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Oil Prices Have Crashed 70%, Where Is This Leading?
March 27, 2009

Enjoy filling your cars up at the pump for just a little while more. This article explains where we see the price of oil heading this year.


Author : iFAST Research Team



Untitled Document
Chart 1: Reduced Contango In Futures Market  
 
Chart 2: Finding Costs
 
Chart 3: Quarterly Correlations of Oil and USD
 

Seldom has the price of one thing held sway over everyone’s attention. The price of this thing has impacted our lives in such a way that wars have been fought because of it and endless debates over its future supply have occurred because of it. The name of this thing is oil.

There have been arguments whether the bubble has truly burst, considering that it has fallen from its highs of US$147 per barrel in June 2008 to current levels hovering from US$35 - US$40 per barrel, a sharp decline of about 70%.

We examine the questions surrounding the demand-supply equation of oil in this article in the light of current economic conditions, and explain where we see oil trading at the end of this year.

Is This A Secular Or Cyclical Market In Energy?

Indeed, there are arguments for both views. Over the last few years, the argument for the increase in demand for energy from the middle class in the emerging markets like China and India has been well-known to us all. Factories ramped up their activity to meet demands for orders, and with the increased economic activity came the increase in demand for energy.

We live in a very uncertain world at the moment. Commodities and crude oil in particular, along with all other asset classes were hit massively as correlations of most asset classes increased over the last few months due to the deleveraging taking place across the financial markets. This meant that it was difficult to diversify away market risk, and commodity investors also saw losses from their portfolios despite traditionally low correlations with equities.

While it widely reported that investing in commodity investments was a good hedge against inflation, we are not so sure that this continues to be the case today. Going forward, we expect to see inflation numbers come in lower in year-on-year terms as the global economy still continues to suffer. The rally in oil prices in the first half of 2008 was in effect a self fulfilling prophecy, as higher inflation numbers led to more people chasing after “inflation hedges” like oil. The major sell off for commodities in general because of indiscriminate deleveraging is now leading to fears of deflation.

However, crude oil prices have fallen faster and harder than most people have expected or even anticipated, and we do think that there lies the bias toward the upside.  The question of when however, will be answered later in this article. While commodity prices are back to levels last seen in 2005, oil prices have fallen even faster, and are currently trading at 2004 prices at time of writing.

In short, we think the secular story for oil and energy remains intact, but within this secular trend, we are currently witnessing a down cycle in energy. How long the down cycle will last, we think, depends largely on the fundamental factors of the demand-supply equation, which is directly related to economic activity.

Geopolitical Risk

Unfortunately, we do not live in a perfect world. It should serve the reader well to remember that while most of us are focused on the gloomy global economic outlook at the moment, geopolitical tensions continue to brew in parts of the world. A worsening of the situation between Israel and Palestine over the Gaza Strip is likely to throw all fundamental analysis out of the window as crude oil prices have historically been extremely volatile towards the upside during times of unrest. Large energy producing countries like Russia have also in recent times, cut off natural gas supplies to the rest of Europe, leading to a short term spike in energy prices.

As there are few models to quantify the resulting cause and effect of a worsening geopolitical scenario on the price of oil, we ask the reader to ponder on the fundamental reasons instead.

Contango Curve In Oil Futures

Last year, we highlighted that we believed speculation was peaking in the price of oil, leading to a backwardation curve in oil futures prices. This time, we see contango back in the futures markets, similar to the curves we saw in 2004 and 2005.  (See Chart 1)

The futures market has been implying that it expects demand for oil to slow down, hence, contango appears to be sharply back in focus. Contango can be interpreted in two ways – either that of a shortage of future supply, which is why prices are higher in the future than now, or that of a current excess supply in the present. We believe the latter reason is more relevant to the current economic situation and believe that the extent of contango that is back in the markets indicates sharply declining demand at least in the near term.

This time around, the futures market is pricing in the fact that demand is likely to slow, hence, contracts for delivery in the future are only trading at slight premiums to spot prices. Put it another way, the forward curve at the moment is merely now pricing in the cost of ‘carry’, like storage costs and any interest rate differentials. This is common during recessionary periods now.

The question to ask ourselves is, has the drop in demand already been priced into the futures market? We happen to think so, although we have to say that the near term outlook for the price of oil remains very volatile, and are more confident of calling for oil prices to be significantly higher by the end of this year.

What we should remember however is that while the demand side of the equation remains weak, we expect OPEC (Organization of Petroleum Exporting Countries) and other oil producing countries to make a concerted cut to ease supply. While the demand curve is widely expected to shift downwards significantly, the nature of a good with inelastic demand like oil means that prices will eventually catch up with reduced supply.   

Crude Oil Supply

While OPEC is widely expected to cut production leading to reduced supply in the next few months or so, we think that these are just short term supply factors. The more pertinent question is whether current low oil prices are able to sustain the cost of finding new sources of oil supply, and its implications for prices down the road.  

If oil prices are too low to warrant the effort of finding new oil fields, and further factoring in current credit conditions, oil producing nations are likely to think of how to maintain their oil revenues first before making plans on how ramping up production. Future exploration and the building of infrastructure needed to produce oil will be put on hold, further limiting supply in the longer term.

Chart 2 shows average finding costs over the last 2 decades. At current prices of US$35 – US$40 per barrel, it would make little sense to spend money exploring for new oil fields, and then investing in the relevant infrastructure only to turn in a miniscule profit. Causality, as we know, often moves in a price-cost direction – more efforts to find future supplies will only be worth it if the selling price of oil warrants the costs of doing so.

Correlations with the USD

Many are concerned about the strength of the USD as there is widespread belief that the price of oil and the USD are always negatively correlated. (A strong dollar would mean low prices of oil and vice versa). Indeed, it is easy to conclude that recent dollar strength (despite considerations like quantitative easing by the Fed and the zero interest rate policy) can be linked to the steep falls in the price of oil.

While there is some evidence that there are generally inverse correlations between the USD and commodity prices, over the last 20 quarters or so, we have generally seen erratic quarterly correlations between the price of oil and the USD, represented by the DXY Index (US Dollar Index). In fact, if not for the year of 2006, where we observed almost perfect negative correlations between the price of oil and the dollar, it would be hard to conclude that going forward the price of oil can be determined by how strong or weak the dollar is.

Conclusion

Owing to the current economic climate and sentiment, we expect oil prices to continue to be low in the short term, barring any geopolitical risks that lie ahead. Volatility is also expected to continue, but the market does not appear to be pricing in the potential for a potential supply crunch down the road if OPEC decides to cut. This signifies to us that oil prices are likely to appreciate swiftly and steadily when this happens.

While current demand looks to be extremely weak, we believe that the futures curve has expressly priced this in from the return of contango in the futures curve and that the floor price for oil will be in the range of US$30 - $40 / bbl. As we move ahead in 2009, the price of oil will largely be dictated by supply-demand fundamentals.

However, the speculative flow of money chasing after a cyclical bull trend, like what was observed in the 1H of 2008 is unlikely to occur again during this year. Long term, we continue to believe in the secular argument that energy prices will be higher in the long run and think that we are likely to resume a secular bull trend in energy as the world economy recovers by the end of 2009.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This video is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


 


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