Oil markets: when is a fundamental a ‘fundamental'?

Classic price signals such as falling inventories, economic quagmire in the OECD and slackened growth in emerging markets all failed to quell a bull market on the way up to July, while geopolitical flashpoints, storms looming over the Gulf of Mexico, and the persistence of tight markets are failing to stop its bearish decline on the way back down. This raises a number of ‘inconvenient' truths as to the self-selecting nature of ‘fundamentals' in play at any given time in oil markets.

Red rag to a bull, or is that a bear…

During a stampeding bull market up to July 2008, traders failed to let news of sharp falls in US employment figures or weakened growth in Asia cool the market, as speculators piled into oil as a hedge against the weak dollar amid rising inflationary pressures. The longer term cause of this upward run was the fact that financial investors were convinced that tight supply-demand fundamentals could be exploited as they built up a large net long position in crude oil futures from 2004 onwards.

Every scrap of geopolitical friction was seized upon to push prices up; the hijacking of a small Japanese oil ship passing through the Gulf of Aden prompted the market to hit $117/b while intractable conflicts in Iraq and Nigeria alongside exotic statements from Libya, all supposedly served to bring supply-demand fundamentals closer together. Rumblings in Latin America were billed as a potential ‘Andean cataclysm' rather than a largely predictable and well rehearsed disagreement between Venezuela and Colombia.

Even failed Presidential candidate, Hillary Clinton, managed to move the market by firing a virtual warning shot across Iranian bows as a desperate attempt to increase her poll ratings against Barack Obama after the markets had previously brushed aside US National Intelligence Estimates casting doubt on Iranian nuclear capabilities. Contractual instability in Russia and Central Asia also came as a supposed ‘surprise' to the market in restricting non-OPEC supply, which admittedly, still has more mileage than the death of Benazir Bhutto drawing supply-demand fundamentals closer together when pushing the markets to brink of $100/b in the closing hours of 2007.

Time to talk it up

Little wonder then, that despite a lack of any major change in market fundamentals (beyond Saudi Arabia working towards a record 12.5m b/d output) investment banks started to hint towards forecasts of $200/b. Not to be ‘outdone', Gazprom nudged estimates a little higher hitting $250/b, a figure that many analysts started to present as a self fulfilling prophecy as the markets approached the $150 mark in July 2008.

But just as the bull market wouldn't let weak employment figures or dampened growth forecasts stop the oil markets meteoric rise, it is now highly unlikely that a bear market will let ‘minor' inconveniences such as heightened contractual instability in Russia, North Africa or Central Asia, or major geopolitical flashpoints in the Caucuses between Russia and Georgia (and ‘associated' PKK attacks on the BTC pipeline), stem its decline as investors look for safer waters on its way down. Long-standing OPEC stubbornness to increase output no longer appears to be a major problem, nor does entrenched difficulties in the Niger Delta. The fact that Evo Morales has been fighting for his political life in Bolivia as Pervez Musharraf desperately clung onto his last vestiges of power in Pakistan has barely touched the sides as the oil price slipped to $112/b. Iran's threat in early August to block the Strait of Hormuz should Tehran be attacked also failed to register, (a point which stands in stark contrast to the $6 spike following Iranian missile tests merely a month earlier).

Even the spectre of Hurricane Gustav wiping out the Gulf of Mexico, has failed to rally the market. The slow road to US recovery from the credit crunch is also failing to make much traction in recalibrating oil prices on an upward trajectory.

Wall Street runs its course

This all points us towards our first inconvenient truth; namely, that speculation has added a sizeable chunk on the oil price in capitalising on tight market fundamentals. Given that the latest ‘price signals' emanating from the Caucuses over the fraught existence of the BTC pipeline and access to Central Asian oil reserves that feed it, or looming storms in the Gulf of Mexico, have actually prompted the oil market to drop even further (hitting $106/b), provides unequivocal evidence that the market is currently being dictated by financial investors unwinding their net long positions to realise capital gains and release liquidity, rather than any shorter term price signals in play.

The strategy, as far as the market is concerned, is simple. It is actively looking to steer itself back towards a fundamental correction (probably to around the $85-95/b mark), which remains a truer reflection of the supply-demand fundamentals to hand with OPEC pushing production to its highest level in 48 years to 33mb/d. But what remains remarkable about this correction, is the extent to which the market is once again willing to ignore genuinely seismic events (such as those in the Caucuses), which, even a month ago, would have made prices above $170/b entirely conceivable. While it might be a little strong to say the market is broken, the degree to which speculation has forced the market up, now means that it having to break all the rules in order to restore a semblance of rationality.

