London, 6 January 2011

With WTI spot prices hovering at almost $90 per barrel, "oil prices are entering a dangerous zone for the global economy", according to International Energy Agency Chief Economist Fatih Birol in comments reported in the Financial Times newspaper. The potential for a steep rise in energy prices is possibly the biggest threat to continued global economic recovery in 2011. But at least in the short term a seasonal increase in stocks in the United States could cool the market and relieve upward pressure on futures prices.

MORE FLEXIBILITY

Crude and products inventories are comfortable, and there is plenty of spare capacity at both the crude production and refining stages. But many oil analysts predict the market will tighten over the course of 2011 and 2012 as supply growth fails to keep pace with demand from emerging markets and recovering economies of North America and Western Europe, putting new upward pressure on prices.

By squeezing household expenditure and business margins, price rises could lead to renewed slowdown in the economies of oil-importing countries -- many of which are already facing stiff headwinds in the aftermath of realestate and sovereign debt crises.

It is far from clear the bullish scenario is the most likely one in 2011. In particular many forecasters were wrong-footed by the supply-side response in 2010 and may be surprised again as high prices incentivise near-record levels of exploration and production activity.

The market has also become more flexible. Big price swings in commodities and manufactured items almost always stem from government regulations and other distortions that prevent markets clearing normally and confer exceptional and artificial pricing power on producers or consumers.

In the case of the 2007-2008 price spike, it was propelled by price control and subsidy regimes across Asia and the Middle East, coupled with the rushed and inflexible introduction of low sulphur standards in the United States and the European Union.

But following the liberalisation of price controls and the completion of the desulphurisation process, the oil market should respond more quickly to excess demand growth and high prices in 2011-2012 than in 2007-2008, by curbing emerging market demand and bringing on more supply, avoiding the destabilising dynamics witnessed three years ago.

If prices do start to rise strongly, China and other emerging markets are likely to act much more quickly than in 2008 to ration excess demand by raising domestic gasoline and diesel prices. Price rises will also likely to draw an earlier and more effective response from Saudi Arabia, which has substantial spare production capacity.

With adequate desulphurisation capacity in North America and Western Europe to process marginal Saudi crude, and most extra demand growth now coming from Asia, where product standards are less stringent, the market is unlikely to see a repeat of the squeeze on desulphurisation capacity and light sweet crude oils that fuelled the 2007-2008 rally in its final stages.

Barring significant geopolitical disruptions in Nigeria or Iran, greater flexibility at all stages of the supply chain should ensure prices do not quickly revisit the crisis levels experienced in 2008. If prices do begin to rise they will quickly slow the global economy, and should ease consumption growth, helping deflate the rally much sooner than last time.

RISING STOCKS

Oil bulls nonetheless point to the drawdown in floating storage last summer and commercial crude inventories in the United States in the final two months of 2010 as a sign the market is already beginning to tighten, and a harbinger of significant price increases in 2011-2015.

Those drawdowns have probably been misinterpreted. The entire draw in commercial crude inventories along the U.S. Gulf Coast in November and December can be explained by seasonal inventory management ahead of the year end.

It reflects the impact of "last in first out" (LIFO) accounting conventions and sales and excise tax treatment in the coastal states on stock holding policies rather than an increase in demand or tightening of supply.

In any event, the market is now bracing for a substantial build up in crude oil stocks over the next four months, which has helped take some of the momentum out of the rally, and should restrain further price increases, at least in the short term.

Commercial crude stocks have risen in 27 of the last 30 years between January and April, according to monthly inventory data published by the Energy Information Administration ( EIA), the statistical arm of the U.S. Department of Energy. The median build has been just over 17 million barrels, with an inter-quartile range of 4.6 million to 23.2 million barrels.

In recent years, stock builds have generally been between 10 and 20 million barrels. The PADD III Gulf Coast refining region has typically seen the largest and most consistent stock builds, especially in the first two months of the year, reversing tax and LIFO-driven drawdowns at the end of the previous year. Builds in the rest of the country come later. Inventories outside PADD III are typically flat in the first two months of the year (median 0.8 million; inter-quartile range -2.4 million to +5.1 million barrels) before showing substantial builds in March and April (median 5.4 million; inter-quartile range - 0.8 million to +8.6 million).

NOISY TRADING

In theory, the market should look through these normal seasonal draws and builds to the underlying stock trend. Seasonal stock increases in the first four months of the year should not affect prices, unless the build is much smaller or larger than normal.

The market's apparent over-reaction to stock draws in the final two months of 2010, however, suggests the presence of a significant number of "noise traders", employing a term coined by economist Fisher Black for traders who over-interpret short-term variability in the data, trading on what they think is fundamental information but is in fact random noise.

The noise traders and trend followers who helped propel prices to recent highs above $90, drawing strength in part from stock drawdowns over the last two months, may struggle to generate further enthusiasm and extend the price trend as stocks commence their normal seasonal build up, unless the build up is much smaller than usual.

The prospect of rising stocks could therefore help cool the rally, at least for a few months, as investors and other market participants struggle to look through the seasonal build up to the underlying balance.

The critical threshold is just under 1 million barrels per week. This is the average build in PADD III during January and February, and would confirm the market remains reasonably balanced. If stocks rise more slowly in the next few weeks, prices are likely to burst up through the recent ceiling at $92 and test $100, upping the pressure on Saudi Arabia to add more barrels to the market to stabilise prices.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.