August 28, 2011
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№ 6 (June 2011)

US-Saudi-IEA Cooperate to Set Best Oil Price

IEA action hit oil. The main event in the oil market last week was the surprise announcement from the International Energy Agency that member countries would release 60 million barrels from strategic reserves in order to alleviate supply concerns. The net result was a sharp reversal of the oil price with one-month Brent closing Friday at $105.12 p/bbl and WTI ending at $91.16 p/bbl.

By Chris Weafer, Chief Strategist, UralSib Bank

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The sudden oil price drop resulted in a drop of 2.6% for the RTS Index on Thursday and while the equity market did rally with the global trend in emerging markets on Friday (+1.5%) the over $2 p/bbl loss for Brent by Friday’s close will keep investor sentiment at least cautious as the new week starts.

The oil and Russia relationship remains close. Given how closely linked, i.e. over the short-term, is investor sentiment towards Russia and the price of crude, where oil trades next week will again be one of the major factors determining where Moscow’s bourses, and the ruble, over the short-term.
 
More than one factor at play. Looking at where oil may trade, there are a number of important factors to take into account. The IEA decision was a catalyst for the sudden oil price fall on Thursday but it was not the only reason. If it was then we could expect a relatively quick rally in the price as 60 million barrels is less than half the total oil exports lost from Libya this year and that disruption looks far from a resolution
 
An adjustment down
 
Three other reasons. The main reasons for a weaker oil price, i.e. why oil (Brent) may trade closer to $100 p/bbl than $120 p/bbl in coming months, are threefold;
 
1. Global demand has eased as economic recovery in the US (the world’s biggest oil consumer) and elsewhere continues to be more sluggish than previously expected. The US Fed last week slightly downgraded its GDP forecast for 2011 while not long ago investors had hoped for an upgrade.
 
2. The dollar has rallied despite the likelihood that the US Fed will keep the current low interest rate unchanged this year. A major reason for that is the negative sentiment towards the euro as the regions sovereign debt crisis continues to worsen. The stronger dollar also eases price pressure on oil and on other commodities
 
3. The threat of a further contagion of the internal conflicts in Libya, Syria and Yemen to another oil producing country is now negligible. Bahrain’s neighbours have helped cap the instability in that country and Saudi Arabia has used an aggressive carrot and stick approach to prevent any problems in the Kingdom. Longer term few people believe that Saudi can prevent major internal problems and, possibly, some oil disruption. But that threat seems very low for now.
 
US-Saudi interests are again aligned
 
Neither Saudi nor the US wants too low or too high. It is also important to understand the coordinated actions of the US and Saudi Arabia as they try to establish a more stable – and predictable - oil price. It is in neither country’s interest to either have the oil price fall so low that the threat of major instability in Saudi Arabia increases or, so high that it risks demand destruction and an even faster economic growth reversal. The US and Saudi took a similar action in the early 1980’s when it was agreed that Saudi would act as “swing producer” to maintain an orderly oil market with a price average target of approximately $20 p/bbl (Brent). It worked fine; for the two decades in the ‘80’s and ‘90’s, the price of Brent averaged just under $20 p/bbl. That coordination was blown away with the 1st Gulf war and the emergence of Russia as the world’s biggest producer/exporter.
 
Important questions. Reports over the past few days suggest that the US and Saudi authorities are again coordinating efforts to try and create more stability and, importantly, predictability in the oil market. The important questions are “what is the new price average that they may try to achieve” and “can they achieve that goal again this time”?
 
What average this time?
 
