Oil markets risk rapid repricing – Part 2

Oil markets

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ICB May13.pngAs the blog discussed yesterday, central banks have now kept oil prices above the historical $10-30/bbl range for 10 years.

But can they remain there forever?

What might bring them back in line with the fundamentals of supply/demand? And what would be the risks if this happened?

The background can be simply stated:

• Investors have bought crude oil futures and other assets on a ‘buy and hold’ basis
• Some, according to the IMF, have up to 25% of their assets invested in this way
• So normal supply/demand fundamentals have become irrelevant
• Thus oil markets have lost their price discovery role

Logic therefore suggests that repricing will most likely occur when investors decide they no longer need a ‘store of value’. And this may be about to happen:

• The Bank of Japan’s (BoJ) new policies have begun to reassure investors on this critical point
• It clearly aims to devalue the yen, which would boost the US$ again
• The US$ has already risen from its low of $1: ¥77 to $1: ¥100
• Many expect it to rise further to $1: ¥120 or more, as Japan tries to kick-start economic growth

It was therefore not coincidence that prices of oil, copper and gold all fell by 10% following the BoJ’s announcement last month. The risk is that more falls may now be on the way. Investors never knew, or cared, about their impact on the real economy when they bought their ‘stores of value’. They will also not care about their impact when they sell these positions.

Even more importantly, there will be no warning in terms of the fundamentals. These are already signalling lower prices and a return to historical levels. Therefore prudent companies need to take time now to review how they would manage this critical risk, if serious disinvestment by the investment funds does begin to occur

The problem is that investors can simply sell their futures contracts at the press of a button. But companies cannot do this with their inventories and work-in-progress. Equally, if prices did start to fall during a period of weak demand – say over the summer months – it could become very difficult to avoid a panic.

Boards may understandably feel that there is no more than a 10% risk of this situation developing. But seemingly low probability risks can happen, as we saw in Q4 2008. And unprepared companies can, as then, easily go bankrupt as a result.

We are in very dangerous times. Prudent executives will therefore want to spend time today planning in advance how they would cope with such a crisis.

ADDITIONAL FREE RESOURCES
The blog’s new Research Note focuses on this critical question. Please click here to download it. A video interview with Will Beacham, deputy editor of ICIS Chemical Business, is also available by clicking here.

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