Wednesday, April 22, 2009

Oil at $50/bbl: Where to from Here?

I think oil has more chances of going down than up from here. My main reasons for oil corrections are the following:

1) Marginal cost of production: In the long run, supply curve is determined by production costs of a marginal supplier. The key feature of the oil supply curve is that for the majority of oil demand, supply can be provided at roughly a $10-20/bbl level (mainly Middle Eastern countries). For Russia, it's probably higher and is in the range of $30-35/bbl.

Any extra demand would be met by producers with much higher cost levels of $60-70/bbl. In the first half of 2008, it was assumed that marginal producer would be Canadian oil sands with a $80/bbl cost structure.

Speculators were expecting that it would take too long before Canadian oil sands producers start supplying oil to the market and, thus, further production was needed which was expected to come from even more expensive sources (mainly offshore with over $100/bbl cost levels). This assumption clearly did not work out given the drop in global oil demand.

2) In extreme scenarios, oil supply curve turns negative (meaning downward slope) because of OPEC cheating members. With financial markets still half frozen, developing countries have strong incentives to substitute unavailable external borrowings with extra oil supply. Thus, current OPEC discipline cannot be expected to last long.

3) A significant number of oil projects were coming on stream in Q1 2009 and at the same time a lot of refiners were shutting down for maintenance in spring 2009. This should lead to an over-supply situation, the evidence of which is ever growing oil stocks in the US.

4) It's still a deflationary environment and so production costs are expected to continue to fall, bringing down the supply curve.

5) Technically, the oil forward curve (made of futures prices at different settlement dates) still has a steep rising shape which points to future price correction. This steepness was created by unavailable funding to buy oil on the spot market and sell in the future and also by too high storage fees. But it seems that a few banks (including Morgan Stanley) hired tankers and bought oil for storage a couple of months ago and soon this oil will be coming to markets causing further downward pressure.

So, why is oil not at $30/bbl or below? Because the general mood is that the economy is bottoming out, we will soon see recovery and then, due to point one, oil will jump to above $60 levels. Another reason is inflation expectations given the amount of financial stimulus announced around the world (oil as inflation hedge-thesis). I personally disagree with the first point. I also think the second point would be relevant at the end of 2009 or 2010 (US stimulus is comparable to the amount of capital loss of US banks; besides, with banks still not functioning properly, credit is not flowing and money is not created through credit).

Nevertheless, it does not mean oil cannot grow further from here. I would definitely short it at $60 if you see it at these levels in the near future. If you can wait a few months, shorting it even at these levels should probably work as well.

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