Crude oil prices: On Slippery Ground

Slackening of global demand and rising inventories have brought down crude oil prices from all-time highs. Prices are less likely to bounce back from these levels, finds out Ramkrishna Kashelkar

THE crude oil prices, which shot up to $147 a barrel in mid-2008, have now fallen below $45 levels. The combination of slowing demand and high inventories means that the commodity has a limited upside available from the current levels. Crude oil is the world’s most actively traded commodity, and the light, sweet crude oil futures contracts traded on New York Mercantile Exchange (NYMEX) are the world’s largest-volume futures contracts traded on any single physical commodity. Crude oil is the single-largest source of energy for the entire world representing nearly 35% of the energy basket. In 2007 the world consumed 86 million barrels of crude oil every day (MBPD) - which is coming down.

THE SLOWING DEMAND:
The global economic slowdown has hit the demand for crude oil hard. The International Energy Agency has continuously revised downwards its monthly oil demand estimates for 2008 and 2009. In July 2008, when the agency for the first time published its official estimate on the global oil demand in 2009, it was 87.7 MBPD. This now stands slashed to just 84.7 MBPD and with further downside risk. This means that the global oil consumption in 2009 will be lower than 2008, which itself was lower than 2007. This is the first time in past 25 years that we will witness such demand contraction for two consecutive years.

OPEC CUTTING SUPPLIES:
The Organization of Petroleum Exporting Countries (OPEC), which produces a little over one-third of world’s oil demand, had cut production by 2 MBPD in Nov 2008 and by another 2.2 MBPD starting Jan 2009. However, this didn’t help the crude oil prices as OPEC’s spare capacity rose to 5 MBPD, removing altogether any supply disruption figures. RISING INVENTORIES:
US commercial oil stocks surged a significant 27 million barrels in January to stand at 1,746 million barrels, which are now within a striking distance of the all-time high inventory levels seen in Oct 2006. The inventories in other developed countries such as Japan and the European countries, however, have been steadily coming down in the same period. It is not just the demand falling faster than supply that has resulted in higher inventories. The crude oil market has entered into a contango - a situation where the near term contracts trade at lower value compared to the longer term contracts - which has encouraged traders and producers to store excess crude in floating storage to profit from higher forward prices. By the end of January 2009, an estimated 75 million barrels of oil was stored in 35 very large crude carriers (VLCCs). These developments have lead to a historically unique problem. The US oil inventories at the key WTI delivery point of Cushing, Oklahoma, have shot up substantially. As a result, the crude oil storage at Cushing, which is a land-locked place, has reached 34.9 million barrels, approaching maximum operational capacity of 36 million barrels. This resulted in a distortion in the price of benchmark WTI, which has diverted from broader market fundamentals. West Texas Intermediate crude, the oil that the New York Mercantile Exchange uses as the underlying commodity for its crude futures, is trading at its largest discount ever to Brent crude, the European benchmark and as well as the OPEC crude basket, despite being superior in quality. This discrepancy between WTI and the international oil market could slowly disappear only after the oil demand rebounds and Cushing inventories start falling.

THE WILD CARDS:
Apart from the fundamental demand-supply factors, several other factors also influence the global crude oil prices. The sporadic upsurge in the geo-political tensions in the Middle East region- more prominently the Israel-Palestine unrest and Iran’s nuclear energy programme - can suddenly create supply concerns and boost the crude oil prices. On the other hand, the compliance of OPEC members with the quotas agreed upon by them has always remained questionable. Although the production discipline is being observed currently, any slippage would have a big negative impact on the markets. The weekly data on US petroleum inventories also drives the markets. The inventories, which rose in January, have fallen in the past two weeks providing support to the crude oil prices. The next OPEC meeting on March 15, 2009 will also have a bearing on the market. As crude oil supplies - including the spare capacity - remain strongly above the demand, the speculative interest in the commodity has vanished. At present, there are hardly any factors to help the commodity move up consistently. The recent fall in US inventories is a positive development but is mainly regarded as a temporary blip. Hence crude oil is expected to remain between $40 and $45 per barrel in the near term.