(Guest post by Agnes Paul)
Given the current uncertainty in the future direction of crude oil prices, there is an interesting debate going on about where prices are likely be in 3 to 6 months time.
There are two schools of thought in the market concerning the direction in which the crude oil prices could possibly take. The first anticipates that the prices will decline due to the comparative historical trends in excess production capacity/ excess supply, crude oil prices and their existing levels. The second believes that the current price trend in crude oil is being impacted not so much by the fundamental dynamics of supply and demand but rather by factors such as the weakness of the US dollar (in relation to the Euro), spreads of month on month futures contracts of crude oil and the strength of global equity markets. The latter assess that the weakened state of the dollar, growing strength of global equity markets and narrowing spread between the monthly futures contract act as floors on the falling price of crude and could possibly even lead to an increase in prices.
We present the two varying schools of thought and then provide a list of questions for investors to assess for themselves which school they belong to.
For the analysis we have obtained data for OPEC’s surplus capacity, world crude oil production and consumption and West Texas Intermediate Crude Oil prices (monthly averages) from the Energy Information Administration (EIA) website. Supply and consumption data is available from January 2001. Due to unavailability of spare capacity data for the period before January 2003, certain adjustments were made to the world crude oil total (actual and spare) production capacity to derive the excess production capacity figures for the period January 2001-December 2002. Therefore figures for this period represented in the graph below (left axis) may differ from actual spare capacity numbers that may be available to the reader from other sources.
A.3 Price decline in the face of spare production capacity and excess supply
Excess production capacity and crude oil prices
Excess production capacity refers to the total production capacity for crude oil in OPEC nations less their actual production/ supply at any given point in time. In the graph above we have plotted the historical trend of WTI prices (right axis) against that of excess capacity. Growth in excess capacity may indicate weak demand as production levels are cut so as to curtail a fall in price levels. This is evident in the period January 2001 to May 2004 where price levels were relatively low, whereas the crude oil production spare capacity of the OPEC nations had peaked. Steadily increasing demand for crude oil and petroleum products in the period mid-2004 to mid-2008 pushed spare capacity down to record lows as production levels rose to meet the rising demand. Before the crude oil market was hit by the global financial crisis average prices had breached US$ 130 in June 2008. After this prices fell sharply as demand for crude oil declined leading to an increase in spare capacity as production levels were cut. Currently spare capacity levels have topped at 2001-2004 levels. If demand continues to remain depressed and production levels are either maintained or cut further, there is strong evidence to support the view that prices will continue to decline.
Despite the excess capacity prices have not fallen as much as this group of analysts would have anticipated. Analysts belonging to the opposing school believe that there are a number of factors that have led to this resilience in the prices. These are addressed in part A.4.
Excess supply and crude oil prices
The graph above plots the trend of WTI spot prices along with that of the excess world supply of crude oil (world production less world consumption). In general what can be seen is that as the demand for crude oil exceeds supply prices are pushed upwards. The reverse is true for excess supply.
OPEC nations have reigned in on production so as to provide support for prices at the US $60 – 75 a barrel level. However as demand for oil remains depressed and may continue to remain so for some time to come, such production cuts may not be feasible in the long run as these nations would be under enormous pressure to maintain revenue levels and meet budgetary requirements if prices stay at lower levels for a sustained period. As demand and trade activities stay low, economic pressures and lower prices may lead to a rise in production quotas to meet minimum revenue thresholds. Increased production in the light of increasingly depressed markets could lead to a sell of in prices. However the spare capacity numbers above tell a possibly different story.
A.4 Price will remain at current levels or increase in the face of the depreciating dollar, strengthening equity market and narrowing spreads on futures contracts.
A weakening US dollar and the price of crude oil
Crude oil prices post 2001, have shown a significant negative relationship with the strength of the dollar. This can be observed in the graph above- as the dollar appreciated in value crude oil prices fell whereas when the dollar weakened the prices of crude oil has increased. Some analysts believe that this is a possible result of investors moving towards the commodities market to hedge their investments against the depreciation in the value of the dollar. Despite spare capacity of OPEC nations and inventory levels of countries being at all time highs the price of the crude has been relatively resilient and these analysts are attributing this to the relative weakness of the US dollar, among other factors.
Other analysts hold the view that rather than the trend representing a greater move of investors towards the commodities market when the dollar value depreciates (which may be a small contributing factor to the support witnessed in crude oil prices) it is more likely just a depiction of the translation gain of this devaluation on crude oil prices which are denominated in US dollar. As the dollar value falls the price per barrel of crude oil will increase as a result of the decline in the purchasing power of the dollar.
Equity market and the price of crude oil
In recent years crude oil prices have been increasingly positively correlated to the growth in equity markets. This is depicted in the above graph where we can see the price of crude oil moving in the same direction as the S&P 500 index. Analysts in the price rise school of thought believe that this increase in the value of the index is an indication of the economic growth, increasing consumer confidence and potentially an increase in the demand for crude oil and related products with an upward tick in the global economy. With equity markets showing encouraging signs of growing strength these analysts anticipate that crude oil prices will follow suit or at the very least prices would remain at existing level despite the supply levels being high.
However, viewing the trend in the prices/ index over the period 2001 -2009 (see graph below) we can see that this highly positive correlated behaviour is a fairly recent phenomenon.
In fact there are certain time periods (circled) in the duration when there appears to be a negative correlation with the equity index. This leads analysts with an opposing view to the above to believe that the recent correlation trends are coincidental and ephemeral. Some consider that the recent trends are based on increased speculative activity of commodity-based index funds and that subjected to enough market pressure and resultant control such correlations are more than likely to breakdown in the future.
Future contract spreads and the price of crude oil
Spreads between futures contracts of a particular month over that of the consecutive month are a possible proxy for future demand of crude oil. In the above graph we have looked at the spread between most current futures contract (Contract 1) and the futures contract of the month following Contract 1 (Contract 2). As can be seen in the recent months there has been a narrowing of spreads. Analysts believe that low spreads are indicators that the demand for crude oil will grow in the near future and potentially eat into the inventories that have built up over the past year. They believe that declining spreads are one of the factors that have dampened the recent fall in the crude oil prices. From the graph it is evident that there is a negative correlation between spreads and crude oil prices in the last twelve months or so.
To answer the directional question on crude oil prices one needs to form a view on the following drivers and the following countries:
- What is the outlook of the global economy? If you believe that the global economy is picking up and that there is likely to be increased economic activity leading to a potential increase in the demand for crude oil one would expect prices to rise or in the very least remain at current levels. Look no further than China to answer this question.
- What is the outlook for the US dollar? Will it appreciate, depreciate further or remain at current levels? More importantly is this relationship true correlation at work or simply a translation adjustment?
- Does the same hold true for the correlation with S&P 500 index?
- What is the remaining appetite of crude oil consumer’s inventory build up? When the prices of crude oil fell countries started to increase their stockpiles of oil. However, in the face of weakened demand net importers of crude may be nearing their holding thresholds. If inventory build up slows down what would be the impact on future contract spreads and support level for prices?
- What is the threshold revenue level that will force OPEC nations to review their current quotas regarding spare capacity in light of dampened demand, lower trade levels and falling or static prices? Look no further than Saudi Arabia and Iran.
“Oil Price Patterns Portend Shrinking Of Excess Stockpiles”- Brian Baskin of Dow Jones Newswires –Wall Street Journal (30 September 2009)
“Energy outlook: Crude correlations and what comes next”- Christine Birkner –Futures Mag.Com (October 2009)