London, 5 February 2010

Volatility in the NYMEX front month crude oil contract has dropped to the lowest for more than two years, and some of the lowest levels at any time since 1996. The market's remarkable stability appears to be the product of a number of factors.

Spot market trading has been confined in a relatively narrow $65-85 per barrel range since Aug 2009, with news flow causing only small day-to-day disturbances. The market seems comfortable trading around $75. It is an equilibrium that satisfies most producers and consumers -- high enough to incentivise new investment in fossil fuels and clean energy, without triggering too much demand destruction.

Close-to-close volatility has been declining more or less continuously since peaking at the height of the banking and financial crisis in January 2009, but in the 30 days ending February it hit a new low of 26.01 percent (Chart 1).

Current volatility is the lowest since the autumn of 2007. In fact, daily price changes have been some of the smallest since 1996. Present volatility is ranked at just the tenth percentile for the whole period (Chart 2).

MARKET FINDS SWEET SPOT

The market's remarkable stability appears to be the product of a number of factors:

(1) Prices are high enough to satisfy key producer governments (notably Saudi Arabia). Current levels are sufficient to incentivise investment in new capacity and provide adequate fiscal revenues for social and capital programmes, while balancing demand destruction in the OECD economies with demand growth in emerging markets such as China.

(2) The Saudi government has shown its willingness and now has the means to stabilise market prices around current levels, at least in the short term, owing to the generous cushion of spare capacity. OPEC nations are currently holding around 4.5 million barrels per day of spare production capacity, according to the U.S. Energy Information Administration ( EIA), most of it in Saudi Arabia.

(3) Inventories remain comfortable, with no real prospect of a shortfall in either crude or refined products for at least twelve months. There is enough stock at all levels (crude, gasoline, distillates) to provide a comfortable cushion against unexpected refinery outages or a surge in demand linked to the weather, a sudden spurt of growth in emerging markets, or an unexpectedly strong recovery in the advanced economies.

(4) Cashflow is sufficient to cover exploration, development and production for enough conventional and unconventional projects to meet demand for the foreseeable future. BP Chief Executive Tony Hayward confimrmed $74 is a "very comfortable" price for the company, in a Reuters Television interview.

(5) The current stability of prices is itself a huge benefit for the oil companies because it makes planning and investment far easier. Most would much prefer a stable price around $75 than an unstable one gyrating around $100- 120.

(6) Prices are broadly in line with consumer country objectives -- high enough to support their efforts to reduce greenhouse gas emissions and roll out a new generation of clean technologies, but not so high that conservation and substitution efforts are accelerated.

PRICE VIEWS HAVE CONVERGED

Most consumer countries do not want to see oil prices collapse back to less than $50 per barrel. While it would produce a short-term growth stimulus and fillip for real household incomes, it would also discourage investment in nuclear, gas and renewable power generation, and retard deployment of energy efficiency technologies crucial to lessening long-term dependence on oil imports and meeting emissions targets.

For the first time, there is a rough consensus between producer and consumer countries about the desirability of stabilising prices around current levels. Prices around $75 deliver the security of supply the OECD countries want while promising the security of demand OPEC needs to maintain and increase output.

The price also seems to reflect a rough consensus in the market. While prices appear generous given the high level of inventories and spare capacity ("current fundamentals") the market has become increasingly forward-looking as a result of the influx of investment money and prices are increasingly set with reference to the medium term ("expected fundamentals"). On a medium term basis, $75 looks sustainable.

DEMAND TO PEAK BEFORE SUPPLY

The panic about "peak oil" seems to have receded. It has been evident for some time the total hydrocarbon reserve (including natural gas and coal, as well as shale oil, bitumen and conventional oil from unconventional fields or enhanced recovery methods) will provide plentiful energy into the distant future. The question is engineering and price not physical availability.

But there is now an increasing recognition that demand itself will peak. Crude consumption in the OECD economies has already peaked and is unlikely to exceed 2007 levels in future. But senior policymakers and executives are now starting to talk about a global demand peak sometime between 2020 and 2030 as emissions controls and energy efficiency programmes bite into demand in emerging markets as well as the advanced economies. 95 and 110 million barrels per day (compared with around 85 million currently). "World demand will peak before its supply because there is plenty of oil in the world, there really is," he said in an interview on BBC Radio 4.

As the peak oil panic gives way to a more nuanced view, it removes one of the factors underpinning the expectation of ever-rising real oil prices that drove the 2008 price spike and the more ambitious forecasts about price increases in the next 5-10 years.

NEW "BANDS OF BELIEF" EMERGING

Like other commodities, crude oil prices display strong mean-reverting properties (stabilising in response to temporary shocks) often for quite extended periods, until a structural break occurs (something that alters the structure of supply and demand permanently). Volatility is often higher after a structural break as the market tries to find a new trading range.

In response, market participants (traders, investors, producers and consumers) form what Paul Stevens, formerly professor of petroleum policy at the University of Dundee and now senior research fellow at Chatham House, has termed "bands of belief". These psychological boundaries inform perceptions about what constitutes the maximum sustainable high and low price, and the likely trading range (www.cass.city. ac.uk/conferences/energy/files/Paul%20Stevens.pdf).

Bands of belief tend to reinforce the mean-reverting properties of the market, until they are shattered by a structural change. Throughout the 1990s, the bands of belief appeared stable around $15-25 per barrel. But they were shattered by the relentless price increases between 2003 and H1 2008. Following the structural break market participants have struggled to form a stable and reasonably widespread view about what constitutes the likely trading range.

Recent price stability, underpinned by a variety of cost and demand-side factors, as well as a rough convergence of views between producer and consumer countries, might signal a new set of bands emerging around $65-85.

Of course bands are more obvious in retrospect. Even then prices can travel outside them substantially as a result of temporary shocks and cyclical factors. And bands are themselves subject to further structural breaks which are never obvious except after the event.

Saying prices might stabilise around $65-85 does not preclude prices moving above or below this level, even for extended periods. But it does suggest that the market might be finding a new equilibrium after groping blindly for five years.

Ends --

By John Kemp, Reuters columnist. The views expressed are his own.