MARKET WATCH: Economic worries drive down crude prices

Dec. 17, 2007
Energy prices continued to slip with crude falling below $92/bbl Dec. 14 on fears that rising consumer prices could reduce demand for fuel.

Sam Fletcher
Senior Writer

HOUSTON, Dec. 17 -- Energy prices continued to slip with crude falling below $92/bbl Dec. 14 on fears that rising consumer prices could reduce demand for fuel.

The US Department of Labor said US consumer prices jumped by 0.8% in November. It was the biggest increase in more than 2 years and was driven by higher energy costs, officials said.

Meanwhile, the US dollar rose to a 7-week high Dec. 14, putting more financial pressure on commodities that usually trade inversely to US currency. Still, the US dollar has been relatively weak against other key currencies through much of this year. As a result, crude is not only challenging gold as a financial hedge against inflation but is now also challenging it as a hedge against the dollar's weakness, said analysts with the Societe Generale Group in Paris.

Financial market outlook
"Historically, the correlation between the oil price and the US dollar has always been weak," SGG reported in its December commodities review. However, it said, "Since the start of 2007, this correlation, and more precisely the euro and US dollar vs. the oil price, has increased to reach a record high recently. While a weakening of the US dollar gives a natural incentive to European and Asian oil consumers to hedge more to capture this foreign exchange effect, we are convinced that this traditional relationship does not suffice to explain the recent surge in the correlation."

The foreign exchange (forex) market for international currencies is the largest financial market in the world, trading more than $3 trillion/day. Traders include large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The higher the oil price, the more US dollar reserves are accumulated by central banks and sovereign wealth funds of oil exporting countries. A sovereign wealth fund is composed of state-owned financial assets such as stocks, bonds, and property; such a fund manages the national savings for the purposes of investment.

A weak US dollar gives foreign oil producing countries more incentive to exchange it for other currencies to diversify their exposure in both forex reserves and investments. "However, we feel that once the correlation has reached such a visible level, the causality may have been reversed for the last few months, with some investors trading it exactly the same way they have traded the gold and dollar correlation," SGG analysts said.

"Inflation expectations have clearly become the main driver of investors' attraction to commodities," SGG analysts said, adding, "Indeed, while gold has confirmed its status as the best hedge against US dollar depreciation, it is facing stiff competition as the best hedge against inflationary pressure. This results from the perception that the current inflation trend is fuelled by commodity price increases, in particular energy and food prices. This would explain why gold, oil, and grains have performed so well since October while base metals, US natural gas, and other soft commodities have underperformed."

SGG said it "does not expect the subprime crisis fears to recede significantly before the second half of 2008, opening then the door to rate hikes on both side of the Atlantic." It said, "Not only should this return to more restrictive monetary policies temper inflation pressures but it should also trigger a trend reversal in the US dollar. In short, the financial outlook is expected to remain favorable for commodities until the third quarter of 2008, which partly explains our more pronounced bearish price forecasts for the second half."

Meanwhile, SGG analysts said, "The demand picture for oil looks similar, with a slight decrease in Organization for Economic Cooperation and Development [members'] oil demand in 2007 and growth coming almost entirely from China and the Middle East."

Although the increase in the marginal cost of crude production has been "spectacular over the last 5 years," SGG analysts expect the cost increase to be "much more moderate" over the next 5 years. They said, "Some current shortages may ease over that period (staff, equipment, and servicing charges)." But more importantly, they said, "The marginal cost increase is not a linear function. It tends to jump when the industry has to develop a new type of production (tar sands, ultradeep offshore, coal and gas-to-liquids, biofuels) and then to remain quite stable as long as it provides enough supply potential to cover the demand growth for some time."

SGG reported, "Apart from biofuels, which are still not economic without government subsidies, the current forward price is high enough to justify investing in any new type of supply. The maturing oil resource base, lower access to reserves, and higher perceived long-run political risk have also been taken into account, along with our forecasts for supply, demand, the Organization of Petroleum Exporting Countries' [production] capacity, and refining capacity."

Analysts at SGG said, "The key feature for 2008 should be the strengthening of the linkage between the US and European natural gas markets. Indeed, while LNG still represents a small component of US supply, it is about to represent the marginal molecule driving the price discovery mechanism on both sides of the Atlantic. However, US natural gas is potentially the commodity that could suffer the most from the subprime crisis and its impact on the US economy, and we therefore see Henry Hub, Okla., [gas spot market] prices averaging the same level as in 2007 ($7.10/MMbtu)."

Winter storms
In other news, the National Weather Service posted winter storm warnings from Michigan to Maine as blowing snow and sleet blanketed much of the Midwest to Northeast US over the weekend, hampering air and automotive traffic. Storms canceled hundreds of commercial flights from Chicago to Boston. In Rhode Island, a US Airways Express Flight from Philadelphia slid off an icy runway as it attempted to land.

Meanwhile, thousands of homes and businesses were still without electricity in sections of Oklahoma, Kansas, and Missouri that were struck by ice storms last week.

Energy prices
The January crude contract for US light, sweet crudes fell 98¢ to $91.27/bbl Dec. 14 on the New York Mercantile Exchange. The February contract dropped 91¢ to $91.55/bbl. On the US spot market, West Texas Intermediate at Cushing, Okla., was down 98¢ to $91.28/bbl. The January heating oil contract declined 0.68¢ to $2.61/gal on NYMEX. The January contract for reformulated blend stock for oxygenate blending (RBOB) lost 3.27¢ to $2.34/gal. The January natural gas contract fell 16.8¢ to $7.03/MMbtu on NYMEX.

In London, the January IPE contract for North Sea Brent gained 55¢ to $92.67/bbl, once again trading at a premium to benchmark crude in New York. Gas oil for January lost $1.75 to $823.50/tonne.

The average price of OPEC's basket of 12 benchmark crudes dropped 65¢ to $87.97/bbl Dec. 14. So far this year, OPEC's basket price has averaged $68.31/bbl, up from $61.08 for all of 2006.

Contact Sam Fletcher at [email protected].