INSIGHT: The downside risk to crude is substantial

15 June 2012 16:12  [Source: ICIS news]

By John Richardson

PERTH (ICIS)--What goes up can come crashing down, which is most obviously the risk with crude oil.

On Wednesday, 13 June, West Texas Intermediate (WTI) was trading at its lowest level since 11 October with Brent at its lowest since January of this year.

"Ironically, a geopolitical crisis might help the chemicals industry as the price of crude would remain firm – thus enabling companies to avoid inventory losses," said Paul Hodges, chairman of UK-based chemicals consultancy, International eChem.

The risk is that chemical companies, and end-users, built up raw-material inventories when oil prices were on their way up earlier this year.

Many people might well have been rushing to protect margins, particularly buyers of chemicals who had made price commitments to their customers for the next 3-6 months.

This could have created the illusion of strong demand when, in fact, buyers were merely panicking as oil prices increased.

Stocking-up might have also been the result of more confidence over the eurozone, relative to the fourth quarter of 2011, and the belief that China would bounce back after a disappointing 2011 as a result of stronger economic stimulus.

The US economy also looked as if it was in the midst of a reasonably strong economic recovery.

But the eurozone is now in deeper crisis and China is slowing down far more quickly than most people had expected.

US jobs growth in May was the slowest for a year, casting further gloom on the outlook.

Expensive crude has also caused demand destruction, according to Hodges. In the first quarter of this year, oil prices averaged $119/bbl, just 7% below the second half of 2008 record of $127/bbl, adjusted for inflation, he estimates.

“Today's oil price is now costing 5.5% of global GDP,” he wrote in a 2 April blog postcompared with 1%-3% of GDP during 1982-2007.

This has left consumers, already struggling with economic problems in the West, with less money to spend on discretionary items, he added.

Support for this argument came from India’s Petroleum Minister, Jaipal Reddy, who on Wednesday of this week was quoted in India’s Business Standard newspaper as saying that high oil prices reduced his country’s 2011 GDP growth to 6.9% from what otherwise would have been 8%.

 “It is estimated that a sustained 10 dollar increase in oil prices leads to a 1.5% reduction in the GDP of developing countries,” Reddy told the newspaper, during this week’s fifth OPEC International Seminar in Vienna.

Whether the recent high price of oil was justified by supply and demand fundamentals, or was mainly the result of financial speculation, is a separate and complex debate.

But what seems clear is that the downside risk to crude is now substantial as the global economy weakens, leading to what could be a prolonged destocking cycle in the chemical industry.

"Global demand (for oil) is softening, we have got recessionary elements in Europe, a small slowdown in Asia Pacific,” said Peter Voser, Shell CEO, in a press conference during last week’s World Gas Conference in Kuala Lumpur, Malaysia.

“At the same time, some of the geopolitical elements of price volatility over the past few months have kind of receded, and therefore we see a softening of prices which I expect to go well into the second half of this year."

The lack of visibility in crude, chemical and polymer markets is also likely to make everyone down all the value chains reluctant to acquire raw materials on anything more than a “hand to mouth” basis.

China’s polyolefins market is a good case in point, where buying activity is exceptionally weak.

“Traders have nothing to do apart from bet on the Euro 2012 soccer championships because demand is absolutely dismal,” said a Singapore-based polyolefins trader.

“This is the worst I can remember in 10 years in this business, and it is definitely now worse than in 2008," he added.

"The shock of 2008 was more sudden, more dramatic, but more short-lived. What we have seen in 2011-2012 have been longer periods of depressed demand where prices have been flat or declining, with very brief periods of recovery. These recoveries have followed improvements in equity markets and crude oil.

"Take the last few days as an example. Last Friday morning, after China had announced its 25 basis points cut in interest rates, the Dalian Commodity Exchange rallied and there was a slight uptick in interest for physical cargoes."

(The Dalian Commodity Exchange operates a futures contract in linear low-density polyethylene).

"But by the afternoon, people were asking themselves 'will the interest rate cut make that much of a difference?' They decided no, and so the Dalian retreated again and what appetite there was for acquiring physical cargoes disappeared.

"On Monday this week, the recovery at least lasted all day, thanks to the rescue package for the Spanish banks. But on Tuesday, the futures and physical markets fell back again.

"The problem is that there is absolutely no visibility out there - nobody knows when the market will bottom out, and nobody is prepared to take any risks."

During 2011, lack of liquidity held the market back as the Chinese government increased bank-reserve requirements and raised interest rates, he added.

This forced polyolefin buyers to either cut back on activity or turn to the shadow-banking system, where they paid very high interest rates.

"Over the last couple of months there has been a very significant sea change," the trader added.

"Our customers no longer want to borrow money, even though financing is more available and cheaper. There is no demand out there, so why would they borrow money?"

The market was so bad that the prospect of new supply, from start-ups in Saudi Arabia, Qatar and Singapore, had not caused panic, he added.

"The attitude towards this new supply is, 'bring it on because it, surely, cannot make the demand any worse,' " he said.

Read Paul Hodges’ Chemicals and the Economy blog
Bookmark John Richardson and Malini Hariharan’s Asian Chemical Connections blog

By: John Richardson
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