Commodities | Oct 01 2008
By Greg Peel
The price of crude oil has experienced unprecedented volatility in 2008, rising rapidly to US$147/bbl before falling rapidly again to US$91/bbl, but nothing had ever prepared the market for the level of day-to-day volatility experienced since the world economy threatened to collapse last week and then Congress decided to interfere with a rescue plan.
The global price of different oils is traded in US dollars, and as such the “price” of oil will fluctuate with reference to the opposite fluctuation of the dollar. However, whatever dollar exchange rates may be, the “price” of oil will always ultimately be set by demand and supply. Demand will be determined by economic growth.
If US economic growth is strong, then the US dollar will be strong, but so will be the demand for oil. Thus consumable commodities, such as oil, base metals and agricultural products, do not necessarily track a simple inverse path to the US dollar index. Longer term trends will see commodities prices “decoupling” from US dollar movements. Since 2006 the dollar index has fallen 23% but the oil price has risen 170% (from around US$60 to US$100 now) or 245% to its 2008 peak. Dollar-schmollar.
Oil’s rise in price (ignoring the speculative bubble blow-out for now) has been driven by increased global demand particularly from emerging economies. As we all know, China is by far the leading culprit.
The oil price bubble burst back in July because all bubbles burst eventually, which in the case of commodities is usually at the point of demand destruction. The price of a commodity can only go so far until consumers can no longer afford to pay. When US demand for gasoline collapsed over the normally high-demand “summer driving season”, it was all over for oil. We have now fallen back to about US$100/bbl once more.
The price of oil has bounced around like a rubber ball this last week as one moment the world economy was about to collapse, the next moment it wasn’t, and then it was again. As of today, maybe it isn’t. Maybe next week it will. We don’t know. What we do know is that if oil is US$90 one day and US$110 the next, neither price is indicative of the longer term trend. These are simply panic markets at present.
If the US Congress fails to act, or any action fails, then the world will enter a depression. The price of oil would likely fall back to US$60. Not nice to think about (a depression that is), so let’s just assume the best.
Assuming a Plan is delivered, the best we can hope for is economic stability. No Plan is going to be the panacea that turns economies and share markets back into instant bullish mode. We will avoid another Great Depression, probably, but we will not avoid a global economic slowdown. It is still likely we will have at least a global recession.
(Before you ask, a recession is “technically” defined as two consecutive quarters of negative GDP growth. A depression is considered to be reached at 10% negative GDP growth. The Depression of the 1930s was Great because US GDP growth fell 33%.)
This means that commodity prices will remain under pressure. There is little disagreement among analysts that Europe, the UK and Japan are either in or about to enter recession, and were anyway before there was ever any need for a Plan. Nor is there disagreement that China’s economy will also slow from its lofty peak. But there is a raging argument as to just how much China will slow. On the one hand you have the ongoing diminishment of China’s export market with developed economies, and on the other hand you have ongoing Chinese industrialisation and urbanisation.
Thus one can argue as to whether commodity prices are set to fall a lot further from here, as global demand diminishes, or whether a bottom is close by already given the extreme and rapid falls of past months. There is also the question of deleveraging. Has short term speculative money been so quickly removed as to cause prices to overshoot on the downside?
Commodity prices always overshoot in both directions at the top and bottom of cycles. But as economic turmoil continues to rage, it is very difficult to determine where that overshoot point might be. In the case of oil, however, we have at least two factors offered up by analysts this week to consider.
It is long forgotten now, but at the beginning of last month OPEC held production meeting. Views were split, but Venezuela was leading the charge to cut oil production given the rapid price fall while Saudi Arabia was happy with the status quo. So in the end (the Saudis have the sway) there were no production cuts, simply a crackdown on exceeding quotas, which still “reduces” production by a margin, if quotas are adhered to.
Quotas or no quotas, what we learnt from the meeting is that OPEC has around US$100/bbl as its target. OPEC wants to receive as much per barrel as it can without destroying demand. US$100 is the magic number.
On the flipside, the Saudis and others among the less volatile OPEC members also appreciate that the global economy is in strife. As the analysts at Danske Bank put it:
“Given the latest events in the global economy, it certainly cannot be ruled out that the more pragmatic members of OPEC, such as Saudi Arabia, Kuwait and the Emirates, would be willing to accept a lower oil price in the coming months to support the global economy. Remember that the wealthy OPEC countries are currently suffering badly from the global destruction of assets that is happening on financial markets”.
Nevertheless, Danske till believes US$100 achieves this “lower” price in OPEC’s eyes. We are not yet talking about increased production that might see oil fall to US$85/bbl – which happens to be where the technical analysts see long term support.
But just how much control does OPEC have? Non-OPEC production is currently in rapid decline. Russia spent all year shocking the world with its ever decreasing production volumes, and now its Mexico’s turn. Could oil fall to US$85 before OPEC can do anything about it? Quite possibly. The US is still by far the world’s greatest consumer of oil. If the US economy goes into recession, which it will be unlikely to avoid if it isn’t already there, then there remains plenty of downside for the oil price.
But let’s not forget China, who after all, along with India and friends, provide the “stronger for longer” macro view on commodity prices.
Astute analyst Dennis Gartman notes China is currently undergoing a long term project to build a strategic oil reserve, just as the US can boast. Phase One is due to be completed next year, which involves a new 5 million cubic metre storage facility to add to existing 3mcm and 1.2mcm facilities in other locations. Phase One thus sees a total of 9.2mcm of oil held for storage, which at Gartman’s best estimation represents about 35% of the 100 million barrel initial target. That target is enough oil to last the country 30 days.
But that is only the initial target. Eventually China wants to be safe for 90 days.
That would take years to achieve so there’s no point in getting overly excited just yet. However, as Gartman puts it:
“If we must find one thing that is bullish of crude and may help to support its price it is this. China will be at it for years trying to buy enough oil to have 90 days of use in storage. We’ve our doubts it can happen in our lifetime [Dennis is fit as a trout but no spring chicken]; thus, this is a bid for the ages.”
Or perhaps a “stronger for longer” theme?
