Oil Market Report May, 2011

Nothing pleases the “man on the street” more than when “experts” are at a loss to explain things and to a certain extent, this is what happened at the beginning of May. Virtually unparalleled price drops had analysts around the world scratching their heads and gazing at the stars for some form of explanation. What huge event had taken place or was about to take place to explain such drops in price? Or was it just what the cynics had always suspected / known; that the evil power of the speculators was simply manipulating markets to their own benefit?

Firstly the facts, because the first few days of May were indeed spectacular. Prices actually began to fall on the last day of April and by the middle of the first week of May, they were in full flow. On the 5th of May, Crude Oil dropped by $7 per barrel and Gasoil (the main European marker grade) fell by $60.25; that’s the biggest single drop in prices in 10 years – bigger than anything experienced in the post-credit crunch era. These falls continued until the middle of the month and more than a few ashen faces were witnessed on trading desks, as memories of Autumn 2008 came flooding back.

The graph below shows just how significant May was in the context of recent history. In fact, the drop in price in May was the 6th biggest monthly price fall over the last 20 years. Excluding the financial crash of Autumn 2008, it was the 2nd biggest drop over the same period.

Oct 08 – Dec 08: Post Credit Crunch abyss. Crude falls from $147 per barrel to $35 in 5 months.

Apr 03 – Iraq War & confidence that US will control Iraq stocks leads to price drop.

May 11 – Price correction?

Sep 06 – US Army hands power over to Iraqi authorities. End of Iraq war in sight.

Nov 05 – Price correction after previous rises following Hurricane Katrina.

Feb 09 – Sting in tail of financial crisis and fears of “double-dip” recession.

Jan 07 – Unrealised fears around impact of Dec 06 Iranian sanctions causes price correction downwards.

Looking at the graph, the period August – December 2008 obviously completely dominates, with a staggering 25ppl drop over a 5 month period, but another interesting point of note is how all the major price drops over the 20 year period have occurred in the last 8 years. Proof if ever was needed say the cynics, that price manipulation and volatility are a disease of recent times. Such a view has some validity, but then again the world has not experienced similar energy demand growth (emanating from China), since perhaps the early / mid 19th Century and Britain’s Industrial Revolution. Plus of course, the higher the oil price, the greater the absolute movements in price, even though in percentage terms they may be small. For example, it would be difficult to see diesel in July 2001 falling by 8ppl, when the starting price was 15ppl (brings tears to your eyes doesn’t it!).

Going back to May, here’s the bad news. By the middle of the month, prices had stabilised and began to slowly creep-up again. By 31st May, diesel had recovered the 5ppl it dropped at the beginning of the month, so that it was only 2.5ppl ppl lower than the 1st May. Like most observers, Portland is at a loss to fully explain the sudden price drops in the early days of May and cannot point to any significant event that stimulated the fall. In the days following, there were rumours that trading stop-loss systems – installed after the massive losses of the credit crunch – kicked-in once prices fell by a certain percentage, thus doubling the effect of the fall (stop-loss systems automatically close all open positions causing a grand sell-off effect). A nice explanation maybe, but one that ignores the significant impact individuals play in managing trading portfolios. Furthermore, to Portland’s knowledge, only 1 or 2 major players in the market have active systems such as these in place.

Far more likely is that the price-drop was a price correction – inevitable after 4 months of price rises, which at times had the look of the pre-credit crunch price bubble. Once the correction took place, there followed cold and steely observations on supply and demand fundamentals, including assessments around OPEC’s mooted production increase in June. As Portland pointed out in last month’s report, there is little evidence to suggest that prices can fall for prolonged periods, as long as the eastern economies continue to boom, Japan looks to stock-up as part of its post-earthquake rebuilding programme and the US / EU take tentative steps to recovery.

So we must be careful what we wish for. From where we sit, prices can only really drop for prolonged periods of time if we have a second economic crash and enter the feared double-dip recessionary phase. That will be bad, bad-news for everyone and so it may well be that high fuel costs are the price we have to pay for economic recovery, job creation and a return to relative prosperity.