Although WTI crude oil opened the year at around $90 per barrel and raced to highs near $115 after fighting broke out in Libya last spring, crude has retraced and currently is trading below the year’s open. Like many commodities, oil is stuck in a tug-of-war between demand destruction from a slowing global economy, and uncertainty over what central banks may do to combat that slowing.
As the Libyan conflict escalated earlier this year, one of the effects it had was to expand the spread between WTI and Brent crude oil contracts. According to Rich Ilczyszyn, senior market strategist at MF Global, WTI normally trades at a premium to Brent by $2-$3, but that spread recently has reversed to Brent trading at a premium of up to $25 over WTI.
Dominick Chirichella, founder of the Energy Management Institute, says a number of factors have contributed to the turnaround. "The WTI-Brent spread is being driven strictly by the underperformance in the North Sea, Libya still being shut in and the force majeure in Nigeria. To a lesser extent, the oversupply situation in PADD 2 in Cushing, Okla. has largely gone away," he says.
Chirichella goes on to say that he expects the spread to hover around the $25-$26 mark until we see breaks in Libya, Nigeria and the North Sea, all of which he says could happen over the next two to three months. Once those factors begin to resolve themselves, he says we should see the spread move into correction mode.
Although things may be resolving in Libya, Nigeria may require more attention says Phil Flynn, senior energy analyst at PFGBest Research. "If you look at the fallout from the Libyan situation, it really hurt the U.S. gasoline situation because European refiners couldn’t refine the higher grade crudes. The hope is that if Libya can get back on-line, then that will fill that void. If we gain Libya but lose Nigeria, then we really haven’t made that much progress," he says.
Supply issues have been the dominant factor in crude oil trading this year largely because of firm demand from the developing world (see "Fueling the dragon"). "Demand, surprisingly, outside of the developed world has held pretty steady," Chirichella says. "If you look at projected demand growth, well over 90% of it is coming from emerging markets, and Asia in particular."
Much of this demand comes from China’s expanding economy, but the People’s Bank of China (PBOC) is working to engineer a "soft landing" to curb rising inflation. Ilczyszyn says that if the PBOC is able to engineer a slowdown, then demand for oil will drop, and regardless of events in the Middle East, if demand isn’t there, then prices should come down.
Conversely, Flynn says China has the potential to add to the demand equation. "One thing that would increase demand but keep prices down a little would be the Chinese allowing their currency to float. Initially that could create a lot more demand in China because with a stronger currency, oil looks cheaper to them, but that could level off and be a bit more bearish," he says.
Although the United States imports the majority of its oil from Canada and Mexico (see "Oil flows"), any discussion of oil supply and demand fundamentals needs to include OPEC. The most recent OPEC meeting saw infighting among members, particularly between Venezuela and Saudi Arabia, that resulted in no agreements over quotas or price targets. "OPEC is going to continue to do what they’re doing and the Saudis will continue to produce at the level they are producing. With prices where they are right now, it’s like a Goldilocks — they’re not too high and they’re not too low," Chirichella says.
Ilczyszyn agrees but adds that because of social expenditures in OPEC countries, oil likely will have a floor around $70. "They have years of budgets based on oil being $70-$80. If there [were] a spike below $70, OPEC probably [wouldn’t] do anything; but if there’s a sustained move below $70, then OPEC could start to pull back on some of their output," he says.
Looking ahead, Ilczyszyn expects WTI to trade in a range of $70-$100 for much of the rest of the year because "The White House wants oil under $100 and OPEC wants it above $70," he says.
Sovereign shenanigans
With all these issues brewing around the world, central banks in Europe and the Federal Reserve in the United States add to the uncertainty. In Europe, sovereign debt issues still exist, although the most recent actions by the European Central Bank have kicked them down the road. "Bailouts are bullish when looking at the European sovereign debt issues. If Greece is bailed out again, that will be bullish for commodities," Flynn says. "It might be artificial and built on printed money, but it does stimulate demand and create a desire to put money into hard assets."
In the United States, a disheartening August nonfarm payroll showed zero jobs created and added to the speculation that the Fed may move toward a third round of quantitative easing (QE3) or some other measure. One idea, dubbed "Operation Twist," could see the Fed sell short-term Treasuries and buy an equal number of longer-term issues in an attempt to lower long-term interest rates and stimulate borrowing.
Although it’s hard to tell what effect that may have in the markets, Chirichella says any action from the Fed is likely to be bullish. "[Any Fed action] would have a positive impact on oil and the broader commodity complex. At a minimum, it would put a floor on oil prices," he says. "It’s inflationary. It would weaken the dollar and push oil and most commodities up a bit."
Flynn expects we will see some action from the Fed and it will give a boost to WTI oil prices, but does not see sustained prices above $100. If more bad news is in the pipeline, he says oil will find support in the low-$80s, but could get to the high-$70s on very bad news.
Unless the Fed releases a very large stimulus package, Chirichella expects WTI oil to trade in a range of $80-$90 for much of the rest of the year, although a spike to $95 would be possible.
Natural gas glut
Although natural gas has gyrated between $3.75 and $5 per mmBtu, that kind of volatility is nothing compared to just a couple of years ago. "The volatility has slipped out of this market. It used to be going into the fall that a hurricane could shut down nat gas wells, then it would be extreme cold weather and the market would be off to the races," Ilczyszyn says. "Because we have the capacity to store as much natural gas as we do and the ease with which we can get it, the market is settling into a new normal." Ilczyszyn expects natural gas to trade in a range of $3-$6 for the rest of the year.
