently, US crude futures oscillated more than $7, enough to jolt any bored trader.
And with the forecast of an active hurricane season in the energy-rich US Gulf of Mexico, prices have surged back above $75 a barrel. Volatility is, nonetheless, well below highs set during the worst of the financial crisis. This is partly because of ample idle capacity among refiners and the producers inside the Opec oil cartel. A series of output cuts approved in late 2008 enabled Opec to more than double oil prices from the $30 a barrel doldrums of early 2009.
But higher prices have weakened resolve among its 11 quota-bound members, notably Iran and Venezuela, says David Kirsch, director of market intelligence at PFC Energy, a consultant. Opec is now pumping 1.4m more barrels a day than a year ago, in spite of no official change to output policy.
The cartel’s desire to keep prices steady – and relatively high, by historic standards – is also challenged by a spurt of new oil from non-members. Russia, for example, has defied expectations with increased output.
Opec’s next scheduled meeting is October. “The prospect of prices going below $70 and remaining there for several months will really change the dynamics within Opec,” says Mr Kirsch. Oil’s recent volatility could also disturb the tacit truce between producing and consuming countries, who acknowledge prices between $70 and $80 are enough to stimulate drilling without derailing fragile economies.
The producer group is a key factor in keeping crude oil futures in “contango”, a term used to describe when contracts for later delivery cost more than those for spot cargoes. The pattern, the object of endless theorising by economists, is said to reflect various factors: a glut of crude in storage, worries about supply security or even the presence of passive investors such as pension funds bidding up futures.
Several Wall Street analysts say rising demand will draw down inventories this year, flipping the futures market into the opposite of contango, where spot cargoes command the highest price.
But Opec, with some 6m b/d of capacity, could quickly replenish stockpiles, at least this year. Opec itself predicts demand will grow by 900,000 b/d in 2010.
“We’re looking at probably two years to start testing production capacity limits again,” says Harry Tchilinguirian, senior oil analyst at BNP Paribas.
Where will oil prices go? Forecasts vary widely. Mr Tchilinguirian sees US crude averaging $90 a barrel in the fourth quarter of 2010. Deutsche Bank, one of the more bearish on Wall Street, predicts $70. Bank of America Merrill Lynch last month cut its forecast for the quarter to $80 from $94, citing Europe’s debt crisis, a weaker euro and more supply from outside Opec.
The US Department of Energy foresees $84 crude at year-end, but notes: “Energy price forecasts are highly uncertain, as history has shown.” This was certainly the case in 2008, when oil shot from $100 a barrel to $147, then dropped to $32 by December.
The International Monetary Fund, in its most recent economic outlook, refrained from calling the oil price but warned that commodity prices are likely to remain high by historical standards.
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