End of Road for Overpriced Oil

Andrew McKillop

GOLD, OIL AND THE DOLLAR

This heavyweight trio decide investor sentiment in the commodities space, and to them we can add sovereign debt, interest rates and currency valuations, in a cocktail mix that reads very badly for oil above $85 – $90 per barrel for Brent grade, and perhaps $10 less for US WTI oil.

Short term bounces and dips in commodity prices driven by the Eurozone merry-go-round might grind onward, perhaps, but the sundown on commodities of all kinds is shaping up on the horizon. Taking only the dollar, if the USD strengthens due to other moneys being so fantastically weak, “traditional” confidence in natural resource commodity assets and the so-called Commodities Supercycle looks set to drain and bleed away on an almost daily basis.

As of early April 2013 we still have no problem finding still-typical Herd statements (this one from Capital Economics) such as: “Admittedly, the price of gold has not yet benefited as much as we had expected from the Eurozone crisis, so we are lowering our projections”. Like others, Capital Economics simply pushed forward its gold forecast of a “fresh surge to new highs around $2 000″, to the year-end. This is becoming mightily unlikely, as the markets are showing more and more openly. Gold price weakening also means shrinking crude oil prices in the current and nearterm context.

The main source of what we can call “conventional macroeconomic uncertainty” for Herd analysts is the Eurozone and the parlous state of other EU27 economies, but this downplays remaining high level uncertainty concerning the US economy, increasing concern on Japan’s “monetary experiment” for restoring inflation, and rising uncertainty concerning China’s economy. Taking simply the complex and long-running US “fiscal cliff issue”, which isnt going away, Societe Generale’s commodity experts advise this could potentially shave as much as 3% from US economic growth in 2013-14. This would create a Eurozone economic future for the US. Welcome to zero growth!

WILDLY BEARISH

The day after a wildly bearish report from the US Energy Information Administration showing that crude supplies are at their highest level for 28 years and refinery runs are at a 6-year high for this time of year, the oil market response was set in stone. Add in the worldwide pressure, not only from central banks but also North Korea that bolster the dollar, and talking about Brent at $125 becomes fond memories of a receding past – for the trader herd, whose Ferrarri’s run on champagne (you didnt know?). Their Fisker Karma sport cars burn under water, but don’t use oil to do it.

Whatever Mario Draghi of the ECB may be saying about the Eurozone economy in his coded language, the readout is continuing or deeper recession in Europe, which in 2013 entered its 7th straight year of declining oil demand.

Back-flow from a strengthening dollar in the shape of more expensive US exports will also play its own baleful role in further depressing any potential for expanded oil demand in the US, whose crude oil imports can only decline due to powerful growth of domestic oil production. Add in China’s potentially serious new bird flu outbreak, and the antics of North Korea’s basketball loving Kim, and things look even worse for global economic growth and non-US oil demand.

Once upon a time, down Memory Lane, cold weather could give a fillip to US heating oil demand and lever growth of crude prices in its wake, but natural gas usurped that role long ago. US natural gas prices struggle to exceed a barrel equivalent price of $23. The highly exceptional long-life winter conditions ruling the northern hemisphere, especially strong in Europe, have helped gas prices in several markets, to be sure, but cold winter conditions have also depressed gasoline demand, while global gas prospects, including stranded resource and shale resource potentials make it clear that gas shortage, anywhere, can only be temporary.

In Europe, despite its high-cost renewable energy action plans (REAPs) mandating a switch away from carbon fuels for power generating, real world change this winter has featured rising use of coal, “clean” or otherwise, and declines in natural gas demand, in most EU27 countries reaching double-digit percentage rates of decline. Coal stays cheap, with prices still as low as $8 per barrel equivalent before shipping costs.

For US power producers, like European generators, the choice is a no-brainer, shown by US coal-fired generation up 21 percent on 12 months ago. How long this will last is however in question, as the Obama administration turns its political heat “to save the planet from global warming” on coal steam power into something of a crusade.

GEOPOLITICS TO THE RESCUE?

This is always a wildcard, and even the North Korean nuclear issue (replacing the Iran nuclear issue for a while) could or might prove worthy of a short upbeat interval in the general decline of crude prices, but first and most it can bolster the dollar.

Israel-Palestine tensions, with the return of Spring are back on the boil, and the Syrian civil war can at all times break out of its borders – but almost only westward into Lebanon. The decline in Turkey-Israel tension due to recent “peace feelers” from Israel runs counter to the usual program of rising Mid East tensions, which traditionally bolster oil.

More important and a real fundamental change, global oil production is poised to move out and away from the Mid East on a steadily accelerating basis. To the increasing number of onshore and offshore oil E&P projects moving forward to commercial supply status in west and central Africa, east African projects are adding their weight. In many cases including gas resources, often large, the Dark Continent is now revealing its potential promise of a global shift of oil-and-gas emphasis that can chip away at Mid East domination, with a major downward impact on the always-variable “risk premium on oil”.

Global oil, today, provides around 32 percent of world energy compared with 53 percent at the time of the first oil shock in 1973 and this longterm fundamental is unlikely to change its direction. In turn, this changes the metrics for gauging geopolitical risk in oil, making current probable premiums of round $15 per barrel and up, another hangover from the receding past

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