The Momentum Shifts

What a difference a few weeks makes. A month ago, I was contacted by a TV news producer who was lining up "talking heads" for the day when oil broke $100/barrel--then expected at any moment. Subsequently, instead of breaching that level, the most-watched oil price has receded by more than 10% and the entire shape of the market has changed. Yesterday in Abu Dhabi, OPEC apparently concluded that the risk of a price collapse exceeds that of killing demand and held its quotas steady. What has changed since early November, and is the current weakness any likelier to persist than the market's flirtation with the inflation-adjusted all-time high price did?

While I share the general sense of momentary relief that oil prices are heading back into more comfortable territory for the economy--no one can call $85/barrel normal--I'm also oddly disappointed, and not just because I missed a chance to be on TV, for now. Breaking $100/barrel would have sent an important signal about the fundamental shifts that have taken hold in the global oil market in the last few years, and it would have underlined the need for consumer behavior to change, while we wait for more efficient cars, homes, and devices to become mainstream. It also would have set a new record oil price, settling the annoying controversy over what the 1980-81 historical high means today. That no longer seems likely, at least for the next few months.

Media analysis of the change seems focused on slowing global economic growth, oil inventories, and the new intelligence on Iran's nuclear program. You almost have to smile at the perversity of some of this, when traders take the otherwise bullish news of OPEC's failure to increase quotas as a signal that economic growth must be so weak that oil demand will fall, and prices with it. This contrasts with the fall in reported US oil inventories this week, which puts them right in the middle of their seasonally-adjusted historical average range, hardly a bearish indicator.

From "This Week in Petroleum", December 5, 2007, Energy Information Agency

The most significant change, other than the absolute price level, is the dramatic decrease in "backwardation", the difference between the price of the prompt oil futures contract and those of succeeding months. Less than a dollar per barrel now separates the January 2008 and April 2008 contracts. A few weeks ago that spread was $3/bbl. This shift reflects a market that is in much better balance. That could be a function of easing physical supply and demand, a reduction in speculative pressure--as OPEC would have it--or a bit of both. Either way, the impetus that was driving prices ever higher seems to have crested for the moment, and we might even see a return to "contango", if the prompt market becomes oversupplied.

One of my futures trading mentors liked to say, "The trend is your friend, until it ends." As oil approached $100/barrel--a level with more psychological than real significance--the price seemed to have a life of its own. You can ascribe that to the impact of speculation, or the degree to which most global oil consumption is insulated from day-to-day changes in oil prices, requiring truly big spikes to bring demand back into line with supply. But whether speculators lost heart and chose to take profits, thus ending the trend, or the prospect of record oil prices finally cast a large enough pall over the global economy, prices have returned to where they were in October. The one certainty in all of this is volatility. Global supply and demand remain tightly balanced, and depending on the nature of the events ahead, we could soon be on verge of $100 again, or of $50. That's hardly reassuring for those investing in alternative fuels.