Daily Telegraph: Add oil, and a price dip is suddenly a slippery slope

EXTRACT: Since the end of July, the share price of Royal Dutch Shell has slumped by 11pc…

THE ARTICLE

(Filed: 26/09/2006)

As prices plunge to their lowest levels in months, the effects are being felt well beyond the trading floors, writes Tom Stevenson

Oil prices tumble over fears of US recession

If you were looking for a reason not to jump on the commodities bandwagon, you will have found it in the 23pc fall in the price of oil in the past six weeks. The unpredictable market in black gold is not for the faint of heart.

Since closing at $78.42 on Aug 7, the price of a barrel of oil has plunged, falling under $60 yesterday. It is the first time it has traded below this level since February, and more than a year since oil was cheaper for an extended period. Only a brief rally took it back above $60 late yesterday.

Even by the volatile standards of the oil market, this is a significant correction. It is already bigger than the 16pc slide between September and November last year and is fast catching up with the 24pc plunge in the final quarter of 2004.

The effects are beginning to be felt well beyond the oil trading floors of London and New York. In Britain, the average price of fuel is below 90p a litre. In America, the Federal Reserve, leaving rates unchanged for the second time, cited “reduced impetus from energy prices” as a reason why inflation was likely to ease.

In financial markets, the Amaranth hedge fund lost an eye-watering $6bn betting on the price of natural gas, dragged lower on oil’s coat-tails. In the context of the highly leveraged speculative punts entered into by some hedge funds, a fall of more than 20pc is catastrophic. No wonder short-term traders are in ragged retreat.

A survey of analysts, traders and brokers by Bloomberg last week showed more than half expected prices to fall again this week as Amaranth’s big loss spurred liquidations by other funds.

Oil’s rapid fall reflects a range of factors. Geo-political tensions have eased as both George Bush and Iran’s president Mahmoud Ahmadinejad back off from recent posturing. “Talks are much better than threats and confrontation,” Mr Ahmadinejad told the Washington Post.

Weather worries have receded, too. Last year, Hurricanes Katrina and Rita wreaked havoc in the Gulf of Mexico and the market was priced for a repeat performance this year. So far, the winds have steered clear of the rigs.

As the timing of the two most recent corrections suggest, there is also a seasonal factor at work. The period between the American summer “driving season” and the Northern hemisphere winter is a time for building reserves. As the Department of Energy indicated last week, stockpiles are full to bursting.

“The markets will be unable to ignore all this crude and product sloshing around the world. There’s not one iota of bullish news out there,” said one American trader.

Demand is easing too, as the US economy starts to slow on the back of a weakening housing market and the Chinese rein in their runaway economy. The final reason is the growing influence of financial investors. The rapidity in the pull-back since August reflects the weight of speculative money shifting from long to short.

In part, that has been triggered by the oil price crashing through technical support three weeks ago. According to John Noyce, a technical analyst at Citigroup, when the oil price dived through its 55-week moving average, it set up a target of $55 a barrel. Failure to consolidate there could send oil down to the 200-week average, expected to be about $50 by the year end.

Tony Dolphin, director of strategy at Henderson Global Investors, says: “The two most important effects of lower oil prices, if they are sustained, will be to boost spending power in non-oil producing countries and help lower inflation expectations.”

In the US, Mr Dolphin thinks the Federal Reserve will welcome cheaper oil because it will take the pressure off it to raise rates even as growth is already slowing.

In Europe and the UK, on the other hand, the boost to economic growth might be seen as adding fuel to the fire. “If anything, lower oil prices make it a little more likely that the European Central Bank and the Bank of England raise rates in coming months,” he adds. For most businesses, the oil majors excepted, the fall in the oil price is good news. That hasn’t passed unnoticed in the stock markets. Since the end of July, the share price of Royal Dutch Shell has slumped by 11pc, while that of British Airways, a big oil user, has risen by more than a quarter.

According to Andrew Milligan, global strategist at Standard Life Investments, if you were to strip out energy stocks, the S&P500 would now be safely higher than May’s peak. “The fall in the oil price is being priced in as we speak, but I don’t know if it’s fully priced in yet,” he said.

Key to putting a floor under the price will be how OPEC responds to the slide. The oil producers’ cartel recently held back from cutting production to underpin the price but it left open the possibility that it would do so later in the year. It doesn’t want to see the price fall much further.

Adam Sieminski, chief energy economist at Deutsche Bank in New York, said: “Traders are going to push toward $55 and see what OPEC’s resolve looks like. Look for OPEC ministers to get serious about an emergency meeting and quota cuts.” They may not have to worry. The long-term factors driving the oil price higher have not gone away in the past six weeks.

Demand remains on a relentless upward path, driven by simple arithmetic. There are four times as many Chinese as Americans but each one uses on average only a tenth as much oil. There are 50 times as many cars per head of population in America than China. It will take time, but these differences will narrow.

The other side of the equation shows oil companies struggling to increase production or replace their reserves. Output from producing fields is shrinking at 8pc to 10pc a year. There has not been a serious oil find in 30 years and you don’t need to believe the gloomiest “peak oil” scenarios to accept that the world’s most accessible reserves have already been tapped.

There is no right price for oil, but the bar has been raised. In 2004, BP’s chief executive Lord Browne said $40 a barrel was unsustainable and the real value was $25-$27. What looks more likely now is that oil has found a new trading range, capped at $80 by the knock-on impact on the wider economy but underpinned near $60 by revenue-hungry OPEC producers.
 
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