London, 9 August 2011

Oil has sold off as recession fears have mounted. Risky assets have turned sharply lower in recent days as renewed fears of recession have mounted. Yet oil demand growth in the OECD has been moving into negative territory for months already. So how low could oil go in a recession?  BofA Merrill Lynch Global Commodities Research have a few suggestions.

"As we have repeatedly argued, high oil prices are a drag on global economic activity. Brent crude oil prices only stayed above $100/ bbl for 6 months in 2008 and now Brent has held closing prices above $100/bbl since February 9th 2011. In fact, the last two times that energy as a share of global GDP neared 9%, basically the current level, the world economy experienced severe crises: the double dip recession of the 1980s and the Great Recession of 2008," according to  Francisco Blanch, BofA commodity strategist.

How low could oil go under a recessionary scenario?

"On the demand side, a recessionary environment could create an actual oil demand contraction of 0.4 million b/d next year compared to our current baseline projection of positive demand growth of 1.5 million b/d. Similarly, demand in OECD North America could drop by 620 thousand b/d rather than our current projection of a drop of 110 thousand b/d. This drop in consumption would require a substantial output reduction. Where could the cuts come from? Our economists estimate that the Saudi government budget requires $95/bbl to break even this year, and $85/bbl next year. For landlocked North American producers, any drop in WTI crude oil prices below $70/bbl could lead to production shut-ins in Canada," say BofA.

"In a mild recession, Brent stabilizes at $80, WTI at $60/bbl Thus, in a mild recession, we would expect to see Brent crude oil prices briefly breaking below $80/bbl, only to gain back that level as OPEC turns the taps off. In the US, we would see landlocked WTI crude oil prices stabilizing at a much lower level, as OPEC supplies are of little relevance to the supply and demand balances for crude oil in the Midwest. With shale output still projected to increase substantially over the next few months, we believe that WTI crude oil prices could briefly drop to $50/bbl under a recession scenario only to recover back up towards $60/bbl as shale oil output is scaled back."

With fiscal policy constrained, monetary policy is key, contend BofA.  "If oil prices dropped sharply on the back of a recession scenario, how long would it take for them to recover? Well, with fiscal policy clearly on a retrenchment mode, monetary policy could become a key tool. Some Emerging Markets like Turkey are already cutting back interest rates in a pre-emptive fashion even as core inflation pressures continue to bite. With gold prices already moving higher, a recession-driven pullback in Brent crude oil due to economic weakness could be short-lived. Thus, we still lean towards maintaining our average Brent forecast of $114/bbl for next year, despite the growing downside risks."

Ends --

BofA Merrill Lynch Global Commodities Research. www.baml.com