Saudi needs close to $100 Brent. Before the so-called Arab Spring uprisings, Saudi’s oil minister was regularly quoted as saying that the right price average for (Brent) crude was around $80 p/bbl. Since then, the government in Riyadh has thrown billions of dollars of extra spending into social programmes in order to try and head off any spread of the instability seen in Libya, Egypt, Syria, Bahrain, etc. Saudi Arabia has one of the fastest growing populations in the world and one of the highest rates of unemployment amongst 18-30 year old men. The Muslim Brotherhood, for all of its conciliatory talk in Egypt, has a very specific and long-held objective of establishing control over The Arabian Peninsula. Bottom line is that the Saudi government dare not cut back on the new social spending and its budget now needs close to $100 p/bbl (average Brent) to balance.
 
Consumers could live with $100 Brent. The US, and consuming economies generally, could probably live with that average over the longer term. Demand destruction would be relatively mild and that price would also support the commercial case for new oil developments and exploration in, e.g. offshore Brazil, the Caspian, the Arctic, offshore West Africa and in the Gulf of Mexico.
 
Creates a backdrop for lower oil through the 2nd half. Such an “agreement” would also provide a much-needed boost to global economies for the rest of this year. The average price of Brent in 2011 to date is approximately $110 p/bbl, which means that the average for the rest of the year needs only be approximately $90 p/bbl to allow for a full year average of approximately $100 p/bbl.
 
Can it be achieved?
 
Saudi success in OPEC would have made it easier. Predicting the short to medium price trend for oil is more often an exercise in speculative conjecture. Actual physical supply and demand play a part, as does investor sentiment and the purchasing power of the dollar. Saudi Arabia was in a good position, along with Kuwait and the UAE, to regulate the market through the 1980’s and 1990’s, albeit there was still lots of short to medium term volatility. Had Saudi succeeded in getting OPEC member agreement to raise the official quota at the recent meeting in Vienna then its position would again have been strengthened. The triumvirate of Saudi, UAE and Kuwait account for by far the biggest portion of the above-quote oil production and converting that into an extra “official quota” would have left the sub-group in a strong position to regulate the market. Of course they can still do that but the risk is that Iran and anti-western Islamic groups may accuse them of pro-western action.
 
Bottom Line
 
Mid East risks still remain. The US-Saudi-IEA action adds a new dynamic to the oil market, i.e. as does the slower than expected growth in the US economy. All else being otherwise equal, it does suggest that the price of Brent is more likely to drift back towards $100 p/bbl and with a good chance of a period, in the summer and early autumn, when the price trades in the $90 to $100 p/bbl range. But even that is a tough call because of the unpredictability of global macro trends and the still unresolved issues in the Middle East. The holy month of Ramadan – the full month of August this year – may be a period of heightened risk as religious fervour is highest.
 
Speculators will be more wary. But, what recent events strongly suggest is;
 
a) If oil (Brent) again spikes up toward $120 p/bbl, the IEA may add more oil from strategic reserves to cool the price. That prospect will make traders and speculative investors a lot more cautious than they have been,
 
b) If the price of oil (Brent) drop below $90 p/bbl in the coming months then Saudi Arabia, along with Kuwait and the UAE, will likely quickly cut production to keep the price above $90 p/bbl in the 2nd half and above $100 p/bbl towards the end of the year.
 
Implications for Russia
 
Russia benefits from stable and moderate oil. Maintaining an average oil (Brent) price anywhere in the $90 to $110 p/bbl range would be near ideal for Russia. A lower average price would mean a rising budget deficit while a higher price puts upward pressure on domestic inflation and leads to a loss of competitiveness as the ruble rises. Russia will not participate in any price control mechanism, i.e. oil output will remain at maximum, so, as has been the case for the past decade, Russia’s budget will continue to benefit from Saudi Arabia’s oil price management.
 
Less global risk would help Russian market values. The implications for the stock market are also generally positive, i.e. apart from the predictable short-term reaction to any oil price volatility. More importantly, a more stable oil (Brent) price in that $90 to $110 p/bbl range would provide a boost to the global economy and ease risk aversion in markets. Investor sentiment towards Russia would benefit from that, as investors would be better able to focus on the improving domestic economy and the next phase of the government’s economic development strategy.
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