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Oppenheimer Holdings Inc
Oil prices got another push lower this week as talks with Iran over its nuclear program appear to be progressing. For the first time in five years, it looks like the International Atomic Energy Agency will have access to the country’s Parchin military complex, easing concerns about an eventual Iranian supply disruption.
Five months ago the market was terrified about the possibility of war with Iran and the effect this would have on the world’s oil supply. Just to be sure they were ahead of the curve, oil speculators piled into futures contracts like crazy, pricing at the equivalent of a nine-month Iranian supply disruption by early March. Now that the threat seems to be dissipating (and Europe is deteriorating again, further depressing demand), speculators are rushing for the exits, liquidating their net long positions by more than half since peaking in March. So in the span of eight months, largely because of threats that never materialized, the price of oil jumped more than 30 percent, only to fall about 16 percent. Isn’t that a bit like the boy who cried wolf? Or Chicken Little? Probably, but that’s the nature of the futures market. Better to discover the price early than late, or so they say.
As threats over Iran have waned, and the euro crisis has picked up steam, the oil market has refocused on actual supply-demand fundamentals—which don’t come close to supporting oil at its current price. “If you remove the speculators, supply and demand fundamentals support oil prices at barely $80,” says Fadel Gheit, an oil and gas analyst at Oppenheimer (OPY). On Wednesday the price of West Texas Intermediate oil, the benchmark for North American crude, fell to less than $90 for the first time since November, as U.S. oil supplies rose to a 22-year high. WTI has largely been immune from international chaos, which has been more reflected in the price of Brent crude, the international benchmark oil contract. Brent has shed nearly $15 this month and closed just above $107 on Wednesday.
But here’s where it really gets weird. From a pure science perspective, there’s still a total disconnect between the price of oil and the price of natural gas. A barrel of oil contains about 6 million BTUs of energy; 1,000 cubic feet of natural gas contain about 1 million BTUs. That means on a pure unit of energy measurement, a barrel of oil should be about 6 times more expensive than 1,000 cubic feet of natural gas, a 6 to 1 price ratio. So if natural gas is trading at $2.72 per million BTUs, which it is, then a barrel of oil should be about $16.
Of course, that’s a reflection of perfect parity and doesn’t take into consideration such things as transportation and extraction costs. Or supply and demand, for that matter. The world doesn’t function in a vacuum. But if you go back over the past 20 years, that price ratio stayed mostly consistent, hovering around 10 to 1 from the early 1990s until about 2009. During the past two years, though, as the price of oil has risen and natural gas has tanked, the ratio has spiked, peaking to almost 50 to 1 this spring.
“It’s a very quirky situation,” says Gheit. “It’s like having a hailstorm when the sun is shining. You cannot model it or make a bet on it. It’s completely unpredictable.”
That ratio has gone off kilter for several reasons. For one, natural gas supplies have far outpaced our ability to use the stuff. The U.S. is still in the early stages of retooling its economy around natural gas. Also, the warm winter cut way down on demand for natural gas, which has pushed supplies up and prices down. At the same time, oil rebounded steadily from its lows in early 2009 as global demand ramped up (the world was coming out of recession) and as chaos in the Middle East fueled fears of supply shortages.