Oil prices fall

The price of crude has fallen more than $35/bbl this year and could go even lower in the current environment of severe risk aversion and macroeconomic pessimism, said analysts with Barclays Commodities Research. “Whether oil fundamentals alone warrant such a sharp move remains debatable, but clearly sovereign debt concerns surrounding southern European countries have taken a material turn for the worse and have been dominating sentiment,” they said.

“Like most assets exposed to global growth, oil could very well trade in a broad range in the next few years, with…the upside capped by a weaker growth and investment environment, barring the flaring up of geopolitical events,” said Barclays analysts.

Yet they said, “Contrary to popular belief, actual oil demand in the first 5 months of this year has actually held up just fine, despite the fairly sharp slowdown in Chinese demand growth. However, there is no doubt that June has seen a severe deterioration in demand, with cargoes around the world finding no bid.” Physical differentials have weakened, and Brent has gone into contango. “It also seems to us that some of the latest trends of demand weakness have been exaggerated by destocking and a complete freezing of purchases owing to a sudden rise of uncertainty about the global macro outlook combined with a sharp depreciation of emerging market currencies, most of which are large importers of oil,” they said.

Rebound of oil prices requires increased demand by China and India, plus stabilization of demand among members of the Organization for Economic Cooperation and Development, “which has recovered robustly from the first quarter,” the Barclays analysts said. “The sudden bout of severe uncertainty together with some stockpiling may well delay the rebound in oil demand to the end of the third quarter or fourth quarter, but our base case still remains for a recovery, albeit delayed, and not a falling away from current levels as seen in 2008-09.”

If demand improves, little additional effort will be required on the supply side. The call for crude from the Organization of Petroleum Exporting Countries in the last half of this year is broadly the group’s current output, “with the uncertainty around Iranian supplies risking pushing actual OPEC output lower than the call,” Barclays analysts said. “Commercial inventory builds do not appear to be excessive, in our view, and in some cases the need for restocking could create additional support for demand. In this case, beyond any momentum driven sell-off, prices should bottom around current levels through in the third quarter before picking up in the fourth quarter.” But further economic discontinuity could keep crude prices “arguably closer” to $80 or less before OPEC eventually shores up prices to their desired level of $100/bbl, they said.

Sweet crude supply

Meanwhile, the conventional sweet crude market has been disrupted by the US shale oil boom, said James Zhang at Standard New York Securities Inc., the Standard Bank Group.

“The perceived wisdom is that the world is very tight on sweet crude since the distillate crunch in 2008 (when global refineries struggled to produce enough low-sulfur distillate fuel from sour crude). Back then it was also widely projected that incremental crude oil supply would be mainly high sulfur,” he said. Consequently, investments in the refining sector over the past few years have been geared towards processing sour crude.

However, Zhang said, “The whole hypothesis has been thrown off course by the rapid growth of US shale oil production, which has similar characteristics to that of conventional sweet crude oil. According to the US government, domestic US oil production hit the highest quarterly level in 14 years in the first 3 months of 2012.”

Much of the incremental production previously was trapped in the Midwest, but new infrastructure is allowing more shale oil to be moved to the US Gulf Coast, where about half of the US refining capacity is located and has traditionally relied heavily on foreign crude imports.

“Consequently, the US imported less crude oil, particularly sweet crude, which in turn weakened the premium typically commanded by sweet crude,” said Zhang. As a result, he said, “The Bonny light crude price differential has softened materially.” That situation is likely to persist, “which means that some of the refining investments aimed specifically at sour crude won’t realize the return they had promised. Fortunately, it is typically easier for refineries to replace sour crude feed with sweet crude than the vice-versa,” he said.

(Online June 25, 2012; author's e-mail: samf@ogjonline.com)

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