Oil markets seem to have defied logic in the second half of 2012. From late-June to mid-September, crude oil prices surged 28.9% despite an oversupplied market and cooling demand as the global economy slowed, supposedly on fears over a possible conflict between Israel and Iran. Exactly as the Fed unleashed QE3, WTI peaked, and has since tumbled more than 12%, dropping 4.2% on Wednesday despite the pledge of unlimited liquidity from Bernanke, the ECB, and other major global central banks.
Two factors could be driving the return to what appear to be fundamentals in oil markets: Israeli’s Prime Minister Benjamin Netanyahu’s less aggressive rhetoric toward Iran, and the pricing-in of easing expectations. Crude oil may be but one more indicator that the effects of quantitative easing are preemptive, expressing themselves in prices all the way to the announcement, but not necessarily as the policy is being executed.
“Oil prices performed strongly in the anticipation of QE [and global easing] and are maybe now slipping as the news was already priced in,” explained Caroline Bain, lead commodities analyst at the Economist Intelligence Unit (EIU). This hypothesis appears plausible, as it’s an effect that can be observed in the price movements of several risk-assets: a three month chart of the gold, the Dow, and the euro-dollar exchange rate all show a big move up to mid-September, followed by plateaus.
Indeed, oil markets had been trading out of sync with the underlying supply and demand environment this year, as I explained in a column titled What’s Wrong With This Picture? Oil Up More Than 20% As World Stagnates. Bain puts it in perspective, she notes that “the demand and supply outlook for the oil market certainly suggests prices could or should ease,” adding that consumption in both the U.S. and Europe has been contracting have joined with bearish news out of China, “the only source of global oil consumption growth in the last year or so.”
Wednesday's precipitous fall in crude oil, with WTI dropping 4.2% to $88.03 and Brent falling 3.15% to $108.05, may be explainable with data. Early on Wednesday, China’s non-manufacturing PMI survey slipped to 53.7 in September, while the Department of Energy announced that crude output was up 11,000 barrels per day to 6.52 million, the highest since December 1996. According to Anthony Lazzara, CEO of Lido Isle Advisors, if supplies, which are on the rise, remain high, and crude can’t break $93 to the upside, then it could fall the way to $82 in the near-to-medium term.
While the supply story is mixed, it is definitely tilted toward surplus. Beyond the boom in unconventional oil in the U.S., Bain points out the increase in Iraqi and African production and, most importantly, the high levels of Saudi output. As I pointed out previously, the Saudis have been very clear on their target for Brent: $100 per barrel. Supply constraints emanating from Iran (hit by sanctions) and the North Sea (afflicted by strikes and unexpected maintenance) are not enough large enough to push the market the other way.
Returning now to the geopolitical issue, traders may have taken their cue from Israeli Prime Minister Benjamin Netanyahu. At the United Nations, and with the help of a cartoonish drawing of a bomb, Netanyahu indicated that “Iran’s capability to enrich uranium must be stopped before next spring or early summer,” suggesting “that by that time the country will be in a position to make a short, perhaps undetectable, sprint to manufacture its first nuclear weapon,” according to The New York Times. (He did this by drawing a red line on his bomb diagram)
Netanyahu also “appears to be shifting Israel’s Iran policy toward more sanctions,” the same paper noted in a report on the Prime Ministers scheduled trips to Europe to push for more EU sanctions against Iran. “It seems likely that the EU will approve further stringent sanctions on Iran by the end of the year, making it even more difficult for the country to export its oil,” added EIU’s Bain.
Israel’s receding rhetoric and a push toward sanctions, along with Netanyahu’s suggestion that a possible strike may wait until next year, could have pushed investors to lower their expectations for oil price jumps. But risk, Bain explains, is “decidedly to the upside:
Going forward, we believe the market will be in surplus in 2013, partly because we see only very modestly higher global GDP growth next year.
However, and somewhat frustratingly, political risk premia will continue to exert pressure in the global oil market so prices could be higher than fundamentals suggest. If the EU's proposed tightening of sanctions goes ahead (seemingly likely) then it will make it even more difficult for Iran to export its oil so bringing the country's economy to its knees and raising the likelihood of a major geopolitical event next year.
Major oil producers seem to have followed in crude’s tracks. Exxon Mobil, Chevron, and BP, for example, have rallied in tandem with oil prices but haven’t dropped since mid-September, rather, they’ve gone sideways. Oil field service names like Halliburton and Schlumberger, on the other hand, seem to be more closely linked to crude, having followed a similar trajectory even over the last few weeks.
It has been a weird second half of the year for oil. Traders pushed prices up on their perceptions of geopolitical risk and the pricing in of easing expectations. With the Fed and Mario Draghi having delivered, and with an apparent move toward diplomacy by Israel, prices have fallen dramatically. But the Fed hasn’t even bought bonds aggressively yet, and the ECB hasn’t even received a bailout request from Spain, which on the face of it means the easing is yet to come, which should be bullish for prices. Commodities are by nature volatile, and oil has proven it can play the game. The question now is, where does it go next?
- Politics & Government