Rebound in oil markets could prove lasting

May 07:

Predicting oil prices is a risky endeavour. Photo: Bloomberg

As Brent crude oil reached more than $68 per barrel Wednesday, a high for 2015, analysts started to backtrack on earlier predictions of $40-$50 oil. The rebound, however, may not last: Speculators appear to have disrupted Saudi Arabia’s strategic game against US shale oil producers.

Predicting oil prices is a risky endeavour. They are determined by a multitude of political, economic, psychological and climate-related factors that cannot be modeled with accuracy. So analysts would suggest that Brent is rising because of unexpectedly fast demand growth in China; another bout of trouble in Libya, where a key oil port has shut down; a decrease in US inventories; the continuing fighting in Yemen; and any number of other events.

It’s just as likely, however, that oil’s rise is driven by hedge funds holding a net long position of 550,000 futures and options contracts, or 550,000 barrels of imaginary oil. Arguably, when the actual crude oil supply is about 92.5 million barrels a day but futures markets trade about 1 billion barrels a day, speculators are more important than any real-world factors in determining the price. The speculators, though, listen to the analysts who do their best to take the real world into account. That means there’s contamination, making the price movements even more unpredictable.

Sometimes, however, there is a bigger story that gets obscured by all the noise.

I predicted the current rebound back in November. The biggest factor is shrinking oil investment as a result of last year’s steep price drop. A senior executive at Saudi Aramco, the national oil company, said in March that $1 trillion worth of projects would be cancelled globally in the next couple of years. There has been a steady stream of announcements from oil companies about cutting jobs and canceling projects. There’s also the shrinking US rig count, which led the US Energy Information Administration to predict last month that crude production would decline in June through September.

By refusing to cut production last fall and thus engineering the price drop, Saudi Arabia and other members of the Organization of Petroleum Exporting Countries (Opec) mainly targeted the US shale producers, whose projects have higher costs than most Middle Eastern, ex-Soviet, African or Latin American plays. Yet gloom spread throughout the industry, and this year, speculators have seized upon the slightest bits of news to bid prices back up. Consequently, $50 Brent didn’t last long enough to wreak havoc on the US frackers. They have survived, and at current prices, we should expect a limited “frack counterattack.”

The Saudis needed more time, and perhaps a major disruptive event such as Iran’s return to the crude markets, for their power play to have a devastating effect. As it is, success has only been partial. The oil kingdom has showed it still has plenty of market power. It has given the highly leveraged, low- margin producers in the U.S. a big scare. It has also won back some market share by making other players reduce investment. Yet, by trading on the Saudi scare, financial speculators, in effect, defused it.

It may well be that, by their combined efforts, the Saudis, the frackers and the hedge funds have created a new equilibrium, and current prices will prevail for a while. Thanks to the Saudi play, shale operators understand the risk well enough to scale back their ambitions. The Saudis, for their part, can’t boost production fast enough to cause the shale operators more pain, and they can live comfortably with $65-70 oil. So can non-Opec producers such as Russia that have devalued their currencies and mostly absorbed the effects of devaluation. Russia’s current budget is based on $50 Brent, and the extra revenue will be welcome.

Only the speculators won’t be happy as prices settle: They love volatility. When the market is in equilibrium, all they can do is gamble on news headlines. So there will be spikes and troughs, but, for the rest of this year, the oil market should be more stable. Bloomberg

Source:www.livemint.com/Opinion/RdhLZWC9CmqIyPIr4eJOfJ/Rebound-in-oil-markets-could-prove-lasting.html?