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What goes up, usually comes down

Oil markets

WTI v natgas Jun13.pngSomething very strange has happened to oil prices since 2009, as the chart of the ratio between US oil and natural gas prices shows:

• Between 1986-2008, the ratio averaged 9.6, and was typically in the 6 – 14 range (6 is oil’s relative energy content versus natgas, whilst 14 was seen during the first Gulf War in 1990-1)
• This period included oil’s record price levels during 2008, which also saw strong natgas demand
• But from 2009, the ratio moved into a new paradigm, and has averaged 23.8 since then

The key question is whether this ‘new paradigm’ is real, or artificially caused by central bank liquidity programmes? The chart itself strongly suggests the latter. The ‘melt-up‘ peak at 53 is history, and the ratio seems to be returning to historical levels. In terms of output, the shale gas boost to natgas volumes is being matched by the boost to oil output via ‘tight oil’.

Thus the downside risk in oil markets is increasing day by day, as the blog warned last month:

OPEC’s meeting last week maintained current output, whilst non-OPEC output is rising rapidly
• US output hit 7.4mbd (back at 1992 levels), whilst US inventories remain at 80-year highs
• This is now pressuring West African producers, who can no longer sell on secure term contracts to the US, and are instead having to find new markets on a spot basis in Asia
• On the geo-political side, a major price fall could further damage Iran’s struggling economy, and so might be welcome news for some Western and Arab countries.

The key issue is that markets have lost their role of price discovery due to the constant supply of central bank liquidity. Japan may well be an important indicator of what happens when investors refocus on the fundamentals that should drive market prices:

• Its Nikkei index saw more volatility last week, falling a further 5% on Thursday, whilst yen and government bond markets went on a roller-coaster ride
• The reason is that investors are realising that so-called Abenomics is inherently contradictory. No sane person would buy bonds at today’s rock-bottom yields when the government is aiming to increase inflation to 2% and to devalue the yen
• Any domestic buyer will lose money if inflation does rise, whilst any foreign buyer will automatically lose money if the value of the yen falls

Of course, the optimists will still argue that oil demand is just about to recover in the major regions. But in reality, Eurozone unemployment remains at record levels, whilst China’s growth is clearly slowing and India’s GDP is at a decade-low. Equally, latest readings on US consumer spending show this slipping as the sequester takes effect.

The message of recent volatility is clear. Companies may still believe there is only a 10%-20% chance of a major oil price fall in coming months. But the damage this could do means that the development of a detailed contingency plan should now be an absolute priority. Life could become very difficult for those who are unprepared.