Crude oil and the major commodity markets have been a "fool's paradise" in the past 4 years, created by the arrival of the central banks' massive liquidity programmes. 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 2 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.
Repricing is therefore becoming almost inevitable as we move through 2013. The reason is that since 2009 the speculators have taken over the markets, and have no longer just provided liquidity. So no single financial market has really known what it was meant to be pricing. But now, signs of strain in oil markets are becoming very visible.
Saudi Arabia has already had to cut production by 1 million bpd due to lack of demand. But others do not have this luxury, and instead have to sell in order to pay their bills. So a downward spiral seems to be developing:
• 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
And all the time, supply is rising under the influence of sustained high prices. US output is now at 7mbd, the highest level since 1993.
Only Brent (red) is now uniquely strong at $110/bbl, due to its key role in Russian finances as the price-setting mechanism for European gas and oil markets. Pre-2009, it would have been $1/bbl below WTI. With the US now in surplus, and the European economy in recession, Brent should now be trading well below WTI.
Of course, some naive analysts now argue that high capital investment costs have to be repaid, and will keep prices high. But anyone with manufacturing industry experience knows that once the capital is spent, the only cost that matters is the variable cost of production. And even that can be irrelevant if the producer needs to pay a major bill - then, the field will simply run for cash flow.
Repricing is thus now a real risk in the market. And once Brent prices begin to crack, then buyers will disappear. In turn, all the owners of oil and oil products currently being hoarded in Rotterdam and elsewhere will become distressed sellers. Already, for example, Europe is 600kt long on naphtha according to ICIS pricing reports.
There is a lot of product sitting in tanks around the world that will have to be sold in a hurry, if a panic starts. Anyone without a contingency plan to handle this scenario, now needs to develop one with extreme urgency.