The Federal Reserve’s 75 basis point interest rate cut on 18th March knocked some shine off recent oil price rises, along with other commodities, by bringing economic fundamentals back into focus.
The markets are now openly predicting a US recession, and, combined with a seasonally lower demand for oil in the second quarter, the mood has turned bearish after oil prices reached $110 a barrel a week ago.
The world’s largest guzzler of oil, the US, has began to curb its demand for imported oil and February saw a contraction of 3 percent in demand compared to the previous month.
The bearish picture is further underpinned by special factors — looming quarter-end speculative funds booking profits, rising margin calls, and a further deliveraging of contracts, along with a slight improvement in the dollar’s value ,opens the door for crude oil to retreat back into the $85-$100 ranges that held before late February’s oil price explosion.
This downside pressure could become self-reinforcing, should writers of put options rush to hedge their exposures by selling futures. It is then that we will witness the extent of international speculative fund trading in oil futures, which OPEC ministers have bitterly complained as adding anywhere between an extra $15-$25 per barrel of oil.
In such scenarios, OPEC seems vindicated by its recent stance that has maintained that recent high oil prices have been dislocated from economic fundamentals, and the retreat from $110 prices reinforces their point.
As long as crude oil prices remain above $85 ranges, seen to be the unofficial OPEC “benchmark” since October 2007, OPEC will remain unconvinced to increase oil production further.
The decision by OPEC last week to leave output on hold was aimed at allowing stocks to build up through the second quarter, in an effort to see prices moderate. While current US oil demand is slowing down, there are those in OPEC who argue that Middle East and Asian demand are holding up for the time being, and are taking up the slack in US demand.
Should the financial market contagion spread much faster and cause Asian economies to begin to falter, then the oil demand situation in the Far East could alter and more hawkish OPEC voices will be heard to reduce OPEC output.
For the time being the Kingdom is maintaining its production level of 9.2 million barrels a day and watching the situation in the US very closely. This is in the short term.
In the long term, what happens to oil prices has a fundamental impact on the pace and scope of further investment in the energy sector. If the outlook for global growth deteriorates in a significant manner, there will be a slowdown in energy related investment programs, which are also being hard hit by escalating costs and inflation.
Projects in the planning stages might have to be postponed or shelved for those whose economic viability might be questionable, if they are hit by both weakening oil prices in real terms, as well as higher costs. It does not also help the energy sector that there could arise an aversion to lending by banks to this sector, following the sub-prime fiasco.
The current global credit crunch could hit harder the International Oil Companies (IOC’s), than National Oil Companies (NOC’s), who will dip into national reserves and use equity capital for new investments, rather than bank debt.
What happens to the price of oil is then a crucial factor for both the consumer, and producer equation, and markets hate uncertainty.
A period of stable oil prices around the unofficial OPEC price benchmark of $85-90, will ensure that long term planning and investment can go ahead to the benefit of all in the future.
(Dr. Mohamed Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.)