Bernanke holds fire, and the slip is showing for oil

Oil prices are likely to stay depressed in the immediate term, which may slip past the psychological $100 mark. The global crisis and therefore, slowing demand for oil, no signs of another round of quantitative easing by the United States and removal of some supply side constraints are all at work, keeping the prices down.

Let us first look at the demand-supply situation, and for that, we will take Brent crude rather than the US West Texas Intermediate (WTI - Nymex), the other global benchmark in oil. Before getting into the nuances, let’s find out why we are looking particularly at Brent. Reasons Vandana Hari, Asia editorial director, Platts, a think-tank on metals and energy segment: “WTI has been disconnected from the world and it is not a reliable benchmark even for European refiners. WTI basically represents price of slight (low density) sweet (low sulphur) crude, and the issue is it is landlocked in the US.”

[caption id=“attachment_72630” align=“alignleft” width=“380” caption=“This trend could continue up to 2012, it says, which meansoil prices will be under pressure. Getty Images”]  [/caption]

This means it is off-limits for exports and there is no adequate infrastructure to take the oil to other parts of the United States. So, this leads us to a situation where supply has an upper hand. WTI has been disconnected even from gasoline prices. In the Gulf Coast, gasoline prices are selling at a premium of more than $40 per barrel over WTI. To sustain the prices of WTI and put it on par with global benchmarks, the US is increasingly under pressure to allow exports. Platts’ line of thinking is that even though there are export curbs since 2000, the US could start exporting sweet crude as early as second half of 2012.

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So, that brings us toBrent’s demand-supply situation. The demand side picture does not look rosy, either in Europe or the US as the crisis deepens. Morgan Stanley has mentioned in its August 18 report how the US and Europe are “hovering dangerously close to recession” while Goldman Sachs was quick to follow it up with a warning that “US economy is losing further momentum”. International Energy Agency (IEA) oil market report expects oil demand to grow by 1.2 million barrel per day, but might revise the figures soon, says Hari.

A report by Citi, however, estimates growth in oil demand at 1 million barrel per day, and expects supply to outstrip demand by 700,000 barrels per day. This trend could continue up to 2012, it says, which meansoil prices will be under pressure. Citi also echoes sentiments of Platts that IEA has been far too optimistic in its demand projection ignoring macro headwinds. Chinese growth has also been a cause of concern and slow demand could, therefore, mean lower price for Brent. A hard landing in China could pose some threats to any significant upsides to oil prices.

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On the supply front, flow of oil from the Organization of Petroleum Exporting Countries (OPEC) has been muted due to the political crisis in Libya and thus a loss of 1.3 million barrel per day of light and sweet oil. OPEC accounts for 40 percent of the total global supply. OPEC members like Iran and Venezuela want to keep a tight supply while Saudi Arabia wants to ramp up production. The June 8 meeting by the OPEC countries, which was called as the “one of the worst meetings” by the Saudi Arabia oil minister, could not reach any consensus on the supply of oil.

Saudi Arabia has got two reasons to push for higher supply and therefore, lower prices. First, due to its vast inventories and reserves, as the Citi report shows, it is able to sustain lower oil prices. Second, as a member of G20 countries, it has a bigger role to play in ramping up global growth. So, there is no reason why supply should be cut even if prices plunge below 100 dollars per barrel. To illustrate the point, Citi estimates that a 1mb/day overproduction by the Saudis could drive down oil prices by $15/bbl.

Libya is another factor where oil production should resume partly in another three months and be restored fully in another year. Then, OPEC will pull back to early 2011 levels of 9 million barrels per day. The minor threats to oil supply could come from political problems in Syria and Sudan (post its split). Sudan especially could have a lot of potential for trouble as 75 percent of its production capacity lies with the South and pipelines with the North.

Fed Chairman Bernanke, in his speech on Friday, did not discuss any tools to be used if growth were to slow in the US. Last year, he had set the stage for QE2 through his speech. UBS says, “The omission this year probably disappointed some market participants, and it signalled somewhat of a policy shift for the Fed no-easing bias.” This also means fewer chances for oil prices to rally with softer policies by the US.

So, what does this all mean for oil? Citi expects prices to be around $86 per barrel, which is close to the latest report by Fitch Ratings that says oil prices could drop to $90/bbl in 2012 and $85/bbl in 2013. Platts also expects oil to hover below $100/bbl unless there is a major surprise on turnaround of the global economy. However, though cautious, JP Morgan still puts the number at $115 a barrel next year even after cutting its estimates by 9 dollars. Between now and the end of next year, it expects the crude to trade in a $100-120 a barrel range. Standard Chartered puts its estimate at $112 a barrel.

If the projections are anything to go by, Indian oil marketing companies would benefit as their share of subsidy would go down, especially as losses on diesel shoot up exorbitantly when crude prices go up. So, a fall in crude could give the government an opportunity to deregulate diesel, carry out pricing reforms and implement a better subsidy-sharing mechanism. However, lower oil prices do not augur well for private sector oil refiners, which will be affected by low gross refining margins.