Lack of volatility belies oil price hike later

The oil price graph curve seems to be flatlining these days. That's not necessarily a bad thing.

Oil prices scarcely budged in the first week of July—albeit at a robust level near $27/bbl for next-month crude futures contracts on the New York Mercantile Exchange. Even at that, the NYMEX contract wasn't far from that level for much of June, following a dip early in the month.

Have traders really become all that blasé over oil market fundamentals? The International Energy Agency notes that, while the perception of geopolitical risk that has been such a key driver in oil markets has eased, the reality of such risk has not.

At the same time, says IEA in its June oil market report, market sentiment has become bearish on near-term fundamentals, especially over the scope and timing of global economic recovery.

Market fatigue
Even with such dynamic influences, trading activity slumped dramatically in late May. Noncommercial NYMEX crude contacts traded on May 21 totaled 18,000, vs. the 60,000 traded Mar. 26.

This flight of speculators contributed to a price slide in early June. The mass exodus of speculators from oil markets found haven in other commodities, which in turn has boosted gold and silver prices.

IEA attributes this exodus to oil "market fatigue." In this case, markets have been forced to face unprecedented risk in recent months while, conversely, coping with an economic recovery that seems to be coming in fits and starts.

Thus, said IEA, "Markets are numb and excessively focused on near-term issues."

That says much about the reason why oil prices scarcely rippled when the Organization of Petroleum Exporting Countries late last month agreed to stand pat on their current production quotas. That denouement had already been factored into oil prices for weeks. Traders instead have remained fixated on the latest Middle East violence or saber rattling between Iraq and the US or India and Pakistan or opposing forces in Venezuela.

Stage set for higher prices
But traders should instead focus on the underlying fundamentals of oil markets. That's because the stage is being set for higher prices.

Sarah Emerson, managing director of Boston-based Energy Security Analysis Inc., contends that the OPEC decision to keep a lid on production for another quarter "can only mean higher crude oil prices."

She tracked the behavior of crude oil stocks in the wake of OPEC quota decisions over the past decade to better gauge the subsequent trajectory of oil prices.

"First, it is obvious that until the mid-1990s, the global oil industry was in the process of liquidating inventories. This was the much-analyzed 'just-in-time' inventory policy," she noted. "By the end of 1996, the global industry's buffer stocks had been eliminated. From then on, crude inventories became a function of OPEC production decisions."

OPEC and inventories
To illustrate her point Emerson focuses on three periods since the mid-1990s:

• From mid-1997 through 1998, OPEC production rose, pushing up inventories from early 1998 through mid-1999. West Texas Intermediate crude collapsed to $11/bbl by early 1999.
• From early 1999 to yearend 1999, OPEC slashed output, resulting in a steep drawdown of stocks and a doubling of crude oil prices.
• For most of 2000 through first half 2001, OPEC boosted production again, stocks swelled, and oil prices fell below $20/bbl from highs of over $30/bbl.

In each case, the lag time between the OPEC decision and the market-defining stock level was about 6 months.

As for now?

"OPEC's lower production since late 2001 due to lower Iraqi exports and a significant reduction in quotas has set the stage for yet another crude oil inventory liquidation," Emerson said. "It just hasn't happened yet. It is only now, 6 months after the reduction in output began, that we should begin to see significant reduction in global crude inventories. Prices will rise."

Of course, on the price risk downside, there is the prospect of disdain for production restraint officially (Russia, Norway) and unofficially (some within OPEC).

But on the price risk upside, there are Venezuela, the Middle East conflict, South Asian tensions, terrorist attack threats (and reprisals), a recovering economy, strong gasoline demand, the seasonal uptick in demand in the second half, and the self-fulfilling prophecy of stockbuilding to create a buffer against supply and price shocks.

Can't get too blasé about that.

(Online July 5, 2002; author's e-mail: [email protected])

OGJ Hotline Market Pulse

OGJ Hotline Market Pulse has ceased tracking the price of Saudi light crude oil and replaced it with the average daily price of the OPEC basket of crudes, in light of the latter's greater importance to OPEC strategy and thus to oil markets.