So, what next? OPEC is back on, as is the ‘market'

Once prices become reattached to the fundamentals in play, shorter term price signals will re-enter market sentiment. This will come as welcome news to OPEC, and in particular, Saudi Arabia, which prizes notional control over the market more highly than receipt maximisation. Indeed, the fact that OPEC earned as much in the first half of this year as they did in the whole of 2007 - putting $645bn into state coffers in six months - underlines the fact that they have more petrodollars to recycle than they actually know what do with.

But with speculators taking a back seat, and market fundamentals starting to act as price signals once more, the downside for OPEC is that it will come under renewed scrutiny to increase output when it next meets on September 9th, particularly as non-OPEC supply continues to lag. Unfortunately, this brings us to our second inconvenient truth; OPEC is likely to continue to put a floor under prices by further restricting output.

This is either because most members of the cartel are already producing at maximum capacity, or more pertinently, because all producers (including Saudi Arabia) are enjoying elevated prices and are becoming increasingly confident that demand will remain relatively inelastic in the midst of an economic downturn. Admittedly, Saudi Arabia might increase output on an ad hoc basis to cool the political ardour of Iran on geopolitical issues such as Lebanon or nuclear proliferation, but this will remain a short-term play rather than a revision to flooded markets in the 1980s. In effect, the days of ‘price moderates' could be over.

The upshot is that prices are unlikely to ease much into 2009-10, with further pressure expected by 2011-12, not least as OPEC will struggle to match demand with actual supply. Needless to say, this is all getting ‘peak oilers' very excited, but in reality, it is not so much the physical availability of resources that is in question, but amassing the necessary capital and political conditions needed in order to make major investments. This brings us to our third inconvenient truth; the frequently quoted IEA figure that $22 trillion of investment will be needed in resource development, generation and infrastructure in order to meet global demand by 2030 remains as distant, as it is daunting. So far, attempts to raise investment in the energy sector have been self-defeating with cost inflation usurping increases in nominal spending. This means that the world is struggling to invest in sustaining current supply, let alone meeting projected demand growth of 50% over the next 25 years.

Even now, analysts continue to make the assumption that the availability of funds for new investment is linked to prices. But this basic assumption overlooks the fact that the flow of private and state investment depends to a great extent on domestic stability and the political outlook of producer states. Indeed, as far as International Oil Companies (IOCs) are concerned, the greatest risk already pivots around limited access to low-cost reserves with IOCs having gone from holding well over half the world's oil reserves in the late 1970s, to less than 10% today. Opening offshore reserves in the US, or greater development of the North Sea will help to stem this decline a little, but remain insufficient to level the playing field between International and National Oil Companies (NOCs). Whoever eventually ‘wins the Arctic' could tip the balance in either direction, but at this stage, few would bet against Gazprom taking the lion's share of reserves.

‘Geopolitical peak' is the real concern

To reinforce this point, around 53% of the world's proven oil reserves reside in four countries. Of these, Kuwait and Iran had tried to encourage IOC investment but the process has stalled because of domestic politics or international friction. Saudi Arabia refuses to allow investment from abroad in upstream oil, while Iraq remains particularly challenging for IOCs to make concrete commitments. The other major opening is Russia, which has increasingly cut IOCs out of Production Sharing Agreements; BP is set to become the latest contractual casualty as TNK-BP relations deteriorate. Meanwhile, Mexico will not relax a constitutional ban on outsiders, even as PEMEX production plummets.

Governments with heavy demands on their domestic budgets have also failed to resist the temptation to over-tax exploitation of natural resources, inhibiting further investment. Venezuela, Angola, Algeria, Bolivia, Kazakhstan, Libya and Nigeria are merely a short list of states that have already bitten into the ‘contract renegotiation apple'. Even in producer states where the door to reserves remains ajar, invariably the risk profile attached is simply too high for IOCs to take on. This explains why Gazprom has filled Total's boots in Iran (a role it would also like to perform in Nigeria at Shell's expense) while CNPC, ONGC and Petronas surpassed Talisman in Sudan and CNOOC is conducting offshore drilling in Somalia. Similarly cavalier risk appetites from Asian NOCs can be expected in Iraq.

But those waiting for NOCs to fill the supply breach by virtue of reserves, could prove to be disappointed. Even in states not running an active ‘depletion policy', NOCs will still find it difficult to extract sufficient reserves out of the ground. The point here is not to champion the role of IOCs (who are arguably paying a heavy price for focusing on shareholders rather than exploration for too long). Nor is it to denigrate National Oil Companies whose governance standards often leave much to be desired when operating overseas, and remain politically expedient at home when cutting IOCs in and out of production agreements. But rather, to highlight the fact that without a seismic shift in political capping of developing reserves, we are likely to meet our fourth and final ‘inconvenient truth'; namely, that speculation will be the last thing the world needs to worry about as supply-demand fundamentals run headlong into the limits of a ‘geopolitical peak'.

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