Why oil prices could decline sharply

Written by Sunil Kewalramani | Sunil Kewalramani | Updated: Oct 6 2012, 07:02am hrs
Despite the Feds QE3, Saudi Arabias excess supply and geopolitical stability in the Middle East will push down oil prices

Weak global growth is slamming oil prices, sending them nearly 12% lower in less than three weeks, with more declines likely. With the absence of a Mideast crisis, oil prices have likely seen their 2012 highs, and Brent could easily slide to $100 or below before the end of the year.

Recent US government inventory data released on September 26 showed a drop of 8.7 % in demand for distillates, which include diesel fuel and heating oil. Supplies are strengthening even as demand is decreasing, due to both seasonal factors and as a result of the high oil prices. The latest evidence of ample supply was EIA data released on Wednesday showing US crude inventories rose 8.5 million barrels in the week ended September 14, much more than expected.

The drop in demand for distillates has been the worrying factor, after last weeks 10% drop in distillates demand, on a four-week average basis. The numbers are reflecting the drop in economic activity discussed by transportation companies FedEx, in its earnings warning, and Norfolk Southern. The prospect of military conflict over Irans nuclear programme pushed oil prices to their highest level in July. But as the focus in markets around the world turned to Spain and Italy's regional finances as well as the growing possibility of Greece exiting the eurozone, crude oil turned south.

How hyperactive policymakers become when the price of oil starts to haunt their dreams. Three weeks ago, the group of seven leading industrial countries demanded that oil-exporting nations be ready to pump more of the stuff. That was after a rise in the price from $90 a barrel to $115.

Saudi Arabian oil minister Ali al-Naimi said in an obliging tone that the current supply and demand do not justify current prices, and a news report quoted a Gulf official saying Saudi Arabia was currently pumping about 10 million barrels a day. OPEC is already producing record levels, and production in North America continues to grow.

Obviously, there is discussion around the US releasing its Strategic Petroleum Reserves (SPR), which I think is a headwind to investors who are trying to stay long on oil. The White House, in comments this week, gave a nod to Saudi Arabia, praising it for a continued commitment to take all the necessary steps to ensure the market is well supplied. The comments were an unusually open recognition of Saudi cooperation.

Then there was the oil-price flash crasha $4 plunge in 30 minutes on Monday, September 17. If this was any other commodity, an insider trading inquiry would already be underway. It is tempting to write off the events of September 17 as merely a flash crash. But they also appear to have coincided with, and perhaps caused, a much bigger turning point in the oil markets. After rising steadily by almost $25.70 per barrel or 28% from June 28 ($91.35) to September 17 ($117.02), the ICE November Brent futures contract has fallen $9.75 (8.4%) in the space of three days, in what appears to be a decisive turning point.

The oil market, left alone, is likely to do its job and balance the political threats to supply and the economic threats to demand. When the oil price soared to about $145 in the summer of 2008, it did not do any lasting damage; the world economy was already in crisis because of the breakdown of the banking system and, in any case, oil prices fell back to about $60 in the early spring of the following year.

Here are some of the other bearish signals the market has been watching:

* In addition to a huge build-up of oil supplies, there has been a dramatic decline in distillate demanddown 11% year-on-year.

* Brent crude has broken below its 200-day, 50-day moving averages and Fibonacci retracement level. These are key technical indicatorsand reinforce the bearish sentiment in this market.

* US oil prices may be headed to $90 a barrel, after hitting $100 just last Friday.

* One short-term bear's outlook, by John Kilduff of Again Capital, said WTI oil could be headed toward $88 a barrel.

Gasoline, rising rapidly in August and September due to refining issues and Hurricane Isaac, could start to decline. The gasoline market is extremely sensitive since supply is so stretched. Gasoline inventories in the Northeast have fallen to the lowest level since EIA records began in November 1990, according to Dow Jones. The gasoline market should ease substantially by the middle of winter. One could expect to see gas prices head back to $3.50 per gallon, from the current national average of $3.85 per gallon. The market has lost much of the geopolitical premium that returned after the US Ambassador to Libya and three other Americans were killed a three weeks ago. It is also not being pressured much by the tensions surrounding Irans nuclear programme, which has resulted in financial sanctions and an oil embargo against it.

For some investors, the comment by Israeli Prime Minister Benjamin Netanyahu a fortnight ago that Iran is six months away from having enough enriched uranium for a nuclear bomb pushed back the idea that Israel would attack Iran in the near future.

WTI soared to $100 in the week ending September 15-16 even as the Fed announced its latest round of quantitative easing. The market shot up significantly faster than any of the indicators behind the shoot-up indicated it should go. There was risk-on news across all asset classes.

The Fed announced QE3 on September 13 and, initially, commodities gained smartly. But late on September 17, Brent crude tumbled $4 a barrel in just four minutes, apparently inexplicably. The next two days erased another $5.60 and oil became what one analyst called a falling knife. The market ended the week sharply lower, even after a partial bounce.

In theory, a river of cheap money should inflate the value of finite materials. Besides the Fed, the Bank of Japan also announced another round of monetary stimulus. On September 6, the European Central Bank announced its own plans for unlimited buying of peripheral eurozone sovereign debt. Oils plunge showed what happens when economic theory tangles with the reality of commodities trading.

The Saudi offer to supply extra oil to big customers reflects longstanding worries about a worsening slowdown in growth that has already helped remove 2 million barrels of daily US oil demand over the past 5 years. As the global economy slows, so does consumption.

Commodity prices are determined by many factors, including physical supply, usage and storage costs, and not just monetary policy. US pipeline constraints mean barrels of the two main global oil benchmarks are $18 apart, confounding even the most savvy investors. All else being equal, QE should be bullish for commodities. A key measure of inflation expectations has risen in the Treasury debt market since last week, as has gold.

The problem is that very little is equal. Theres a lot of other stuff going on in the world that makes it difficult to pick up the impact of QE alone. Monetary easing had also been predicted for months, helping drive crude to $118 a barrel two weeks ago.

At least now we have concrete examples of past QE to examine the impact on oil. The Fed launched the first round at the height of the 2008-09 financial crisis and the second in November 2010. Oil prices rose with both decisions, but the main reason most asset prices rallied in early 2009 was the fact that global growth had stopped imploding, with the stabilisation of the financial system being the key factor. QE2s effect was ambiguous at best. On balance, it suggests that while such easing has generally given risk assets a short-term boost, the sustainability of the rebound has been contingent on whether it is followed by a rebound in economic growth.

This is what Fed chairman Ben Bernanke wants and what the first two rounds of easing did not lastingly achieve. The oil markets lack of a knee-jerk response to QE3 suggests he may have breathing room to jolt the economy without hitting motorists at the pumps. As Bernanke said in Jackson Hole last month, The expansion of the balance sheet to date has not materially affected inflation expectations. Or, it suggests that the effects of quantitative easing, even the latest open-ended version, have run their course.

It is well and good for the Saudis to pump more oil when they think the price justifies it. Taking action to assuage skittish policymakers, on the other hand, is good politics but bad economics. Even after stimulus and quantitative easing in the US and elsewhere, fundamental factors of supply, demand and the world economy are more likely to bring the oil price back down to about $100 a barrel.

The author is CEO, Global Money Investor