Cashing in on the dynamics of crude

There is nothing quite like a Goldman Sachs research note to rally one's faith in the invisible hand of the market.

A oil worker works on a oil pump "nodding donkey " at an oil field near Baku, Azerbaijan, on Friday, Jan. 30, 2009.  Since gaining its independence with the 1991 collapse of the Soviet Union, Azerbaijan has become an important energy exporter and transport hub for Caspian Sea oil and gas. Photographer: Jeyhun Abdulla/Bloomberg News
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There is nothing quite like a Goldman Sachs research note to rally one's faith in the invisible hand of the market. You may recall that in May last year, the US bank predicted medium-term oil prices averaging US$150 (Dh550) to $200 a barrel. Shortly thereafter, oil began the slump that took it to a January low of $32.70. Halfway through that remarkable slide, the US bank produced another note, stating the eventual bottom of the market "may be as low as $50 a barrel".

Having failed so successfully to predict the top and the bottom of that cycle, Goldman Sachs recently set forth its prediction for oil once again. On the basis of a recent futures rally, the bank increased its price forecast for the end of this year to $85 - up $20 on its previous prediction - with prices expected to hit $95 by the end of 2010, on the back of economic recovery in China. Such bullishness was immediately rubbished by the veteran analyst John Hall, who described Goldman's numbers - perhaps with some justification - as being "all over the place". His initial reaction, quite naturally, was "who would pay those prices?" According to Mr Hall, certainly not China. As such, he anticipates a further lull in the price of oil, with the current $70 level representing the peak in the current market.

Mr Hall's analysis is backed up by a look into the prices of other energy markets. Natural gas is currently trading at its largest discount to oil since the collapse of the Soviet Union. Gas tends to average a price per million Btu (British thermal units) of around 1/8th that of oil. On June 4, however, an extended slump in gas added to a rally in oil spot prices, lifting that ratio to 1/18.1. Prices of less than $4 per million Btu currently place natural gas at almost half the marginal cost of supply to producers, suggesting inventories still have some way to run down before the market can be expected to recover.

If anything, oil inventories are currently even higher than for gas, so why such a discrepancy between the market performance of the two? Sadly, the answer has much to do with the continued distortion of futures contracts due to the effect of speculation. As the world's most traded commodity, oil is not priced purely in relation to its own supply and demand fundamentals (which are, in any case, prone to distortion due to a lack of transparency in the market). Rather, the price of oil sits within a nexus of other traded commodities, currencies and financial products. A good deal of the hot air pumped into last summer's record market, for example, was simply a case of investors looking for a high-yield investment opportunity outside of the unstable financial sector.

Eventually, the sheer weight of inevitability caused the collapse of that market: even a global economy purring along at 5 per cent annual growth could not sustain $150 per barrel, let alone one where consumer demand was falling off a cliff. Yet, thanks to the dynamics of the oil market, even a modest rally in global economic performance has allowed speculators to cash in through the futures market. The positive news from producers of manufactured goods such as Japan and China in recent months - where inventories have started to run down, signalling an imminent pickup in production - coupled with decisive cuts in oil production from OPEC, have created a sufficient illusion of strengthening fundamentals in the oil market to help push West Texas Intermediate and Brent close to the $70 level - an advance of about 20 per cent on the contract since the beginning of last month.

While some economic fundamentals are exhibiting green shoots of recovery, in general it is much too soon to tell whether or not global demand has turned the corner, or if further trouble still looms ahead. Given the current low interest rate environment prevailing in much of the developed world, however, there still remains an incentive for investors to diversify into higher yielding asset classes - however artificial. In such an environment - and with quantitative easing in some cases significantly expanding the supply of hard cash - the short-term benefit to be gained from a rally in the price of oil encourages traders to get carried away. As it stands, the complexity of the market combined with the absence of clear price signals will continue to make oil prone to wild, and highly profitable, exaggerations.

Breaking the wall of silence which surrounds oil - not just among producers, but also among traders who stockpile enormous quantities in idle tankers - will become increasingly urgent in the coming years. The alternative is a global economy blighted by a vicious circle of recovery and recession, as demand constantly rebuilds to a level which pushes available supply, causing prices to rise to a level that tips global industry into recession. On each occasion, at the top and bottom of each market, the speculators will continue to cash in on everyone else's misfortune. Thanks to the current crisis, public opinion will no longer permit such behaviour in the financial sector; time will tell whether oil will follow.

Oliver Cornock is regional editor of the Oxford Business Group