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Sowing the seeds of demand destruction

With Brent trading at an 18-month high, the oil market’s bulls appear to have good reasons to celebrate. But the long-term outlook is far more troubling. A steep correction is on the cards

Talk about irrational exuberance. One minute Greece agrees to more austerity and the next minute global equity, bond and commodity markets react as if the Eurozone has found a way out of debt and the global economy will resume its pre-crisis march towards everlasting prosperity.

Never mind the violent reaction on the streets of Athens or that, with elections looming in Greece, the country’s public could yet wreck the best-laid plans of the Eurozone’s political masters. With central banks continuing to inflate the bubble – the UK pumped another £50 billion ($78.7 billion) of electronic money last week into financial markets – traders are more than willing to keep the party going.

For the past week, Brent crude futures have been hovering at around $118 a barrel, their highest level in more than six months – a gravity-defying act of bravado that, were it not so costly to the global economy, might inspire admiration.

Brent in backwardation

Yet while the Brent market’s backwardation – futures prices lower than prompt – suggests physical tightness in the short-term, the supply and demand fundamentals of the coming quarters ought to give even the market’s most bullish speculators the jitters. The momentum behind a correction is growing by the day.

The reasons for Brent’s strength are, at best, short term. Cold weather in Europe in recent weeks has pushed up demand for heating oil, supporting Brent as well as tightening the discounts between it and other lower-quality crudes. With Iranian oil to disappear from the continent from July, southern European importers of the country’s crude have been buying up similar grades, also tightening the market.

A spat between South Sudan and Sudan has shut in about 350,000 barrels a day (b/d) of exports. (A new deal between South Sudan, Ethiopia and Eritrea, to pipe oil to the sea along a route that avoids Sudan, could solve the dispute, but only in the long term. The same goes for plans to pipe the oil through Kenya.) Political unrest in Nigeria, as ever, is also supporting prices.

In short, Brent’s strength rests on a host of short-term forces and many of them could quickly fade. Iran is the headline political risk that is propping up the market. But that story also looks less bullish than previously thought. To avoid the coming embargo, Iran’s clients in Asia have already begun to make special arrangements, either agreeing to pay the country in alternative currencies (such as Indian rupees), or buying up supplies from other exporters.

Yet Arab producers in the region expect any curtailment of Iranian exports to be brief and easily compensated for. Saudi Arabia, which shares almost the same client base as Iran and is acting once again like a swing producer, has said it will meet any extra requests for its oil. It can quickly increase output to 11.8 million b/d to compensate for any loss in Iranian volumes – the country produced 9.6 million b/d in January according to Opec.

The International Energy Agency (IEA) is understood to have discussed an emergency stock release, too. Iran produces around 3.5 million b/d – a hefty amount to go missing. But any curtailment of its exports will, it seems, have less of an impact on the market than the shutting down of Libya’s 1.6 million b/d of production last year.

Extra oil on the way

Meanwhile, Opec’s last agreement, which some in the market interpreted to be a 30 million b/d ceiling on output, has already been smashed: the group is producing almost 31 million b/d. Nigeria and Angola are likely to increase their supply in coming months. Libya’s continues to grow and has likely already exceeded 1.3 million b/d, according to internal sources – that puts it well above either Opec or the IEA’s figures for its production in January.

Non-Opec production, which has been hampered by a string of short-term factors – maintenance in the North Sea, for example – is on an upward trend, too. The IEA expects almost 1 million b/d of growth from that segment in 2012.

So there’s extra oil coming. In fact, after the tightness seen in the market in the previous quarters, there’s a sloshy look to the supply/demand balance over the next few months. Having effectively opened the taps at its meeting in December, Opec will exceed the call on its crude by up to 2 million b/d in the next two quarters.

Those extra barrels could emerge just as the demand data begin to get ugly for producers. In their latest monthly market outlooks, both Opec and the IEA say consumption for 2012 will grow less than previously thought. Reflecting the IMF’s downgrading of global economic growth for the year, which it now says will be 3.3% against 4.0%, the IEA reckons oil consumption will grow to 89.9 million b/d, an 800,000 b/d gain, but down by 300,000 b/d from its projection in January. Opec, usually the more conservative forecaster, sees a 120,000 b/d trimming of demand growth, which will rise by 900,000 b/d to 88.76 million b/d.

As far as revisions go, those forecasts suggest a significant slowdown in global demand. But they may not go far enough. Both of them still see non-OECD demand picking up the slack caused by sluggish consumption in the rich world. The IEA reckons non-OECD countries will increase demand by 1.2 million b/d in 2012 (2.8% growth), “more than offsetting the reduction in OECD consumption of 400,000 b/d, mimicking the trends seen in 2011”.

