A Kurdish Resolution?

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This story features BHP GROUP LIMITED.
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By Greg Peel

Apart from ongoing demand, and the storm that came and went in Mexico, recent oil price strength has come down to two factors – low US inventories and geopolitical tension. While there are problems in Nigeria and Angola, the most compelling source of tension is the US-Iran stand-off while the most immediate source has been the Turkey-Iraq flare-up with regard to Kurdish rebel activity. This volatile situation has been very much a part of oil’s move into the USD nineties.

Last night Kurdish rebels freed the eight captured Turkish soldiers who were central to the tense situation. The Kurdish Workers’ Party (PKK) handed over the soldiers in healthy condition to the Iraqi regional government in Kurdistan, via US troops. It has been since the soldiers were captured on October 21, and another 12 killed, that Turkey has amassed 100,000 troops along the Iraqi border in readiness for a large scale incursion should no diplomatic resolution be reached.

According to AFP, the Turkish government has said that despite the return of the prisoners Turkey’s resolve on fighting the PKK is not diminished. From that standpoint, one assumes there should be no let up in the pressure on the oil price but given the PKK’s capitulation it would seem Turkey is winning the mind games. The question thus is: will this spark a fall in the price of oil?

Other geopolitical tensions aside, the soaring oil price has been generally put down to rising global demand but specifically, of late, attributed to US inventory levels which continue to surprise on the downside. The fall season in the US is traditionally a time of stockpiling as the summer driving season ends and the winter heating season is yet to get into full swing. Yet low numbers have been a concern to traders.

Market commentator Dennis Gartman is surprised that the market is surprised by low inventories. You only have to look at the oil price forward curve to see that it is in backwardation, and backwardation discourages stockpiling. Backwardation occurs when the price of forward contracts fall over time. As at Friday, the spot crude (WTI) price was US$95.78/bbl, while the one month was US$81.48/bbl, the three months US$76.49/bbl and the one year US$58.64/bbl.

Backwardation is the natural state of prices for any consumable commodity given the “cost of carry”, which includes the funding cost of oil stockpiling and the warehouse charge. Oil had swung into contango in the earlier months at the beginning of 2007 which implied expectations were for ongoing strong demand and tight supply ahead. But it is the effect of immediate problems – such as Turkey-Iraq – which tends to push the spot price sharply higher while the forward months react less spontaneously. Backwardation in the curve now means that not only does it cost money to stockpile oil and sell forward, you would be losing on the forward sale compared to what you can get for spot.

Backwardation is also the enemy of speculators, for they have to suffer on each contract rollover. Thus if a speculator is long at present, he has to be convinced the front-end oil curve will shift up in parallel given he will suffer a two-steps forward, one-step back effect on each contract. Backwardation thus makes the spot price vulnerable to sharp pullbacks if speculators lose their nerve. Once again, is this soldier release story a catalyst for a pullback, or is the situation still sufficiently volatile to keep oil prices surging towards US$100/bbl?

The trend among oil analysts is that US$100/bbl is almost inevitable now based on US dollar weakness. Commonwealth Research notes the International Energy Agency has joined the chorus by flagging some big upward forecast revisions to come. The IEA does not speculate on world matters, it simply analyses transaction flows.

Macquarie analysts have today revised their oil price forecasts as well. Macquarie has long been hanging on to the notion that there would be a pullback later this year, but this year is fast running out. Macquarie has now raised its oil price forecast for the December quarter to US$79.83/bbl, and first quarter ’08 to US$76.00/bbl.

The first thing that leaps out is that these numbers still look pretty conservative. But this was a 20% upgrade. It has meant target price revisions to oil producers in the analysts’ coverage universe. The most notable is that of BHP Billiton ((BHP)), which moves from $41.41 to $42.48. It is notable because, apart from being minor, it compares to the current price of around $44.15 (on today’s weakness) and a price last week over $47.00. Macquarie also retains the lowest target in the FNArena database. The average is currently $47.44 with high-marker UBS calling $52.00.

There are many who have been concerned about a sharp oil price pullback, but also those who have admitted to have been constantly caught out by oil’s relentless rise toward US$100/bbl. The market is, however, nervous, and a sharp bounce in the US dollar could set it off, or the resolution of geopolitical tensions. When the war between Israel and Lebanon ended last year oil immediately fell US$15.

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