The Conversation (0)
The Commodity Investor looks at the factors that have affected oil prices in Q2 2012.
Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestselling Commodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities.
Global oil prices have been on a free fall during the second quarter of this year. Both Brent and WTI crude are down to yearly lows, with Brent trading at $93 per barrel while WTI hovers around $81 per barrel.
One of the driving forces behind these sharp price drops (remember that earlier this year Brent was trading close to $125 per barrel) is increasing global inventories, especially in the US, still the world’s largest oil market.
Increasing global production
Inventories, both in the US and globally, have increased steadily in recent weeks. Specifically, faced with the prospect of completely removing Iranian oil from the global market as a result of the Iranian oil embargo, many key OPEC producers opened up the spigot and dramatically increased their output. The Kingdom of Saudi Arabia, for example, increased its output by over 10 percent this year alone, and is showing no signs of slowing down.
Other OPEC countries, such as Iraq and the United Arab Emirates, also ramped up production. Indeed, faced with the scenario that Iranian oil will no longer be available on the international market due to economic sanctions against the country, the General Directorate of OPEC decided to increase production among its member states in order to make up for the loss of Iranian oil.
However, as OPEC countries ramped up production, Iranian oil continued to flow out of the country. Just last month, China imported 2.2 million barrels of crude from Iran, which was 39 percent more than the previous month. As a result, not only is excess OPEC crude available on the market, but so is the Iranian crude that was supposed to be locked out. This situation has created an output glut that has helped push Brent prices down by more than $25 per barrel in just a few short months this year.
The United States, the world’s most important oil economy, has also increased its output to levels not seen in over 20 years. Helped by more efficient technological developments (such as horizontal drilling), American oil production is becoming a force to be reckoned with in the market. As a result of this increased production, American inventories are up, which is leading to lower prices.
Indeed, American (and North American) production is at such elevated levels that WTI (a North American crude benchmark) is trading almost $10 per barrel below Brent, its global counterpart. US crude inventories are now sitting at five-year highs, significantly above the historical average. US production is definitely having an impact on lowering crude prices not only in North America but around the world as well.
Slowing global economic growth
In addition to increased production from key producing blocks, the world economy is facing a serious threat of contraction due to the Eurozone crisis. Many market participants believe that the Eurozone has entered into a point of no return economically, with disintegration of the financial and economic fabric right around the corner. While many may dismiss this type of analysis as alarmist and a doomsday scenario, the facts point to a very serious crisis in Europe.
Just last week, Greece held a referendum to determine whether it would remain within the confines of the Eurozone or opt for an exit. While the Greeks opted to remain inside the EU for the time being, this does not preclude them from exiting the EU at a later stage down the line. In addition, the situation has become so serious that Spain had to bail out its fourth-largest bank (Bankia SA) to the tune of 25 billion euros. As if that weren’t enough, Spain itself soon after required a bailout from the EU to the tune of 125 billion euros.
It’s fairly clear that the Eurozone as an entity has become unsustainable. The yield on Spain’s ten-year bond is now at over 7 percent, a rate many in the market believe cannot be sustained for very long. Faced with this serious situation in Europe, many investors remain nervous; this anxiety is manifesting in various forms, including a drop in oil prices and other key industrial commodities.
What’s an investor to do?
The uncertainty in Europe is gripping the markets and creating a lot of fear. Right now, oil has been trading similar to many key commodities and doesn’t show signs of stabilizing. For the time being, it’s tough to call bottom on crude oil prices. However, once we have more visibility I would recommend buying an oil company with a string balance sheet and global exposure to both upstream and downstream activities.
Once we begin to see a turnaround I believe a company such as ExxonMobil (NYSE:XOM) can provide some good value for the prudent investor as it has a global footprint and also a solid management team that has vast experience dealing with global market dislocations. This is a safe place to be while waiting for the storm to pass.
Securities Disclosure: I, Amine Bouchentouf, have no positions in the stocks mentioned.