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A crude awakening

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    By Adam Carr

    A crude awakening for the oil market



    The 50 per cent slump in global crude prices provides a substantial tail wind for global growth.



    Indeed 2015 is already shaping up to be another solid year for the global economy, so factoring that slump in, it’s likely that global growth will be well above trend this year. So far, so good.



    A key problem, however, is that crude prices -- commodity prices in general -- are extremely volatile at the moment. So, from its January low, the price of crude (WTI) has already rebounded some 22 per cent and the eventual level crude settles at is subject to considerable uncertainty. Hand on heart, who can honestly say?

    All we know is that expectations of an oil price around the $100 mark are gone.

    Readers will already know the reasoning. The global economy is weak and fragile and this has led to a softening in crude demand. At the same time, the US shale boom has caused a global supply glut. Perhaps now the Saudis are acting to price US shale producers out of the market. Either way, the peak oil crisis of 2008 is dead and buried.
    MORE FROM ADAM CARR


    It’s all very bearish stuff and as if all of the above wasn’t enough, the talk now is that the "substantial increase in debt borne by the oil sector in recent years" may be exacerbating the supply glut. It sounds a fair enough point, especially as it was made by the Bank for International Settlements, one of the few global institutions that has managed to maintain its credibility since the GFC.

    Anyway, the general gist is that as gearing grows then "debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market". So markets aren’t clearing basically.

    Now, this idea has gained considerable traction of late and if you put all the pieces of the puzzle together, it suggests that crude might yet take another tumble. On the view so far, there certainly doesn’t appear to be anything in the way to stop it.

    The main complication in making a call -- anyone making a call -- is that the BIS research also suggests that fundamentals have got little to do with the recent price plunge. This is a point I’ve made myself and its one I also made during the peak oil crisis as well.

    Specifically, the BIS notes that production and consumption have been roughly in line with prior expectations. So, if production and consumption were broadly in line with what the market had been forecasting, then why on earth should prices fall so hard? Obviously they shouldn’t. Especially as the idea of a global supply glut, driven by shale oil, is completely fanciful and lacking in any merit. It simply isn’t supported by the data. Shale has boomed, certainly. But global crude production hasn’t.

    Instead, the BIS suggest, as I did many years ago, that crude prices behave more like a financial asset and that, "as with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions".

    Given that expectations are extremely bearish at this point, it makes sense that the path of least resistance is still down. So, crude prices could easily crash again. Pick your catalyst: Greece, disappointing GDP numbers out of the US or China etc. Anything really, the market is primed for softness.

    At the same time, the BIS research also illustrates why there is in fact nothing really standing in the way of crude spiking back up to $100 either. Sure, it may be unlikely right at this at this point given the global narrative the way it is, yet it’s also true that two of the key assumptions of this narrative -- weak growth and the supply glut -- are false.

    That simple fact suggests the world can’t, or shouldn’t, get too comfortable with low oil prices.

    There is a very high risk of an extremely violent upside correction at some point and the BIS research shows that it wouldn’t take much to get there.
 
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