London, 24 May 2010

Has the balance of risks and opportunities in the oil market shifted to the upside following recent steep price declines? Much of the "froth" that built up as a result of record speculative length and an influx of hot, trend-following money seems to have been blown off the top of the market. Big increases in the front-month contango and the retreat from the mid-$80s toward $70 per barrel have arguably realigned futures prices much more closely with the underlying physical market, which is well supplied.

Only a very brave analyst offers a strong prediction about the next movement in market prices. The future is essentially unknowable; there is no evidence anyone can consistently forecast it with accuracy. All that is possible is to assess risks and devise a strategy to mitigate them most cost effectively.

A more modest, and realistic, ambition is to analyse what Soviet military planners used to call the "correlation of forces", assessing factors that could move the market higher or lower, assigning probabilities and producing a distribution of possible outcomes. Forecasting should be stochastic rather than determinative.

It would be foolish to rule out further price declines after the turbulence of the last three weeks. But it seems to me the balance of risks and opportunities have shifted. In particular, there are increasing risks to being short in this market, while big price declines have created some headroom for a modest price increase in the short to medium term.

Fighting the Saudis

Prices for nearby futures contracts from July 2010 through to June 2011 are trading near or below the $75 target Saudi Arabia's King Abdullah identified in late 2008 as a "fair" price for consumers and producers. They are well within the informal $70-80 range ministers from OPEC and the IEA seemed to endorse implicitly this year as their informal target.

Keeping prices exactly within a $10 band is unrealistic. OPEC did not intervene when they rose above it towards $85-90 in March and April. There is no reason why the cartel should immediately intervene if they dip to $60-70. But there is no doubt the cartel will be surprised, and concerned, by the speed with which the market has gone from being bullish at $85 to being bearish at $70. Policymakers do not like abrupt adjustments because they suggest the market risks overshooting.

If oil prices keep falling rapidly in a straight line, there is a substantial risk Saudi Arabia or the cartel as a whole will seek to intervene to slow or reverse the adjustment, either by issuing hawkish statements to jawbone the market higher or cutting Saudi oil allocations.

So far, shorts have helped push prices back to Saudi Arabia's preferred target. But at these levels, shorts in the oil market will be fighting Saudi Arabia on the way down.

"Time Inconsistency"

There are also sound fundamental reasons to think the long-term floor in the oil market might be around $60-65 per barrel -- based on policymakers' reaction functions and the industry's cost structure and investment needs.

Recent months have seen a rare consensus between oilproducing and consuming countries, as well as the major international oil companies, on the need to stabilise oil prices in a range around $65 to $85.

This level is seen as necessary to restrict demand destruction and substitution; provide sufficient cash flow and incentives to bring on costly deepwater and other hydrocarbon sources in the medium term; and support the deployment of cleaner technologies such as wind, solar and carbon capture and storage (CCS).

Prices much lower are unlikely to be sustainable because they would stunt development of higher-cost oilfields as well as supplementary energy sources such as tar sands and clean technology that will be needed to meet medium-term energy needs.

In some sense, prices below $60-65 would be disequilibrium prices that could not persist indefinitely. They are "time inconsistent". It does not mean the market could not head into this territory, merely that it could not stay there for very long. Prices that low would sow the seeds of their own destruction (just as prices above $100 were ultimately self-defeating in 2008).

Liquidation Over?

Steep price falls have been accelerated by liquidation of some of the record speculative length that had built up in oil markets, according to the Commodity Futures Trading Commission's commitments of traders (COT) report. Much of that length was tempted into the market by the apparently sustained and convincing uptrend beginning in spring 2009 and extending through Q1 2010.

It was liquidation of some of that length that pushed prices down so far so quickly on heavy volume. But with most of the weakest longs already shaken out of the market, there is less inbuilt selling overhang.

None of this is to say that prices cannot or will not fall further. Nor that the market could not in fact trade below $65 for several months or even years, especially if there is a prolonged slump in the global economy. But it does mean the balance of risks has shifted as the market has pulled back.

Crude is perhaps no longer the attractive proposition for the shorts that it was at the start of the month at $85.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.