Wednesday, 30 November 2011

Oil Prices

Oil Prices have climbed making Oil the top performing asset class this past month. Speculators completely ignored the Euro-zone contagion - preferring to bid up the commodity on the potential of another round of QE plus the escalating nuclear tensions in Iran. Spot WTI pricing is up over 25% from October lows. In comparison the S&P TSX  is up only 9%.

A serious concern is the oil futures market which has moved into backwardation – the forward price is less than the current near-month and/or spot price. Looking one-year out, the forward WTI price of oil is currently trading around a 10% discount to the current spot price. Usually oil futures trade in contango with the forward price higher than the near-month - which compensates for the cost of storage and also factoring in the risk of carry.
Early in 2008 oil futures were in steep contango as speculators saw the prospect of recession as low and that any downturn would be short-lived. This gave a strong incentive to build oil inventories and to take advantage of the large forward spread. When the financial crisis hit late in 2008 WTI oil prices collapsed - dropping from $145 to $30 per barrel as global oil inventories were excessive against reduced world demand.
Today speculators are doing the opposite - selling off the long-end of the curve - creating an incentive to draw oil inventories. Global oil inventories now have been reduced to nine year lows and continue to be drawn down with the large forward discount. This is of concern especially if we escape the near-term Euro-debt crisis contagion and the global economy rebounds.

Global demand for crude oil would then expand with global oil inventories at decade lows. The potential of another large spike in oil prices could again derail the economic recovery.

In the near-term a 10% to 15% downside to current spot oil prices is likely. Spot prices should come down when speculators realize that Israel does not have the military capability to attack Iran. It is unlikely Israel will get support from the Europeans - with their own problems to mop up. The USA facing an election year in 2012 and having had troops and casualities for over a decade means few politicians and the electorate would favor further military involvement in Iran..

Bernanke is not interested in inflating commodity prices further at poresent – especially with WTI rocketing to near $100 per barrel again - and knowing that “Every $1 per barrel rise in oil decreases U.S. GDP by $100 billion per year and every 1 cent increase in gasoline decreases U.S. consumer disposable income by about $600 million per year.”