He goes on to say that if natural gas gets up to $6, that is a level that a lot more production comes online because that is the level at which some producers can make money. Consequently, that’s the price ceiling.
Flynn concurs and says the shale gas revolution continues to have an impact. A story to monitor, though, is a possible one-year ban on fracking in New Jersey. Flynn expects a trading range of $3-$6.50 through the rest of the year and says natural gas could become an election issue next year.
Chirichella says natural gas is still oversupplied and this year’s ending inventory projections won’t be much different from last year. Although the earthquake in Japan created more demand for natural gas as nuclear power plants were taken off-line for inspection, that situation is working its way back to normal.
Looking forward, Chirichella says weather will be less of a factor and production will continue to rise. Support could come in the form of a robust recovery in the U.S. economy, but that’s not something he sees happening right now. He expects a trading range of $3.75-$4.50 for much of the rest of the year.
Looking at products, Chirichella says that macroeconomic factors will continue to outweigh supply or demand factors for heating oil and RBOB gasoline. "Everything is moving on a macro trade right now. The whole complex is being driven by what increasingly is looking like a collapse in Europe. The euro is getting pounded and the dollar is strengthening," he says.
He goes on to say that he expects RBOB gasoline and heating oil to follow the larger energy complex fairly closely through much of the rest of the year. "If economic conditions stabilize, then prices will stay in a range. Looking at gasoline and heating oil, those prices are going to follow and stay in the range of WTI," Chirichella says.
Between the two products, Chirichella sees more downside to RBOB. "We’re getting out of the gasoline season and starting to watch distillate fuel more. If the market continues to fall because of economic conditions around the world, I expect gasoline prices to fall further than heating oil prices," he says.
Although a number of fundamentals have been covered here, new ones continue to pop up, ensuring energy traders stay on their toes. One story that may prove worth watching in the coming months is drilling rights in the North Pole as tension mounts about who owns what oil and where. Nonetheless, traders have more than enough to keep them busy in the meantime.
Western woes weakening metals outlook By Philip Burgert
A weak economic outlook in the Western world combined with underwhelming base metals production forecasts are feeding uncertainty in the metals sector in the fourth quarter and beyond. Chinese production and demand trends also continue to drive the outlook for much of the base metal sector with questions remaining on whether China will work to stimulate the world economy.
"The markets are going to remain in a holding pattern," says Leon Westgate, a base metals commodities strategist with Standard Bank Plc in London. "It’s very hard to see prices pushing significantly higher. They will continue grinding sideways and maybe a little bit lower." Contributing to the general weakness is fading consumer confidence. Until consumers and manufacturers supplying them start to see increases, the markets will remain difficult, he says.
Kevin Norrish, managing director for commodities research with Barclays Capital in London, says how much base metals decline into the industry cost curve depends on the degree of oversupply, but Barclays analysts do not expect metals to suffer as they did during the "fear and panic" selling of the 2008-2009 downturn. This time, "risks are better known and speculative positioning is minimal," Norrish says. "Because operating costs have continued to rise, the cost-support level is higher."
Barclays is calculating that nickel prices already are eating into the margins of high-cost blast-furnace nickel pig iron producers and that unless the market begins to reflect a surplus, prices are not expected to fall further. "Although zinc prices are hovering just above Chinese marginal costs, we believe that prices could justifiably eat further into the industry cost curve given the market surplus and high stocks, though the downside looks limited," Barclays analysts said in an early September note.
Norrish adds that aluminum and copper production do not need to be cut further because there are unintended supply cuts already. Chinese aluminum output has fallen because of reduced power supply, and a tightening metal supply is reflected by lower Shanghai Futures Exchange inventories and tightening of SHFE spreads.
"This, together with record-high production costs, signals to us that aluminum prices have the least downside potential," Norrish says. "Copper is the metal for which prices are trading furthest above marginal costs, but because inventories are low, the market is in deficit and refined copper production is declining anyway." He doesn’t expect prices to drop to levels that would induce production cuts.
Edward Meier, senior commodity metals analyst for MF Global, notes that supply concerns have underpinned copper recently, but that the overall outlook remains in doubt. "The global economy is still mired in a soft patch, hardly a scenario for robust metals price appreciation over the short-term," he says.
For industrial metals demand, China is becoming increasingly important, not just for copper but also for aluminum and nickel, says Westgate. "It’s become the world’s factory of choice for many products. So how that economy performs is key in terms of metals demand. At the moment there is much tighter control in terms of money supply and that is impacting Chinese consumers’ ability to hold inventory to do business."
If China continues to focus on keeping a cooling lid on growth, that support for industrial metals is going to be eroded, Westgate adds. "The key is whether in the face of potential recession in Europe and [U.S.] stagnation, China continues along that path or in the light of a weaker export market, it looks to stimulate its own economy again — perhaps through further investment in infrastructure."
In the absence of such stimulus, metals will continue to appear range-bound, Westgate says. However, he cautions that prices will be volatile and if we do enter another recession prices will drop significantly.
While copper and lead are in deficit, other metals like aluminum and zinc recently have been well-supplied. "Aluminum has been supported by high energy costs," Westgate says. "But there is plenty of inventory lying around. It’s tough to get very bullish for aluminum and prices will remain stable — steadily trading sideways. "
Automotive industry demand will be a key driver for aluminum, lead and platinum group metals, Westgate notes. "It boils down to the man on the street and is he in a position to buy a new car. You need [him] to start spending money he doesn’t have on stuff he doesn’t need again if you’re going to get back to the historical picture of growth."
Philip Burgert is managing editor of ResourceInvestor.com. He can be reached at pburgert@sbmedia.com.
