Get set for a wild ride

HOLD on tight, oil is set for a wild ride as economics meets politics in a showdown that Slugcatcher reckons could cause the price to swing from a low of $US70 a barrel to a high of $120/bbl over the next few weeks.
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ENB's infamous Slugcatcher

Staff Reporter

That massive $50/bbl gap will be the result of economic fundamentals trying to drive the price down and Middle East politics pushing it up.

In time, economics will win. It always does. However, until the political uncertainties gripping the oil industry are resolved there will be upward price pressure.

To put this in perspective, consider what has happened in little more than a week. Major oil consumers initially placed big bets on an expected fall in the oil price, followed by a spectacular spike in the price as an embargo on Iran’s crude exports kicked into action.

That price fluctuation means that over the past few weeks the oil price, as measured in terms of Brent-quality crude, has moved from a high of $105/bbl to a low of $89/bbl, and back up to $97.80/bbl the last time The Slug looked.

Oil traders able to play both sides of the market must be rubbing their hands with delight as they work their portfolios.

For everyone else exposed to oil these are dangerous days. No one is quite sure which way the price will move.

The big negative factor in the oil market is global energy demand, which is being weighed down by slowing growth in China and negative growth in Europe.

The big positive factor is the start of an official (but hard to enforce) embargo on Iran’s oil exports. This move which could result in as much as 1 million barrels of oil eliminated from the world market.

Clouding everything is uncertainty over Saudi Arabia’s oil production, with the world’s biggest supplier reported to have boosted output to counter-balance lost Iranian production.

It was into this cocktail of uncertainty that reports emerged last week that big oil consumers, including airlines and trucking companies, were delaying long-term purchases because they believed the price trend was down – as did the International Energy Agency.

In a comment that might return to haunt him, IEA chief economist Fatih Birol said he could see oil prices continuing to fall.

“If the global economy continues to deteriorate, I will not be surprised if we see more downward pressure on oil prices,” he said.

Birol said that on June 24, when the oil price was around $90/bbl.

However, any oil consuming company (or investor) that took the comment as advice and held off buying supplies (or shares in oil companies) quickly found the comment very expensive because five days later the oil price was heading towards $100/bbl.

The difference between the economics of oil, and the politics of oil, can be seen in the buying policies of major airlines. An executive at Southwest Airlines, the leading low-cost US carrier, confirmed his company had minimal forward hedging in place.

In other words, Southwest is confident the oil price will fall over the next 12-to-18 months and it will buy supplies as they are needed. That is good if the oil price falls, expensive if it rises – which it did spectacularly at the end of last week, when oil posted its biggest one-day gain since 2009.

For Southwest, as a case study in playing oil-price poker, that upward swing in the price would have added millions of dollars to its operating costs.

Uncertainty over what happens with the Iranian embargo is the political factor potentially pushing the oil price down, if the embargo works – which would be a first in the tricky business of trying to control to flow of a particularly fluid material.

Similar embargoes, whether on imports or exports, have failed. South Africa in the 1970s learned how to beat an import embargo by renaming ships and re-directing cargoes. Iran is playing the same games today, repainting and renaming its fleet of crude carriers.

Knowing which way the oil market might move over the rest of 2012 is exerting pressure on all players in the oil business with a misstep certain to prove expensive.

If, for example, Iranian crude slips through the embargo (which is highly likely) and Saudi Arabia continues to produce at an inflated rate of 10 million barrels a day, the global oil market could be flooded over the next few months, driving the price down to $70/bbl – and possibly lower.

On balance – and this is not investment advice –The Slug reckons there is a fair chance that once the market adjusts to an ineffectual Iranian embargo and continued slow growth in China, the oil price could easily test a $70/bbl price floor and possibly go even lower without a Saudi cutback.

It is the combination of economic and political uncertainty that means everyone with an interest in oil should prepare for a wild ride.

This article first appeared in ILN's sister publication