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Oil markets prepare for post-QE2 world

Chemical companies, Consumer demand, Currencies, Economic growth, Financial Events, Oil markets
By Paul Hodges on 20-Apr-2011

Saudi oil Apr11.pngThe decision by S&P, the ratings agency, to put the USA’s AAA debt rating on review is a potential game-changer for US economic policy. It means that policymakers can no longer pretend the $5trn they have spent over the past 2 years on stimulus measures somehow “doesn’t count” in terms of needing to be repaid.

Oil markets will be first in the line of fire. The S&P move makes it much less likely that the US Federal Reserve will be able to follow QE2 with QE3. And QE2 has been the prime reason why oil prices have risen from $75/bbl to $125/bbl since August, when it was first announced.

Attention will now start to shift back towards the fundamentals of supply and demand. So the reactions of Saudi Arabia and Russia, as the world’s two largest oil producers, are critical. In 2010, they produced 25% of total output. And today, they seem to have differing viewpoints:

• Russia’s Finance Minister says he still expects prices to fall to $60/bbl at some point in the next 2 years. And he warned that “with oil prices above $110/bbl we are already in the zone of a slowing global economy“.
• Saudi’s Oil Minister has agreed that the “market is over-supplied“. But his response, as the Petromatrix chart shows, has been to cut output.

This reaction mirrors the Saudi response to lower oil demand in the 1980s. Between 1981-5, production was cut from 10.3mbd to just 3.6mbd, in an effort to support a $30/bbl oil price ($85/bbl in 2011 money). Prices then collapsed to $16/bbl in 1986. And it took till 2003 before Saudi production regained the 10mbd level.

Today, Saudi probably needs to sell at least 8mbd at a price of $70/bbl in order to balance its budget. This could prove a very difficult balancing act, if demand really does weaken. So this pre-emptive move by Saudi, to cut production early, makes perfect sense. But whether it will be enough on its own to hold prices, remains to be seen.