Oil Prices – Free Fall or Just Erratic?

Falling from a high of $144.59/barrel back in June, ANS crude oil closed Friday at $68.80/barrel.  There is some major volatility in the market, nobody seem to have a good grasp on where its going.  As soon as gasoline hit $4/gallon American drivers cut back on discretionary driving.  July 2008 marked the peak of Americans driving everywhere, all the time.  The sudden shift from ever-increasing demand for transportation fuel in the U.S. to a slight decline in demand screwed up the entire gasoline production chain, which couldn’t correct production targets to meet demand fast enough.  OPEC chimed in, setting a baseline of $100/barrel, which held for a few weeks until the financial crises hit, sending worldwide demand down even further.  Now OPEC is considering a 1.5 -2.0 million barrel/day production cut in order to fix the price between $70-$90/barrel (see Reuters, here).  The market has not stabilized yet, and I suspect that it will be a while before it does.  From Reuter’s:

The Organization of the Petroleum Exporting Countries will hold an emergency meeting on Oct. 24 in Vienna to discuss the impact of economic weakness on oil markets.

Pressure is mounting within OPEC to reduce supplies as oil prices have fallen more than 50 percent from July’s record of $147.27 and expectations have grown that a global recession will erode fuel demand.

“If the cut is 1.5 million barrels per day, then it will be 1.5 million barrels. If it is 2.0 million barrels per day, it will be 2.0 million barrels per day,” added Khelil [Chakib Khelil, President of OPEC], who is also Algeria’s energy and mining minister.

Earlier, Khelil was quoted in Saturday’s edition of Algerian daily El Watan as saying that OPEC saw oil prices bottoming at $70-$90 per barrel.

“Normally, OPEC has no price target. The market decides on prices. But people say that the bottom price, the bottom cost below which we can not step down, is between $70 and $90 per barrel,” El Watan quoted Khelil as telling reporters.

He cited cases of Canada and Brazil, where oil could not pumped if prices were to fall below $70 per barrel.

On Friday, Khelil told Algerian state radio a “decision will be taken to lower oil supply by some OPEC members so that the oil price will not be damaged.

“This decision will not be implemented immediately because there are contracts, but will probably be implemented 40 days after it (the decision) is taken.”

He did not say which countries were likely to cut supplies.

My guess would be that the Saudis will be opposed to production cuts, given the proximity of U.S. elections.  Venezuela and most of the other middle eastern states will likely be in favor of it.

From Mark Williams, writing in the Alaska Journal of Commerce:

As oil prices zoomed toward an unheard of $147 a barrel this summer, it seemed every analyst prediction that oil would approach $200 was a self-fulfilling prophecy, until suddenly it was not.

Instead of $200, oil is now around $75. Instead of going up, the U.S. has seen the greatest destruction in demand since the oil-shocked 1970s. Drivers have dramatically cut down on driving since November.

Soaring prices for oil and other commodities this summer have turned out to be nothing short of another classic bubble and the bursting may not be over, one analyst said.

I’m not sure if I’d call it a bubble.  A bubble usually implies that the commodity was overpriced, and the burst is the market self-correcting.  It’s questionable whether, or how much, crude oil was overpriced this past spring and summer.  This is more a matter of supply not being able to nimbly track demand.  Historically, demand has been continually increasing for over 70 years.  The production side of the equation got very tight, with insufficient elasticity to handle unexpectedly large fluctuations in demand (demand for oil does fluctuate seasonally and for other reasons, but the market is generally devoid of large-scale corrections).

On Oct. 13, Goldman Sachs, among those predicting $200 a barrel oil, cut its year-end forecast of oil to $70 from $115 and lowered its price outlook for the end of 2009 to $107 per barrel from $125 to reflect weak global economy.

“We clearly underestimated the depth and duration of the global financial crisis and its implications on economic growth and commodity demand,” analyst Jeffrey Currie said in a report.

These projections will not help the financial market.  New oil exploration by industry is already scaling back, which will send ripples through the secondary and tertiary supply chains.

The article continues:

The prevailing sentiment was that prices would continue to rise as strong global demand was goosed by geopolitical events, such as Iran’s uranium enrichment program or the prospect of an ugly guerrilla war in Nigeria.

It took very little in that atmosphere to convince oil traders that oil supply would fail to keep up.

The run-up began about a year ago as the dollar went into a free fall and speculators sold dollars to buy oil and other commodities – sending prices higher.

Then, heavy hitters such as Goldman touted long-term bullish views that oil demand was going to increase and would exceed growth in supply, creating a “buying frenzy,” according to Schork. That pushed oil prices much higher even though Americans were driving less.

Prices began to break in July when the dollar bottomed out. Hedge funds and investment banks – battered by the subprime housing mess, the decline in home prices and frozen credit markets – then began to sell-off positions in commodities, Schork said.

The swoon in oil prices paused only briefly during a conflict in the oil-rich Caucasus region involving Russia, and after two massive hurricanes shut down oil production in the Gulf of Mexico for weeks.

That, Schork said, should have been a clear signal that a bubble had burst.

Schork pegged the rational price for oil at $75 to $95 per barrel, but notes that just as $147 a barrel could not be justified, prices could fall well below what they are truly worth before they stabilize.

In his report, Currie said prices could fall to as low as $50, below what some oil companies need to even break even.

But Currie and Fyfe said they still see demand remaining strong for the long term.

The swiftness and severity of the pullback in oil and other prices creates a much more unstable political environment in many of the producing countries around the world, Currie said.

“Some of the hardest hit sovereigns and companies have been commodity producers, which are highly dependent upon access to capital and were already struggling to grow capacity before recent events,” Currie said, suggesting that supply may still be a concern, even when fewer people are buying.

It’s not over yet…

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