Wednesday, June 13, 2012

The Summer Oil Slump

Instead of US consumers facing $5 gasoline this summer, as some analysts had predicted, we now find prices slipping well below $4 per gallon as oil prices respond to weakening demand, a stronger dollar, and steady supply growth.  Yet as welcome as this is, it's largely the result of a mountain of bad news: Not only does financial turmoil threaten the very existence of the European Monetary Union and its currency, the Euro, but economic growth in the large emerging economies is also slowing, at least partly in response to the weakness in the developed countries that constitute their primary export markets.  The engine of global growth for the next year or two just isn't obvious.  That's the backdrop for this week's OPEC meeting in Vienna.

Before we become too enthusiastic about the prospect of a period of cheaper oil, we should first put "cheap" in context.  Even ignoring West Texas Intermediate (WTI), the doldrums of which I've discussed at length, the world's most representative current crude oil price, for UK Brent, has fallen consistently below $100 per barrel for the first time since the beginning of the Arab Spring in 2011.  Yet even if it fell another $10/bbl, to about where WTI is currently trading, it would still exceed its annual average for every year save 2008 and 2011.  So while oil might be less of a drag on the economy at $90/bbl than at $120, that's still short of the kind of drop that would be necessary for it to provide a substantial positive stimulus, particularly when much of the drop reflects buyers around the world tightening their belts. 

The US is in a somewhat better position, thanks to surging production of "tight oil" in North Dakota and onshore Texas. This has more than made up for the inevitable slide in output from the deepwater Gulf of Mexico, two years after Deepwater Horizon and the ensuing drilling moratorium. With much of the new production trapped on the wrong side of some temporary pipeline bottlenecks, parts of the country are benefiting from oil prices that are $10-15/bbl below world prices, although short-term gains are a poor reason to perpetuate those bottlenecks, rather than resolving them and allowing North American production to reach its full potential.

Then there's the issue of speculation, which some politicians blamed for the recent spike in oil prices.  To whatever extent that was true--and I remain skeptical that the impact was nearly as large as claimed--we could be about to see what happens when the dominant direction of speculation flips from "long" to "short"--bullish to bearish--as noted in today's Wall St. Journal.  Since the main effect of speculation is to increase volatility, we could see oil prices temporarily drop even further than today's weak fundamentals would suggest they should.

All of this will be on the minds of the OPEC ministers meeting in Vienna Thursday, along with the usual dynamics between OPEC's price doves and hawks.  The pressures on the latter have intensified as Iran copes with tighter sanctions on its exports and Venezuela's ailing caudillo faces a serious election challenge.  OPEC meetings are rarely as dramatic as last June's session, but the global context ensures a keenly interested audience for this one.  Given the impact of gas prices on US voters, both presidential campaigns should be watching events in Vienna as closely as any traders.  $3.00 per gallon by November isn't beyond the realm of possibility.  It would only require a sustained dip below $80/bbl.