CRUDE prices fell last week on the assumption that the demise of Muammar Gaddafi would have the magical effect of freeing up oil supplies. Gaddafi’s welcome demise is hopefully a sign that Libya will eventually rejoin the supply-side fold, but this return will not happen tomorrow. In the longer term, oil prices are being pulled in two directions at once. On one hand, recent worrying reserve inventory figures coupled with attacks on Yemeni pipelines and the slow pace at which Libyan oil supply could get back online points to a restriction of supply, forcing up prices. However, deteriorating world economic conditions are pulling prices in the other direction. A recurring bearish theme in all things macro, dominated by unresolved Eurozone debt worries and an impecunious US government, points to a continuing downward pressure on oil demand. Which side is the most likely to win this tug of war?
DEMAND SIDE: MACRO WORRIES
Oil prices and commodities in general have become increasingly correlated with the fortunes of the S&P 500 (see the left-hand graph, below). Barclays Capital announced last week that “oil prices continue to trace macroeconomic sentiment and ignore fundamentals entirely.” Despite some strong US Department of Energy data, the oil market has remained focused on the European debt crisis, and any fundamental data was lost in background noise. Ongoing European and US difficulties in dealing with their debt woes are likely to continue weighing on demand in the future.
The economy has been in the doldrums since the crash in 2008, at which point US oil consumption shrank by 5 per cent or about 1m barrels per day (bpd). At this point, the oil cartel Opec intervened to slash supplies in an attempt to support oil prices.
Prices rebounded, and were driven ever higher by supply fears during the north African uprisings in the spring of this year, which affected a number of major oil supplying nations. But the double hit of European and American political wrangling caused a shift from supply fundamentals to macroeconomic sentiment.
When the American political class clashed over an agreement to raise the debt ceiling this summer, anybody who wasn’t yet fully cognisant woke up to the fact that the US has its own economic mire to deal with. Since then, neither European nor US policymakers have shown real willingness to address their economic problems.
However, traders also need to consider how much these woes have filtered down to the consumer. US consumer confidence figures have fallen to -45, the lowest figure since February 2009. But it could be argued that this number reflects consumers’ sentiment towards the direction of the economy – US car sales were up last month and the September retail sales report pointed to real consumer spending growth of 2.5 per cent. Barclays Capital economists are confident that, combined with US ISM figures rising in September, there are encouraging signs that the US mid-cycle slowdown in the manufacturing sector has largely run its course. They have upgraded their third quarter US GDP forecast to 2.5 per cent. As the chart below right shows, oil demand growth would stand to benefit from this growth. But in the long term, combined US and European problems could really start to bite, degrading this small increase in demand.
SUPPLY SIDE: RUNNING ON EMPTY
On the other side of that tug of war, supply still looks fragile. As oil futures declined last week, they did so despite signs that the supply side of the oil market could be hit by disappearing inventory cover and declining production. International Energy Authority (IEA) data show that a weak supply side has driven both Opec and non-Opec inventories to around 25m barrels below the 5-year average.
On the medium to long term, in the event of a real EU implosion causing worldwide contagion, it is difficult not to see Opec pursuing its 2008 policy of “turning off the tap” – restricting supply to try and counteract slipping demand pulling down prices.
Powerful forces are acting on the oil price from both sides. Equity sentiment volatility is a key driver at the moment, but fundamental weaknesses in both demand and supply risk coming into play.
If demand falls, Opec is likely to try to restrict supply to keep prices buoyant, but if the economic situation starts to look sunnier, supply problems may be a significant constraint. Anybody taking short-term and intra-day positions should do so cautiously. The combination of macro and fundamental plays, alongside the potential for surprise supply manipulation by Opec or by the IEA leaves traders at risk of being hit by big price swings.