US demand in freefall

Maybe. But more recent weekly data, especially from the US, already throw the IEA’s outlook into question. Responding to record-high gasoline prices, US demand is in freefall. At the beginning of the month, the government’s Energy Information Administration said oil consumption dropped in the last week of January by 6%, to 17.65 million b/d – the lowest level in 13 years. US crude oil stocks are now back above the five-year average. (The IEA’s own data for US oil demand in December also support this trend, pointing to a 5.5% year-on-year drop.)

The IEA puts US oil consumption last year at 18.89 million b/d. If demand softens during the coming year, even by half the rate it fell in the last week of January, that would wipe around 560,000 b/d from the country’s total. To put that into context, the IEA expects Chinese demand to grow by 400,000 b/d in 2012. If the US economic recovery is to be an oil-less one, and consumption continues to weaken, the fall will more than compensate for the extra barrels sought by China.

Increased demand from India and other emerging markets may help boost the total – but consumption in the big five oil consumers of the EU (France, Germany, Italy, Spain and the UK), may also fall more steeply than by the 230,000 b/d dip, or 2.65%, expected by the IEA. Demand for transport fuel in the UK, for example, is sliding at roughly the same rate as in the US – it fell by almost 6% in the 12 months to November 2011.

There’s plenty of wiggle room in the data about China, too. Its economic prospects in 2012 may rest on a recovery in Europe, its largest export market. Inflation worries may discourage more loosening of credit to stimulate the economy. The IEA takes the IMF’s forecast of 8.2% GDP growth in China for 2012 and says its oil consumption will rise by 3.9%. But it also says apparent demand in the fourth quarter of 2011 suggested “near stagnation” – the result either of fourth-quarter 2010’s unusually high consumption figure, or a general flattening of the country’s demand. And if Europe goes pear-shaped, says the IMF, Chinese GDP growth could fall by half the rate expected.

There are known unknowns with China’s demand figures, too. The biggest is the impact on its demand of any imports for stock-building. State-owned CNPC has two new stock farms, each capable of holding 18.9 million barrels of oil, and they are ready to be filled. The IEA reckons some 79 million barrels of capacity could be looking for crude during 2012, equivalent to 220,000 b/d of demand. With the embargo against Iran coming in July, China may be in the mood to fill its boots now. That would boost global demand in the next two quarters, but give a misleading picture about China’s economic health, or its population’s demand for oil.

Uncertain global outlook

Above all, with so much uncertainty about the global economic outlook, the projections for demand growth in 2012 should be treated with caution. GDP growth last year came in at 3.7%, well beneath the 5% growth of 2010, and supported extra oil consumption of 700,000 b/d. This year’s forecast of 3.3% growth (5.7% from non-OECD countries and just 1.1% in the OECD) represents another deceleration – but the IEA expects oil demand to grow by roughly the same volume (800,000 b/d) again. It’s a bold statement of faith in the emerging economies of the world, but don’t be surprised when the revisions start coming in later this year.

So the market could be on the cusp of a demand-led correction. Consumption in the fourth quarter of 2011 suggests that the stagnation may already be under way: at 89.8 million b/d, it was 5,000 b/d beneath the same quarter’s figure in 2010, and won’t start growing again until the third quarter of this year.

That makes sense to anyone who drives a vehicle in a country where generous governments don’t subsidise consumption. Fuel prices are soaring. In the US, gasoline prices averaged $3.48 a gallon for the week ending 6 February – their highest-ever level for that time of year.

Suddenly, even Opec is endorsing the argument that high prices are hurting demand. “Firming retail petroleum prices are expected to have a negative impact on oil demand across the globe,” the cartel said in its monthly report. “The transportation and industrial sectors are the ones most affected.”

Opec has for months maintained that a Brent price above $100/b posed no danger either to demand or the world economy. So its belated concern about the impact of soaring prices on consumption is telling.

It should also raise questions in the mind of the market’s bulls. Open interest in Ice Brent contracts continues to rise and money continues to flow into oil-futures markets. The market position of money managers – banks and financial speculators – remains long: at 212,000 contracts, by some distance the biggest position in Nymex’s WTI futures market.

Misplaced optimism

But their optimism increasingly looks misplaced. Beware the triggers for a sell-off, which could come from any direction: renewed strengthening of the dollar, on the back of the Euro’s weakness or a stronger US economy; news of a bargain with Iran; the collapse of Greece’s debt deal; or, most likely of all, more weak demand data. With prices hurting consumption, even another market rally would quickly sow the seeds of its own destruction.

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