Editorial: Beyond fundamentals

June 22, 2009
More remarkable than hints of oil market recovery this month is growing acceptance that supply and demand don't always paint the whole picture.

More remarkable than hints of oil market recovery this month is growing acceptance that supply and demand don't always paint the whole picture. Current conditions illustrate the void. Oil prices have zoomed despite demand weakness and supply health evident in full inventories and resurgent production-capacity surpluses.

The recovery signals are weak. Inventories relative to demand eased slightly in May. And in June market reports, the International Energy Agency, Organization of Petroleum Exporting Countries, and US Energy Information Administration quit cutting forecasts for annual average consumption by as much as they had done in preceding months. IEA and EIA actually raised their projections marginally. OPEC, although trimming its demand outlook, declared, "The worst appears to be behind us."

Recovery?

But these are indications of a possible end to the market's slide, not necessarily of recovery. Nothing says market projections won't resume their slump next month. Nothing says demand, even if it has quit falling, won't stay depressed.

Yet marker prices of crude oil seem to herald recovery. The futures price for light, sweet crude has traded lately above $70/bbl. EIA expects the second-half average price of West Texas Intermediate oil to exceed the first-half number by $16/bbl. How can this be? Supply and demand—the "fundamentals"—provide no ready answer.

Other influences must be at work. "Prospects for equity markets and the global economy, backed up by exchange-rate fluctuations, expectations about future oil market tightness, and, by inference, a shift of money into or out of futures markets can all influence short-term prices," says IEA in its June Oil Market Report. "Indeed, it is tempting to conclude that the shift in [New York Mercantile Exchange] WTI noncommercial positions from a net 11,000 short in early May to 40,000 net long a month later is sufficient explanation for the surge in prices" of more than 20% during May and into early June.

OPEC's June Monthly Oil Market Report notes the apparent failure of fundamental market weakness to suppress oil prices. "Financial market developments," it says, help explain "this recent divergence between oil market fundamentals and prices." Crude price changes recently have correlated with changes in equity markets, as traders anticipate the oil-demand boost that will accompany economic recovery, and in value of the US dollar.

Similarly, EIA's Short Term Energy Outlook this month attributed May oil price gains partly to "expectations of a global economic recovery and future increases in oil consumption." Also, it said, "a weaker dollar and increasing financial market activity are prompting higher prices for commodities, overshadowing weak oil supply and demand fundamentals."

At this time last year, IEA and EIA remained reluctant to attribute surging oil prices, then approaching $130/bbl, to forces other than supply and demand. "In reality," wrote IEA in June 2008, "these abnormally high prices are largely explained by fundamentals." EIA's June 2008 report cited supply uncertainty and demand growth and predicted, "The overall picture of strong demand and tight supply is expected to continue."

Only OPEC, ever wary of oil-price speculation, in the middle of last year looked unapologetically beyond market fundamentals. "In the absence of any change in fundamentals, this strong [price] volatility reconfirms the view that current price levels do not reflect supply and demand realities but are strongly influenced by future market activities and the prevailing bullish sentiment," it said.

Now all three agencies assert factors other than supply and demand, especially dollar gyrations and financial-market dynamics, as important in the determination of oil prices, at least in the short term. Doing so doesn't disengage them from market theory. Dollars and investment flows are part of the market, after all.

Broadened view

Last year's record indicates the broadened view might, to the benefit of everyone, improve forecasting. After listing the nonfundamental forces elevating oil prices in 2008, OPEC wrote, "A review of prospects for the remainder of the year also shows little support for prices to remain at current levels."

That was in June. Crude prices began a 5-month, $90/bbl plunge in the middle of July.