Oil Price Volatility the Hallmark of 2007…and 2008?

The past year has seen unprecedented oil price volatility. WTI spot crude prices ranged from a low of US$50.51/b in January to a high of US$99.16/b in December. The near-US$50/b swing between the two is the greatest ever recorded in a single year. Such volatility brings to mind the oil shocks of the 1970s and 1980s, but even accepting rising Middle East tensions and a string of refinery problems, the past year was notable for a relative lack of real supply disruptions when compared to the recent past (Iraq war, Hurricane Katrina, Venezuela oil strike). Such unusual volatility then requires a more thorough explanation, and in reviewing the reasons for 2007’s violent price swings, what clues are there for the price path in 2008?

It seems further in the past than 12 months ago, but as recently as late January front-month crude prices were hovering around the US$50/b mark, at the end of a four-month price slide from then-record highs of US$78/b in August 2006. The main culprit for the sharp price fall was an unusually mild winter in the northern hemisphere. Although the global economy continued to hum along happily in 2006 and 2007, with global GDP growing at a rate in excess of 3%, oil demand growth in the fourth quarter of 2006 and first quarter of 2007 was exceptionally low year-on-year. Mid-year forecasts from the International Energy Agency (IEA) overestimated demand for the fourth quarter of 2006 by 740,000 b/d, and by 880,000 b/d for the first quarter of 2007. The reason was almost entirely a result of the mild weather. Although some regions experienced near-normal conditions, overall conditions were far warmer than the historic average. Given the expectations, the lower demand saw inventories rise more strongly than expected and prices slumped. Prices had also surged on rather vague nations of Middle East tensions prompted by Israel’s attack on Lebanon in mid-2006. Although no oil was directly threatened during this conflict, prices surged due to market concerns over the risks of a wider conflict. As these diminished in the following months, so too did paper market buyers, and prices reached a trough in January 2007. OPEC was even debating a quota cut in the first quarter. So what happened between the end of January and mid-December to push prices to just under US$100/b?

The short answer is, a little of everything. Support for prices came in three broad categories: fundamentals; geopolitics; and speculative activity. To make use of a phrase that has never been more popular than in 2007, a “perfect storm” might best describe the factors contributing to oil markets over the past year.

Fundamentals

Despite a benign northern hemisphere winter, markets grew concerned that U.S. gasoline (petrol) stocks were too low at the end of the first quarter. Now an annual event, the early U.S. gasoline panic in 2007 proved longer lasting and more sustained than in previous years, thanks to a string of refinery problems. U.S. commercial gasoline inventories dropped as low as 193 million barrels in April, the lowest recorded for that month since 2001. Gasoline prices promptly rose, and crude prices followed. By April WTI passed the US$66/b mark.

Although global crude inventories remained relatively buoyant through the early part of the year, markets grew increasingly concerned about the possibility of a supply shortage in the second quarter. Strong demand coupled with delays to planned new production and a number of smaller outages contributed to a market where risks were often exaggerated due to a lack of spare capacity. Supply concerns remained a persistent theme, though disruptions actually proved to be less severe than in previous years. While Nigeria continued to suffer continued shut-ins, this was less of an unexpected event than in previous years. Iraqi oil output was sporadic too, though when the 2007 averages are calculated, it is likely that output will be higher overall in 2007 than in any year since Saddam Hussein was removed from power. North Sea production again showed evidence of an increase in the decline rate while there were also concerns over production from Mexico’s giant Cantarell field.

The supply worries were also balanced by the strength of demand, which continued to grow at a rate in excess of 1% per year, and much faster in non-Organisation for Economic Co-operation and Development (OECD) countries. This also takes into account unusually mild winter weather. Given the supply squeeze, the additional demand growth meant the market remained tight. Despite this, the latest IEA data suggest that OECD crude and product inventories will close higher in 2007 than they did in 2006.

Market Sentiment

The oil markets themselves may have proved to be the bigger story in 2007, and the market sentiment appeared to change fundamentally among financial institutions. Given the tight, but not dangerously tight, supply/demand balance, how is a US$50/b price swing explained? One key fact was the role of speculators. Activity on NYMEX and other crude markets accelerated over the year as the “peak oil” theory gained greater acceptance within the banking community. While there is no question that supply and demand, particularly regarding the lighter crudes, is tight, there has not been any real potential for shortages. Nonetheless, speculators for most of the year went long on crude, and the prices followed. Unquestionably the activity exaggerated the price move, but sentiment in the financial community at least appears to have turned in 2007. Sentiment is notoriously fickle though, and things could change yet again if economic worries become real.

There was also a very real element to the sentiment change, this time for oil companies. Cost inflation became a key issue and access to oil and gas reserves tightened once again. Profits for the oil majors did not show the sort of growth the price hike might have led one to believe, as labour costs and raw materials swallowed a substantially higher proportion of capital.

Outlook and Implications

The conundrum with 2007 is the market volatility that was evident without, for the majority of the time, the sort of supply disruptions we have witnessed in the recent past. Certainly a weak U.S. dollar played a role and geopolitical worries are still present, but a US$50/b swing is substantial. Fundamentals and the tight balance are ultimately behind the move, as are rising costs and decreasing access to reserves for the IOCs. However, equally as important for pricing is how the oil world was viewed. In 2007 there was a real shift in the way the financial sector viewed the future of energy. Oil companies are also slowly accepting that rising costs will not dissipate, and a higher crude price floor has arrived. With demand destruction only barely evident at US$99/b, the global economy is more robust than OPEC previously thought. OPEC will now defend a much higher price safe in the knowledge that the economy will not be derailed because of it. Fundamentals should improve in 2008, but a return to sub-US$50/b prices now looks to be a thing of the past.

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