Crude Oil, OPEC, and Super Contango

By: James Bibbings | Wed, May 20, 2009
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On May 28th, OPEC will be meeting for the 153rd time in Vienna, Austria. During this meeting, much of the world will look to OPEC for additional guidance on Oil supply and demand; but should they? What will OPEC do? What can OPEC do? OPEC is between a rock and a hard place as market contango has pushed the price of crude to be almost perfectly correlated to the US equities markets.

Can OPEC Afford Not To Cut?

Members of OPEC can neither afford to cut supply, or leave production levels the same. For if the cartel was to be successful in forcing oil prices up through production cuts, they run the risk of prolonging the economic crisis. However, if they don't cut supply the world's oil coffers will continue to spill over. They are trapped at the ultimate economic "rock in a hard place moment." The only thing that is certain is that retail consumers without jobs, in conjunction with companies who are still aggressively scaling back, can ill afford a major increase in energy spending.

Will Demand Spike When The Economy Recovers? How about Supply? Will it Fall?

Over the next six months to a year, there will be no fundamental reason that demand should spike enough to erase the now staggering levels of global supply. Even if the so called "green shoots" fully blossomed it is inconceivable to think that demand will climb quickly to reduce supply. The world is currently swimming in oil and there is little OPEC can do about it in the short term.

As deflationary pressures drive all prices lower, reduce global demand, and move traders out of commodities and towards safety, the price of oil will continue to fall. I think prices will fall so hard in fact, that it would not be inconceivable to see oil return to 2004 prices of around $25/bbl within the next year to year and a half. In turn, I also expect to see the prices of both pump diesel and gasoline drop towards 2004 levels between $1.50 and $2.00 per gallon.

What about "Super Contango"?

For the past several months, it appeared that the markets were in a period of spectacular "Oil Contango." Since December, the phenomenon was so pronounced that oil traders even began throwing out the phrase "Super Contango" within the crude market. That is, traders were seeing record spreads between near term futures contracts and those contracts for delivery in several months. The belief at that time was that the world would start down the road to economic recovery this summer or early fall. As a result, at the beginning of the year, those who believed that contango conditions would begin to unwind by today began to add a great deal of bullish sentiment to the oil market.

This artificially masked true global demand and propped prices higher, causing a major headache for the OPEC cartel. The Cartel, not knowing what to do, recognized that free storage capacity was filling up. Thus, with excess global storage capacity dwindling, they realized that real global demand was still weak, and ultimately decided to pursue production cuts. The only problem with this choice was that OPEC, as usual, was unable to effectively reduce global supply enough to offset plummeting global demand.

OPEC's inability to reduce supply ultimately helped to force them into the "rock in a hard place" situation they are in now. Without reduced supply, large institutions with extra storage capacity, (through long oil speculation on hopes of a near term economic recovery) have been able to move oil and equity market correlation towards record highs. All without any true fundamental change to the underlying supply and demand picture of oil since "Super Contango" began in December. Global Oil Demand was weak then and it is even weaker today. Conversely, oil supply was high then and is even higher today.

If Not Contango What Then?

Currently we are seeing a largely correlated, bear market rally across all financial sectors. Since December we have also seen the US Dollar rally of late 2008 start to fizzle out. The combination of both of these things has lead, now, more than ever before, to various market correlations. In the case of crude oil prices, they, more than many other markets, are being tied to the successes and/or failures of the US equities market. This is in stark contrast to the negative market correlation seen at oil's all time high in July of 2008; which is worth considering in and of itself.


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Although the broad markets and media tend to believe the worst of the economic crisis is behind us, I do not concur. It is my feeling that the worst of the crisis will be upon us within the next three to six months and should drive fuel prices lower than they were in December of 2008.

How Relevant is OPEC anyway?

Due to higher than normal oil and equity market correlation, in conjunction with falling demand and increased storage utilization, OPEC can do very little about global supply in the near term. Over the long term there is also little OPEC can do as their true market influence died decades ago. Time and time again the cartel has shown an inability to collude on prices. Since the beginning of OPEC in the early 1960's, through today, all of the member countries have cheated on production quotas at some point. In fact, in September of 2008, Saudi Arabia, the cartel's largest member whom controls roughly a third of OPEC capacity, publically announced that they would not honor the Cartel's guidance. At that time they even walked out of OPEC meetings effectively saying "We will meet the markets demand." In-fighting within the cartel, coupled with increased global oil capacity over the past 25 years, has significantly reduced OPEC's leverage on the markets making each successive cartel meeting less relevant.

The reason the cartel cannot effectively control supply is simple; even if all of the member countries but one stuck firmly to production guidelines, the defecting country would get rich at the expense of the other countries. Since each member country of the cartel wants what's best for itself, they ultimately desire to be the "defecting country." As a result there currently is, and always has been, simply too much financial incentive for OPEC members to cheat production guidelines.

 


 

James Bibbings

Author: James Bibbings

James Bibbings
CommodityNewsCenter.com

James Bibbings

James Bibbings is an associate editor at Commodity News Center ("CNC"), a website which focuses on providing the latest commodity news and analysis. In addition to this Bibbings is also the president of Hugo James Consulting; a firm which specializes in offering compliance solutions to the brokerage industry. Mr. Bibbings writes daily as the "Economic Bibb" for Commodity News Center and through his writings strives to provide a unique outlook on the economy, the financial markets, and the global political landscape. It is his intention to add variety and insightful information to what he feels is an "over informed, yet "under educated" populace.

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