Crude USD120- A bit too early

At the outset I would like to apologies for not updating the blog. Over the last couple of months there has been something that has been worrying me and it is the sporadic rise in the price of crude oil. By any stretch of imagination the recent rally looks out of place. I would not argue to the fact that yes crude oil market is in a secular bull run and the Bull Run in crude has always had its own share of hysteria but to me it has gone a bit too far this time. I have had an uneasy feeling since the time prices crossed USD90 and it has been growing since then. When I look at the fundamental situation at present in the market doesn't justify such a rally. It has been the financial flows which have been the largest culprit maybe a study of behavioral finance can put some light on the rally. The rally started with a free fall of the USD and as usually geo political tensions in the Middle East. These two have been the biggest driver and have also been supported by the tightness in the distillate markets, slowing imports and huge financial flows into the market.

According to me somewhere near 20-30% of the crude price is purely speculation and nothing else and I believe that it is largely driven today by large banks and hedge funds. I am not really a great exponent of the theory that weakness in the USD should strengthen the crude oil price. I tried to run regression on the time series of USD and Oil and even by historical standards it looks 10% over stretched. Going by the dollar weakness theory with the recent strength in dollar crude oil prices should be coming down but it continues to go up. Which means that is not a full proof theory to trade crude oil with.

Another thing that worries me is the excessive geopolitical premium in the price of crude which never seems to go off even when the geopolitical tension has subsided. Over the last 6 months or so there were events in Middle East and Africa and currently there is peace in both these places but the premium has not shaved off from the price of oil. When you look at both these factors alone there is nearly 20-25% excessive premium in the price of oil. Which means that oil price should have been around 100$ when I remove excessive premium out of the price. Still I haven’t really analysed speculative premium in the market though there has been a brief consensus amongst lot of participants off the record that there is some speculation which has led to the price rise. This trend is pretty evident with the CFTC data released every week.

When I look at the fundamentals of the market it surely gives me a sense of tightness in demand and supply but not as tight as the prices are showing them to be. The price rise in oil is a function of what is going to happen to supply and demand in future. When I look at the data available from various oil producing countries there is nearly 11-12 million barrels of oil is likely to come on track. In 2008 alone it is estimated that nearly 5 million barrels of oil would be on track. So honestly its not as tight as it has been shown to be. Yes there is peak supply on the cards but things are moving too fast in terms of prices. Even with the estimate that 25% of the projects are behind schedule at least 3.5 million barrels would be on track and that is likely to take the spare capacities above 3 million barrels. Also to some extent there has been artificial demand supply tightness created by some parties. There is a catch when you look closely at the demand supply and refinery throughputs figures. The overall crude supply in the market is 87 million barrels per day whereas the demand is at 86.6 mbpd and only 74 mbpd goes into refineries for refining into products which means that nearly 12 mbpd of oil is going into various coffers as inventories. We have already seen oil been stocked by US and China into their strategic petroleum reserves (SPR). The question is that why does US who has increased their SPR from 500 mb to 700 mb in 2-3 years needs to be buying oil above USD 100 for their SPR. Also the economics of business is playing an important role since the refineries are not making profits as it was making earlier due to high crude prices they r not refining enough products and creating shortage of products which has led to rise in price of crude and products. Also with prices consistently above USD 80 it gives lot of space for the non traditional oil producers to come out with the new kind of oil where the cost of production is roughly 40-50$ and an IRR of 17% it would still give them handsome profits. One more point is worth looking at is when crude was at USD 70 there was a huge cry about alternate source of energy and ethanol now when crude is above USD 100 I haven’t heard anything about them.

When I look at all these factors it surely feels that there is more to demand and supply in this market that is driving prices. I feel it’s the financial flow and the need for an alternate investment avenue for investors in wake of global financial turmoil is pushing prices. I feel the the realistic price of oil should be between $85-$90