What’s driving crude markets: Jon Rigby of UBS

Jonathan Rigby of UBS answered FT.com readers’ questions on where oil prices are going, and what is driving the markets. The full Q&A is here and we’ve picked out a few highlights.

Rigby believes that last year’s price run-up towards $150 a barrel had many causes, including speculation but also a steep rise in oil production costs. He says the recent rise in front-month prices is not justified by fundamentals, although the back-end is driven by the market’s view of longer term fundamentals. No single oil company, he says, is able to manipulate oil prices although some participants with access to storage have been able to profit from contango. Rigby is also sceptical about the importance of ETFs in driving the recent price rise, pointing out their holdings have fallen since February.

There is a price at which long-term supply and demand balance. I think this time last year we were well above it. As is the way with markets, especially ones that have to incorporate the long and short term, we had hugely undershot at the start of this year. Much of the rally this year has been to correct that undershoot but it needed liquidity to return to the market and Opec actions to begin to work. The recent rally is most certainly not demand driven.

One reader asked whether oil could be a leading driver of world inflation, and whether prices would skyrocket if the Fed’s exit strategy was mishandled. Rigby replied:

There is a danger that we do revisit the type of oil price inflation that we saw before the current financial crisis and I think this expectation/fear is what is driving prices higher now that markets have recovered somewhat. In other words the price is looking through the current weak fundamentals.

The startling rise in oil prices to almost $150/bbl was driven by a plethora of things not least speculation and easy money but also widespread cost inflation in many of the cost inputs meaning there was some fundamental justification. Oil is getting more technically difficult and expensive to produce as the industry is moving up the supply curve. The speed at which this takes place when economic recovery returns will be dictated by how quickly we use up existing production capacity, the intensity of energy demand and the technological progress in the industry.

In response to a question about European majors such as Shell having such high dividend yields and continuing to increase their dividend, Rigby pointed out that the increase in the yield was partly a function of the market, via the share price; boards themselves tend to focus on the dividend itself. The yield is increasing, he says, partly because the market is discounting oil companies’ shares because of the risk that the dividend cannot be maintained. He adds:

That is probably a fair approach and the same sort of thinking needs to be applied by boards when setting the dividend as well as the capex. I’m relaxed about companies letting debt rise to pay the dividend in any one year since flexible debt levels, like share buybacks, are a tool for balancing the finances of a company across the cycle but of course it is not a sustainable course of events. One might question whether a rise in dividend this year was the most appropriate course of action and I dont think we will be seeing many others in the next 6-12 months.

On the role of Opec in determining oil prices:

JR: The reason the price doesn’t fall to the marginal cost of production (or further) is primarily Opec but also that the market is able in some degree to differentiate between the short and the long-term and the majority of oil market participants remained conviced right through late 08 and early 09 that prices ultimately would have to rise.

The danger for the market lies in the markedly different economics of existing production where development is a sunk cost and that of future production which requires the up front investment. This is why the industry is so cyclical and arguably (although this isn’t a popular view in the major consuming countries) why Opec actually serves some purpose.

On producers withholding production to benefit from the yield curve:

JR: There are very few instances that I have come across where companies take a view on price and value by holding back production. Obviously when production becomes uneconomic then it gets shut in but the companies have obligations to produce and they don’t have limitless financial capacity so if it is profitable to produce then it generally will be. By and large the companies are reluctant to speculate on oil and gas prices which either in the physical or paper markets. A good example right now is the global gas market where the common view is that gas markets will tighten considerably over the coming year but in the near term new LNG supply is being launched into a fairly fragile market. It is fairly clear that the producers are in no special rush to start-up but equally they don’t seem pursuaded to shut in production now for an indeterminate benefit in perhaps 20 or 30 years time.

Related links:

Crude recovery prospects (FT, 10/08/09)

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