Away with jerry cans! Oil bubble is bursting
Comment of the Day

April 18 2012

Commentary by David Fuller

Away with jerry cans! Oil bubble is bursting

This is a lively and topical opinion column (will require subscription registration, PDF also provided) by Nick Butler for the Financial Times. Here is the opening:
One of the great pleasures in life for economists is watching bubbles burst. First the speculative air is pumped in just beyond the point of reason. There is always a trader willing to say that a tulip bulb will soon be worth a million guilders; an investment bank ready to predict $200 oil prices by the end of the year. There is always a looming war or a potential harvest failure to add spurious justification. But the end is inevitably the same. The bubble bursts.

That is what is happening now in the energy market. Sometimes the bubble deflates rapidly, as with the US natural gas price - now at a 10-year low of less than $2 per mmbtu. In other cases the air escapes slowly. That is what has been happening to the oil price since the announcement of a modest fall in Chinese imports.

Once the fall begins it tends to continue. European gas prices are also declining and utilities tied into long-term contracts are struggling to renegotiate terms. If the Japanese succeed in restoring some nuclear power capacity the Asia gas market will follow the downward trend. Simultaneously the important report from the UK's energy department has reopened the door to shale gas development in Britain and perhaps across Europe.

The oil market is also set for a serious adjustment. Iran has backed off from its threats to close the Strait of Hormuz, and another complex negotiating process has begun in Istanbul to find a way in which Israel and Iran can step back from a confrontation neither could win. The sanctions on Iranian oil exports are an important bargaining chip in these negotiations. If there is any progress, Iranian production will come back on to the market.

David Fuller's view There are a number of interesting points in this article that I will comment on but it is not far off the Fullermoney view, although as bubbles go, I would say that oil has been a small one recently. However, there has certainly been an 'Iran premium' in the market which a number of commentators have estimated at about $20. That sounds about right to me in terms of the more expensive Brent benchmark price which does not reflect the shale (tight oil) impact that we see in the US WTI price.

I have often mentioned in recent months that Brent prices were most likely overstating the risk of an air strike against Iran's nuclear facilities. Nevertheless the price is what it is and it has been a headwind for the global economy as we also saw at this time last year.

What also concerned me was that both Brent and WTI were above their trend means approximated by the rising 200-day MAs. They still are but as least we now see some technical evidence of weakening, as I have been mentioning in Audios over the last fortnight. There has clearly been an effort to jawbone the oil price downwards, led by the Obama administration but also with support from more conservative voices expressing concern over the huge volume of oil contracts traded by banks and other speculators relative to oil consumed.

Oil prices have neither come done soon enough nor sufficiently to prevent some damage to the global economy but every 1$ tick lower reduces the headwind. Without a new supply threat this decline can become self-feeding, for a while, as long positions in the petroleum futures markets are unwound.

Nick Butler also mentions the UK's energy department's reopening of the door for shale development, announced this week. This is very good news and if all goes well (minimal evidence of earthquakes) it could lower prices for natural gas in the UK significantly within a year or two, as we have seen in the USA although not to the same extent. Based on earlier statements from France, my guess is that Western Europe will watch developments in the UK and elsewhere before permitting fracking.

For over two years Fullermoney has maintained that energy supplies should be cheaper in real terms than they are today, mainly due to fracking plus renewables and more nuclear in the growth economies. However, while China has abundant reserves of shale gas and shale oil, the country's water shortage poses a significant obstacle to their development. I assume that this problem will be overcome at some point but a viable commercial solution is not yet apparent.

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