Commodities | Feb 16 2007
By Greg Peel
In December 2005, analysts at Goldman Sachs predicted the crude oil price would rise to US$105/bbl. This was a bit of a shock, as the spot price had only moved into the US$50s at the time. But when oil passed US$75/bbl at the height of Middle East tensions, the Goldman prediction was starting to look quite plausible.
As tensions between the US and Iran appear to be simmering still, the fact that the oil price is now below US$60/bbl suggests the fear premium attached to crude pushed too far mid last year, and that supply is no longer as dire as it once was seen to be. A warm start to the northern hemisphere winter also served to trigger fund selling.
A return to winter cold may have restored order, but the spot crude price has lately been very volatile as supply-side news ebbs and flows. One minute OPEC is cutting production, the next minute it isn’t. Then the US wants to increase reserves. And China too. Predicting where the oil price is going to land on any given day has become an impossible task.
One fact that is certain, however, is that the crude oil market is now locked into a steep contango. This has serious ramifications for the value of fund investment.
When life was normal long ago – pre-China – commodities usually traded in backwardation. This meant forward (or futures contract) prices traded at lower levels into time. As commodities can be stored for a rainy day, consumers would turn to inventory supplies if the spot price rose too high, and provided storage costs were economical they would not pay a higher price than spot for forward contracts.
But then the China factor hit and the demand surge caused panic. Consumers rushed to lock in prices into time, and subsequently pushed forward prices above spot prices – known as a contango. Adding to contango conditions today is the fact that storage costs have materially increased. It is now not as economical to store oil rather than buy it on the spot market.
This causes a dilemma for investment funds. It you invest in crude oil now, you have to cover the contango gap before you are in the black. Rolling over contacts into time means paying a higher price. Unless the spot price has risen accordingly then you will actually roll over at a loss. If the spot price has fallen, you will suffer a double loss. To maintain a position under such circumstances is to be confident that oil prices will push ever higher.
Can investors be confident?
It didn’t take a lot for the spot price to drop from US$78/bbl to US$49/bbl. Apart from a “blow-off top” that saw the overstretched fear premium wiped out, the world has become more optimistic that demand is ebbing and supply is flowing. New sources, alternative fuels, claims by Saudi Arabia that it has oil a-plenty, and a diminishing of the peak oil scare has bolstered the supply side, while predictions of a slowing global economy have dampened demand assumptions.
Where OPEC is involved, the supply side is always tenuous. Initial thoughts of an ease off in rampant Chinese growth have been put on hold, while the US economy appears in better shape than expected. And you can never discount the rapid growth of Chinese car ownership.
Yet the growing call is that demand is easing and supply is improving. There is not a great track record among analysts of getting these factors right, but you have to bow to expert opinion.
However, it is in the investment funds side that pressure may well be brought to bear. Net assets invested in the Goldman Sachs Commodity Index rose from US$15 billion in 2003 to nearly US$70 billion in 2006 (Bloomberg). Making money from commodities is not the walk in the park it used to be, and there is already evidence that the bubble has begun to burst.
Oil analysts at Sanford C. Bernstein & Co suggest a “breaking point” for oil could come in March if Saudi Arabia fails to make the production cuts it has indicated. If spare capacity widens, this could force the contango higher and cause an investor bail-out.
Bernstein & Co are predicting a 2007 average price of US$50/bbl. Other analysts share Bernstein’s views and predict that oil could fall as low as US$30/bbl as time goes on and risk of severe supply disruption recedes.
But Goldman Sachs remains fairly resolute. While US$105/bbl has not been mentioned lately, Goldmans maintains producer investment is “significantly” short of requirements (Bloomberg). The analysts have set US$71.50/bbl as their 2007 target.
The market is poised.