Complex Made Simple

No light on the horizon for oil prices

It has been a very tumultuous few months for the price oil with investors becoming increasingly concerned about the future of global growth. Not too long ago the market was focused more on the supply side than the demand situation as tensions in the Middle East threatened to cut off key distribution routes and limit production. Accordingly, the price of oil rose significantly in early 2012. Whilst these concerns have not dissipated, they have eased and the balance is now in favour of factors negatively affecting the demand side of the equation, in particular; the economic slowdown in China, uncertainty surrounding the European debt crisis and more recently the Fed not pulling trigger on QE3.

By Chris Tedder, Research Analyst,

However, this doesn’t mean supply side factors are being completely ignored. In fact, increases in production within Saudi Arabia put downward pressure on the price of oil. Hence, we can find numerous fundamental reasons why the price oil is low but struggle find reasons that may underpin a significant pull-back.

There is still a lot of uncertainty regarding future demand for oil from Europe, which stems from the apparent inability of European leaders to develop a workable solution to the debt crisis. Thus far, most of the efforts to resolve the crisis have been based around throwing money at it, considering its debt crisis this doesn’t sound like a bad thing but the central principle of the money transfer is basically a debt transfer, whereby poorer nations are supported by stronger ones.

Thus, the overriding concern is the threat of contagion which could bring down the entire Eurozone. To prevent this there are strict rules sovereigns must follow in order to receive austerity funds, but these so-called solutions treat the symptoms of the crisis not the underlying problems. Hence, we think a sustained pick-up in growth for the Eurozone is a long way off – most estimates are between 5-10 years before the region sees somewhat respectable levels of growth.

Markets watch for China reaction

The growth slowdown in China is not nearly as dire, at least not yet, but it is weighing heavily on investor sentiment. China has recently been the main driver behind global growth and is one of the largest markets for oil, thus any indications that demand is going to suffer should theoretically impact the price of oil, which it has. However, the market was already expecting a slowdown in China as it was clearly outlined by the government that they were aiming for lower levels of growth. But it is the speed and severity of the slowdown in growth that took the markets by surprise and caused investors to question the ability of the government to control the slowdown.

Overall, we think the Chinese government has both the will and ability to control the slowdown. Nonetheless, this assumption could quickly come undone if the European debt crisis worsens significantly which, in turn, will find its way to China through the export channel and sentiment.

In the US, it is clear the recovery has stalled somewhat in the last few months; growth is pretty much stagnant, the job market is suffering (non-farm payrolls data has fallen significantly) and equity markets have fallen. More recently, the oil price has been dragged lower by the inaction of the Fed (choosing not to implement QE3 and, instead, choosing to tweak Operation Twist).

However, the central bank did make it clear it is considering more decisive action down the road. But we think the Fed has done most of what it can do, at least on a large scale whereby the entire economy is targeted. Thus, without the anticipated boost from an announcement of more stimulus, we cannot see a significant push higher in the price of oil originating from within the US.

Overall, we do not think we will see a significant push higher in the price of oil over the short-medium term, apart from a possible small technical retracement on the back of the recent plunge. However, if there is an unwinding of the factors that are acting as a ceiling for oil prices then, all else being equal, prices may have room to increase, but this is not our base case.