Serious Money: Whatever happened to $100 oil? Investors, households and businesses have all breathed a collective sigh of relief as oil prices have dropped steadily from a record high of more than $78 a barrel in August to below $58 (€46 ) in recent sessions. Prices were even down year-on-year in September for the first time in 30 months.
Not surprisingly, Opec has entered the fray and last week announced the largest cut in production quotas since early 2002. However, the market is not convinced that Opec discipline will hold and prices continue to drop.
The background to the bull market in oil is well-documented. The spike in oil prices was triggered by insufficient spare capacity to meet higher than expected growth in world oil demand combined with political instability in key oil-producing regions. The re-election of Hugo Chavez as president of Venezuela in 2002, the invasion of Iraq in 2003, unrest in Nigeria and hurricanes Katrina and Rita last year all disrupted supply.
Simultaneously, the emergence of China and India as major oil consumers and the increase in oil usage in the former Soviet Union following almost a decade of decline caused spare capacity to drop to record lows. Spare capacity as a percentage of consumption fell from more than 7 per cent in early 2002 to less than 2 per cent for the past 50 months.
Throw in the political stand-off with Iran over its nuclear programme and it's not hard to understand why the price of oil surged.
The sharp drop in oil prices over the past two months has occurred against a background of declining geopolitical tensions with the withdrawal of Israeli forces from Lebanon and the possibility of compromise, however remote, between Iran and the US over the former's nuclear programme.
The end of America's hurricane season without major incident contributed to the favourable backdrop.
Additionally, inventories are close to an eight-year high in America and near a two-decade high in the OECD. Despite the lack of spare capacity, current supplies are clearly too high and a drop in price was inevitable.
However, the current glut is not expected to last as evidenced by futures prices, which are above spot prices, and have been for almost two years. This situation, known as contango, is unusual in the oil market. Indeed, futures prices have been below spot prices or in backwardation almost 90 per cent of the time over the past two decades. Not surprisingly, numerous theories have been offered to explain the current anomaly.
Advocates of the peak oil hypothesis believe that the contango reflects the increasing acceptance by market participants that the world is rapidly running out of oil. Global oil consumption has amounted to more than one trillion barrels over the past two centuries and currently identifiable reserves total a similar amount. Numerous academic papers and bestselling books have documented that, given current consumption and realistic growth projections, peak oil production is imminent.
However, the market does not concur. The forward curve of futures prices peaks for delivery in March 2009 at almost $76 and drops by more than $12 for delivery in December 2012. Furthermore, the volume of long-dated contracts outstanding is low.
If market participants truly believed that peak oil was imminent, demand for long-dated contracts would be high and the forward curve would edge ever higher across the entire maturity spectrum.
It is far more likely that the current contango reflects a temporary glut in the market caused by concerns over the low level of spare capacity, which has been below two million barrels a day for the past two years. The low level of spare capacity means that supply disruptions can have an outsized effect on the market and consequently, it makes sense to buy oil for future delivery as a hedge.
Additionally, the contango induces refiners to store oil now as the rising forward curve of futures prices reflects market expectations of an increase in spot prices. The price of oil to be delivered in one year is almost $9 above the current spot price. Consequently, it is no surprise that inventories are relatively high.
Investors have also emerged as an important factor in the oil market at the margin. More than $100 billion has been directed to commodity funds in recent years, of which roughly half has flowed to oil.
Roughly 90 per cent of this money is passively-managed. These passive funds buy near-dated futures contracts, which are continually rolled into new contracts as expiry approaches. Consequently, near-dated futures prices are inevitably higher than spot prices.
Unfortunately, the actions of these funds are predictable as they roll over contracts every month at set dates. Not surprisingly, they have fallen prey to active traders who buy oil in the spot market and sell the funds near-dated contracts. The profits available greatly exceed the cost of carrying inventory.
Speculation in the oil market has been rife in recent times as active traders have exploited opportunities at the expense of passive commodity funds. The rollover yield in the oil market is negative as exposure is rolled into more expensive contracts. Consequently, spot prices must rise materially for passive funds to earn a positive return.
Perhaps this will happen as Opec implements cutbacks in production, but with inventories at high levels and global growth slowing it may not. Investors should take heed.
• Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland
