Brent hides weakening oil market: Kemp

LONDON: Residual strength in nearby Brent futures reflects lack of liquidity in the benchmark grades rather than the global supply-demand balance.

As global growth slows, the distribution of price risks and investors' positions appears more balanced than at any time since last autumn, shortly after the Federal Reserve prepared to launch its second round of large-scale asset purchases (LSAP2).

Chart 1 shows realised prompt prices for the ICE Brent contract since 2000 as well as the closing forward curve on three selected dates: 1 July 2008 (near the peak of the last price spike), 31 December 2010 and 12 August 2011.

Prompt Brent prices have climbed almost $17 per barrel (18 percent) between December 2010 and August 2011.

But most of the strength is concentrated nearby. Forward prices have risen much less. Futures for Dec 2012 delivery are up just $10.65 (11 percent). Futures for Dec 2013 are up $8.25 (8.7 percent).

Around half rise in Brent prices has come from a rise in long-term price expectations.

The rest has come from a shift from a flat forward structure to a pronounced backwardation.

Forward Brent prices are far below the levels traded at the height of the price spike in 2008. Dec 2012 Brent futures are trading at only $105, roughly 25 percent lower than the $138 per barrel at which it was marked on July 1, 2008. Prices for Dec 2013 and Dec 2014 futures look even weaker compared with July 2008.

Crucially, in July 2008, and again in December 2010, Brent prices were mostly flat or trading in a small contango throughout most of the curve, indicating most market participants expected prices to be sustained around prevailing levels.

The current curve, by contrast, is steeply, indicating nearby prices are being supported by the presence of substantial delivery premiums.

Lack of liquidity in the underlying physical market ensures there is a significant premium for nearby dates. Dwindling output from the key North Sea streams (Brent, Forties, Oseberg and Ekofisk) has been compounded by the absence of Libyan crude and heightened long interest from hedge funds and pension funds.

But few participants seem willing to bet this tightness will be permanent. Brent prices three years ahead and more are currently valued below $100 per barrel, just two-thirds of their level three years ago.

Eventually return of Libyan crude, coupled with a reformulation of the benchmark to widen its physical base and ensure its continued viability is widely expected to ease the pressure on prices in the medium term.

Brent's comparative strength in the term structure contrasts sharply with US crude futures, where the curve remains in contango throughout and prices are now generally lower than they were in December 201.

Now more than ever it is vital market participants distinguish between factors affecting the forward structure (especially liquidity in the underlying physical markets) and those influencing outright prices (including expectations about the global supply-demand-inventory-capacity balance and macroeconomic outlook).

Idiosyncratic Brent is no more representative of the global oil market than the dislocated market for US mid-continent crude reflected by WTI. Perhaps as much as half of the contract's strength stems from supply issues unique to this segment rather than global crude markets as a whole.

Brent trading is as much a gamble on when Libyan exports will resume, and in what quantities, as much as the global economic and demand outlook.

While Libyan crude are a small fraction of global supply, and a modest contribution to the capacity balance, they are close competitors and far more important for the Brent market.

Paying too much attention to prompt Brent prices provides a very unrepresentative view of wider trends and expectations in the oil market.

In the WTI market, hedge funds and other money managers last week cut their net long position in futures and options by 27 million barrels (14 percent) to 171 million barrels, the smallest net long since October 2010, according to data compiled from the US Commodity Futures Trading Commission (Charts 3-4).

Despite the sell-off, which has already seen WTI prices hit the lowest levels since February, money managers boosted their (gross) short positions to 105 million barrels, the largest down-bet for nine months.

Speculators views are more evenly balanced than at any time since last year. The ratio of money managers' long to short positions in WTI-linked futures and options has fallen to 2.6:1, down from a record peak of 10.5:1 at the start of May (Chart 5).

WTI has its own problems with logistics issues and rising production of deliverable oils around the delivery point in the US Midwest. It is no more representative of the global oil market than Brent. But WTI has been the favoured market for macro hedge funds and pension funds. If the global market were really or prospectively that tight, as some Brent bulls imply, WTI futures prices would be far higher.

Widespread long liquidation and the increasingly boldness of short position holders indicate rising prices are no longer seen as a one-way bet.

Market participants often note the best cure for rising prices is raising prices. Existing price rises have already gone a long way to restoring balance to the market, mostly by causing a sharp slowdown in GDP growth in the United States and other advanced economies.

As Professor James Hamilton, the leading authority on the macro impact of oil shocks, notes on his website, modelling suggests the maximum impact from price rises in Q4 2010 and Q1 2011 will not be felt until Q4 2011 and Q1 2012, when it could subtract as much as 2.4 percentage points from GDP growth in both quarters

If Hamilton is right, GDP growth in the United States and Europe will most likely continue to slow in the months ahead, or at least remain mediocre, as their economies continue to digest the impact of past price rises.

Below trend growth in the advanced economies, coupled with a slowdown in overheating emerging markets, should help restore a more comfortable cushion of inventories and spare capacity by the middle of 2012

Copyright Reuters, 2011

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