Oil prices may be falling, but how long can we expect them to stay low?
Writing in today’s FT, Daniel Yergin, Chairman of Cambridge Energy Research Associates, warns that lower prices will force energy companies to scale back their budgets and hold back on new projects (fossil and green).
This will make itself felt in a new turn of the cycle after an economic recovery. In the meantime, it is not only investment in new oil and gas and electric power projects that will be restrained. The energy policies of the new US administration, as in other countries, will emphasise greater energy efficiency and renewables. A “green stimulus programme” is already high on the transition agenda. But the worried question around Washington now is: to what degree lower prices will crimp investment in renewables and efficiency.
Goldman Sachs catches onto this theme in their latest note. They’re noting the intensification of the contango structure of the forward curve (the price of oil into the future). The contango has been steepening, with most analysts attributing it largely to three factors: A supply glut at the front end of the curve, the higher cost of financing into the future, and the belief that tightness may return to the market soon – a fact ever realised by the abandonment of projects by Independent and National oil companies.
According to Goldman though the steepening has more to do with credit constraints than anything else. They write:
While historically these extreme degrees of contango, often referred to as super-contango, are associated with full inventories and therefore due to constraints on available storage, this time they are likely attributable to constraints on available credit. This indicates that the impact of the credit crunch on the oil market is not waning and continues to exacerbate the pressure on prices coming from weakening economic fundamentals.
Credit constraints are not only distorting the incentives to hold inventories but also limiting the ability to close arbitrage opportunities along the forward curve. The recent worsening of the dislocation in the oil forward curve indicates that the impact of the credit crunch on the oil market is not waning to any significant degree and continues to exacerbate the pressure on prices coming from weakening economic fundamentals.
They highlight the fact that timespreads have now breached the limit typically set by the cost-of-carry, which means those buying oil in the future are willing to pay a premium beyond and above the cost-of-carry and storage of oil bought today in the spot market.
Goldman says that in the past 20 years this has only happened in 1998 and temporarily at the end of 2001 and 2006. Each of those times, storage capacity was an issue. There wasn’t enough of it available meaning if you wanted to buy oil today to store and sell into tomorrow, you expected a premium for your efforts. But there is no such storage shortage today. The reason people are expecting a premium to sell oil into the future this time is due to limited access to credit and strong preference for cash.
As this intensifies Goldman says producers will be increasingly incentivised to shut-in their own production.
As the contango gets steeper, breaching the cost-of-carry, it becomes ever clearer that the structure of the forward curve is providing incentives for the highest-cost form of storage,
namely production shut-ins. The “underground storage” is typically considered the most expensive because of the costs associated with shut-ins and start-ups of the oil fields and,
more importantly, because it is normally far from the refinery centers.
This provides incentives for OPEC in particular to abide by their promised production cuts. The same goes for non-OPEC producers like Mexico, with news today the producer has taken steps to protect itself from further oil-price downside by locking in sales at $70 a barrel along the forward curve. According to the FT, Mexico has paid about $1.5bn for the benefit of doing so. Certainly no small financing pressure for an emerging market in time like this. The FT reports:
The cover is far higher than the country – which relies on oil for up to 40 per cent of government revenue – usually seeks. Last year, Mexico hedged 20-30 per cent of its exports.
But even with OPEC producers shutting in, Goldman doesn’t foresee any strength returning to the price of crude until at least January 2009.