SENIOR MARKET STRATEGIST, GFT
LAST week, Brent crude oil traded below $88.50 – a level last seen in November 2010. Back then, crude was in the early stages of a rally which would take it above $126 four months later. The rally was driven, to a great extent, by the US Federal Reserve’s second round of quantitative easing, the $600bn (£385bn) stimulus package launched, coincidentally, at the Federal Open Market Committee’s November 2010 meeting. Many investors were convinced that loosening monetary policy would kick-start the global economy, and feed through to higher demand for oil. Those unconvinced of the efficacy of central bank intervention bought oil as an inflation hedge.
But the world feels very different now. There has been a sharp deterioration in the global economic outlook over the last three months. The European debt crisis has become more acute, Chinese manufacturing continues to contract and growth there is slowing. Meanwhile, evidence of recovery in the US has disappeared, as economic data now consistently comes in below expectations. So demand for crude looks set to moderate further, while supply remains adequate. US crude inventories are high, while Opec’s production ceiling of 30m barrels per day is regularly breached.
Brent has now fallen around 30 per cent since its high point at the end of February. Back then, Iran was threatening to close the Straits of Hormuz, and there was talk of an attack on the country’s nuclear facilities. As oil prices rose earlier this year, both Nicolas Sarkozy and Barack Obama made calls for the Strategic Petroleum Reserve to be tapped, even though their only justification was to help lower prices – not to counter a supply shortage brought on by an outright oil shock. Now we have seen Saudi Arabia lead calls for Opec to lift its output ceiling even as oil prices fall. Saudi Arabia is the country leading the Opec ceiling breach as it has pushed its production up above 10m barrels per day – an all-time record.
This has annoyed many other Opec members, who desperately want to obtain the highest price possible for their output. This helps them pay their bills and meet their domestic commitments. But Saudi Arabia is more concerned that higher oil prices could send the global economy over the edge. In addition, the Kingdom has more of a buffer and can withstand lower prices for longer than other Opec countries. If they continue to pump at a record rate as demand moderates, prices are unlikely to rally significantly. This is no bad thing for major consumers, as a lower oil price decreases the costs of goods and services, plays a major role in bringing down inflation and is obvious for all to see at the pumps. Lower oil prices should also help Obama as he heads towards November’s election. However, cheaper oil also means that developing alternative fuel sources becomes less of a priority. It changes the economic dynamics of drilling for oil shale in North Dakota, or building deep water rigs in the Gulf of Mexico. Ironically, this is good for existing producers, as anything that holds back the development of US oil production, or makes developing alternative energy sources less attractive, ensures that there will always be demand for their output.
Meanwhile, there is a danger that the situation in Syria could escalate beyond its borders after Turkey, a NATO member, had a plane shot down. In addition, despite a string of meetings between Iran and six world powers, EU sanctions against Tehran are due to kick in next week. So, there is an increased probability of a spike in oil prices and the return of the geopolitical risk premium. Consequently, it’s fortunate for us that oil is currently well below $100 per barrel.