By John Richardson
FINANCIAL speculators began to play an increasing role in crude-oil markets following liberalisation of financial trading rules, signed into law by Bill Clinton in 2000, as we argued in chapter 3 of our e-book, Boom Gloom & The New Normal.
The disconnect between real supply and demand for crude and the influence of the financial community on pricing, enabled by this liberalisation, became much greater with the arrival of huge amounts of central bank liquidity four years ago.
"Crude oil and the major commodity markets have been a 'fool's paradise' in the past four years, created by the arrival of the central banks' massive liquidity programmes," wrote fellow blogger Paul Hodges in this post yesterday.
"Pension funds rushed to buy, in the belief they would be a 'store of value'. Hedge funds followed them as a momentum play, encouraged by analyst reports of supply shortages and soaring demand in emerging markets."
"But nothing lasts forever. Financial players have sustained oil prices at record levels for the past two years. But high prices destroy demand, and so buyers of futures contracts have largely lost money over the past 18 months. Plus, of course, there have never been any real shortages in the market to justify today's high prices. So finally, they are leaving the markets to the physical players once more."
He points out that Saudi Arabia has had to cut production by 1 million barrels a day due to lack of demand, but that other producers don't have that luxury as they have to attempt to meet the cost of new investments in crude production.
The chart above shows that:
• US natural gas prices (purple) have dropped to the equivalent of $30/bbl. (Power stations thus continue to prioritise gas over fuel oil).
• This puts pressure on WTI (green), which remains $20/bbl below Brent.
• In turn, Western Canada Select (blue), is under real pressure at $60/bbl.
On the supply side, a major factor behind this dramatic change is US shale oil production.
"By 2014, the US. will import just 6 million barrels of crude oil per day, or roughly a third of what it uses, according to a recent forecast from the federal Energy Information Administration. That's less than half the amount of 2006, when imports accounted for 60% of total US oil consumption," wrote Bloomberg in this article.
At the moment, the financial community and some chemicals companies think we are back to the races. Chinese demand has recovered, the Eurozone at least hasn't imploded and the US has avoided the fiscal cliff.
But prepare for the much-greater risk of a big re-pricing in crude. It would only take one major macroeconomic shock to result in a sharp retreat in oil prices, given the length of supply.