It wasn’t speculators, and it wasn’t fundamentals – at least, not short-term fundamentals.
The key to understanding what has driven crude oil prices since the financial crisis began, according to a new paper by Bassam Fattouh, is what oil market participants chose to believe about long-term fundamentals.
The Oxford Institute of Energy Studies fellow, who wrote a long paper for the world’s energy ministers last month on how oil prices (covered more briefly by us) are determined, argues that 2009 had two unusual characteristics:
- First, it witnessed the sharpest increase in spot oil prices in decades.
- Second, in the second half of 2009, it exhibited a high degree of relative stability despite a very uncertain and volatile global economic environment.
So, how did the stability arise after the tumultuous events of the previous months and years? And what are traders choosing to believe in 2010?
As with his previous paper, Fattouh argues that the ‘speculators versus fundamentals’ argument about oil price drivers is too simplistic. He believes market participants in 2009 were balancing up two concerns: poor outlook for demand, based on the world economic slump, and the knowledge that any pullback in oil production investment would be storing up a price spike in the future.
So, traders chose to focus on the long-term outlook for fundamentals — and also, in Keynesian beauty contest style, on what other traders might expect about that outlook.
But with limited knowledge of what that outlook might be, Fattough writes, market participants converged on some key signals:
These signals originated from various quarters. French President Nicolas Sarkozy and the UK Prime Minister Gordon Brown urged “oil producers to agree a target price range, based on a clearer understanding of the long-term fundamentals… that are not so high as to destroy the prospects of economic growth but not so low as to lead to a slump in investment, as happened in the 1990s”.
Similar signals have also emerged from key oil exporters. In a rare precedent, King Abdullah of Saudi Arabia said in a newspaper interview that he considers $75 to be a “fair” price for a barrel of crude oil. He reiterated his position in December 2009 arguing that “we [the Saudis] expected at the start of the year oil prices between $75 and $80 a barrel and this is a fair price…Oil prices are heading towards stability”.8 The Saudi Oil Minister, Ali Bin Ibrahim Al-Naimi, justified the target price as the “price that marginal producers need to maintain investments sufficient to provide adequate supplies for future oil consumption needs”.
Fattouh concludes by pointing out that there was nothing special about the $70 – $80 consensus towards the end of 2009. So could markets settle on another range?
The answer is yes. There is nothing special about the $70-$80 price range. The market could easily coordinate on a higher or a lower price range. Whether the market will move to a lower or higher price depends on the importance that market participants attach to the possibility that oil market fundamentals will tighten in the future.
The uncertainty around oil markets dynamics, he writes, didn’t deter many analysts from making “bold predictions” about the likelihood of future tightening market fundamentals. Key among these were:
(1) very limited growth in non-OPEC supply due to peak oil and/or over-ground constraints such as geopolitical factors and hardening fiscal terms imposed on oil production; (2) a slowdown in investment in OPEC countries due to a variety of factors such as geopolitical risk, the incapability and/or unwillingness of OPEC countries to invest in their oil sectors in the presence of large spare capacity and amidst demand uncertainty; and (3) a rapid growth in global oil demand fuelled mainly by non-OECD economies.
As prime examples of this, Fattouh points to Goldman Sachs’ note from last year (as reported in FT Energy Source) and the famous Fatih Birol interview in the Independent in which Birol appeared to warn that global oil production would peak by 2020, although subsequently it was pointed out that the reference could be to conventional oil.
The stability seen in the latter months of 2009 benefited both consumers and producers, he writes, but ends with a warning (our emphasis):
Will this convergence of interests be maintained for a long time? Most probably it will not. What market participants fail to appreciate is that this represents a unique period in the history of the oil market and that they should make the most of it while it lasts.