Meanwhile, key energy importing emerging markets like Turkey or India are facing near record oil prices as well, as their currencies have weakened precipitously in recent months. Could the DXY continue to strengthen and oil prices go higher?
Energy as a share of GDP
BofA Merrill Lynch report said energy as a share of European GDP is already near the levels witnessed in 2008, suggesting that there is limited room for prices in EUR per barrel to keep on appreciating on a sustained basis in the short-run. Certainly, energy as a share of GDP in Europe is lower today than it was in the 1970s, but continued sovereign credit downgrades may limit the ability of certain countries to keep financing their trade deficit through external financing. It said the current account of weak European sovereigns is highly exposed to high oil prices, highlighting the risks of another round of sovereign debt woes ahead.
Oil bill
Looking back 10 years, Germany's cumulative current account surplus adds up to roughly $1.90 trillion, while the combined cumulative deficit of Italy, France, Spain, Greece and Portugal equates to $1.50 trillion. Most interestingly, oil has moved from 67 percent of the combined deficit of these countries in the 2000-2010 period to being close to 80 percent, suggesting that Germany's export surplus is effectively financing the rest of the euro zone's oil deficit. This means that, at a combined current account of $258 billion in 2011 for these five nations (and with around 80 percent of that being oil net imports), a 10 percent increase in oil prices would increase the current account deficit by around $21 billion.
Supply disruption
A key concern relates to the potential for yet another Middle East/North Africa oil supply disruption arising from a fresh round of sanctions targeted at Iran. Quite worryingly, troubled sovereigns such as Greece, Italy or Spain are all major importers of Iranian oil and Saudi Arabia likely has limited spare capacity to replace these barrels. In effect, Iran is the second largest crude oil supplier to Europe, highlighting its importance to the European economy at this difficult juncture and the potential risks of an embargo.
Europe's recession
BofA Merrill Lynch economists are already projecting a recession in the euro zone in H1, 2012. A round of higher oil prices or even higher oil prices in EUR could deepen Europe's recession. While demand for oil in Europe has been declining at a fast rate in recent months due to the deceleration in economic activity, Europe's oil bill has not due to high energy prices.
Global oil demand
To a large extent, the trend in Europe is also starting to show up in other regions, and that global oil demand growth continues to decelerate across the board. The decline in global oil demand is consistent with a deceleration in the major economic indicators around the world. After all, industrial output in the euro area is as of November about 1.5 percent below its Q3 level and Chinese export growth slowed in December on a weaker euro zone economy.
Libyan oil supplies
One of the saving graces for the oil market has been the return of Libyan oil supplies. Following the end of the civil war, Libyan supplies have been coming back at a faster than expected rate in recent months. Having said that, other countries like Nigeria and Venezuela have struggled to keep output up, limiting the benefits of higher Libyan exports on Atlantic Basin consumers.
Non-OPEC output
According to BofA Merrill Lynch, supply growth outside the organization should also help ease some of the upside pressures on oil prices. Non-OPEC supply growth is expected to increase by 890 thousand bpd in 2012, at almost double the rate of the 20-year average. It said, much of the incremental crude oil will likely come into the Atlantic Basin, potentially impacting Brent more than other markets such as Dubai.
Inventories
Broadly speaking, crude oil inventories in the United States have already started to build in recent weeks, pushing the WTI crude oil curve back into contango. Having said that, this is not true for other regions. In particular, European crude oil stocks remain at the lowest level since Jan 2001. These low inventory levels have naturally lent good support so far to Brent crude oil prices and term structure.
Consumption
A fact that is hard to reconcile with Brent's strong term structure is the mild winter conditions in the Atlantic Basin. BofA Merrill Lynch estimates that warm weather in Europe and North America may have softened demand by 105 thousand bpd in Q4, 2011. It is somewhat surprising that prices have held up so well under such a soft economic and weather picture, highlighting the physical tightness of this market. On the flip side, it is also true that Chinese oil imports have remained very robust in recent months, partly offsetting the weather-induced weakness.
Brent prices
In sum, despite the geopolitical risks, BofA Merrill Lynch still believes that a weakening economy coupled with an increase in supplies will remain the dominant factors in global oil markets. As a result, it continues to see a pullback in Brent crude oil prices toward an average of $102 barrels in H1, 2012. In part, expectations for lower prices are built around BofA Merrill Lynch view that OECD total commercial petroleum stocks will build by 830 thousand bpd in Q2.
Term structure
In turn, higher inventories in Europe should soon start to impact the term structure of the Brent crude oil market. So far, physical tightness has kept spreads going very strong, and June-December differentials remain near 2011 highs. Should Europe enter a deeper recession, oil demand could contract by 700 thousand bpd in 2012. Under that scenario, inventories would likely build very rapidly, negatively impacting the term structure of Brent. In turn, this could potentially translate into lower volatility, as there would be more room to accommodate for positive demand shocks.
