Rising crude oil prices a signal that it's time to shift to other fuels

Crude oil prices continue to climb despite attempts by oil producers to reassure the market about availability and the existence of enough spare capacity to offset oil lost as a result of US sanctions on Iran.

Recent price moves bear a strong resemblance to previous price spikes in 2007-2008 and 2010-2012, especially if prices are expressed in euros or yen to eliminate the impact of a stronger dollar this time around.

Brent crude has risen to almost 75 euros per barrel, the same level it reached in May 2008, on its way to a peak of 93 euros in July 2008.

Front-month futures have also hit 9,800 yen per barrel, the same as in October 2007, on their way to a peak of 15,300 yen in July 2008.

Prices in Indian rupees are already at the same level that they peaked in 2008 and on the way to the record set in 2013.

Only the strength of the dollar against other currencies is masking how high prices have become in oil-consuming countries outside the United States.

Prices have already risen to a level that has contributed to a slowdown in economic growth and oil consumption in the past.

“Expensive energy is back at a bad time for the global economy,” the chief executive of the International Energy Agency has warned (“IEA boss urges oil producers to ease supply concerns”, Reuters, Oct. 4).

“It is now high time for all the players, especially those key producers and oil exporters, to consider the situation and take the right steps to comfort the market,” he added.

The blame-shifting game is well underway, with the United States blaming OPEC, Russia faulting US sanctions, and Saudi Arabia blaming speculators for escalating prices.

In reality, US sanctions, output restrictions by OPEC and its allies, strong consumption growth and position building among the hedge funds have all contributed to the price surge.

Aggressive implementation of US sanctions on Iran has left refiners and traders concerned about the future availability of crude and questioning whether OPEC will still have enough spare capacity to offset any other losses.

OPEC and its allies became fixated on cutting oil inventories down to the five-year average and waited far too long to start exiting from production curbs, causing the market to overtighten.

And oil consumption has grown much faster than most analysts forecast at the start of the year, while many non-OPEC sources of supply have risen more slowly than expected.

Despite communications between policymakers in the United States, Saudi Arabia and Russia to synchronize output increases with the re-introduction of sanctions there seem to have been a series of misunderstandings.

Policymakers appear to have misjudged how quickly the United States would try to cut Iran’s exports and how rapidly other OPEC and non-OPEC producers could fill the gap.

Sensing the market is moving into a cyclical period of under-supply and low spare capacity, hedge funds and other money managers have built bullish long positions, accelerating and exaggerating the price adjustment.

LOCKED MARKET

The oil market has become locked in an upward price trend as hedge funds and market makers all try to maintain neutral or long positions and few speculative players are willing to take the short side of the market.

Hedge funds and other money managers have accumulated bullish long positions betting on a further rise in prices amounting to almost 1.2 billion barrels of oil.

At the same time, the number of short positions in the six most important petroleum futures and options contracts has fallen to its lowest level since before 2013.

The imbalance between bullish and bearish positions is close to a record, an analysis of regulatory and exchange data showed.

Lopsided positioning has often been the precursor to a sharp reversal in the price trend when fund managers attempt to realize profits by closing some positions.

The impact of lopsided positioning on the evolution of prices has been explored by researchers including the physicist Didier Sornette (“Why stock markets crash: critical events in complex financial systems”, 2017).

But while lopsided positioning is a key signal for a future price reversal it does not indicate how quickly that reversal will take place and at what price level it will occur.

In 2007/08, oil prices continued trending higher for some months, even as analysts warned they had become unsustainable.

Oil prices tend to overshoot on the upside (2008 and 2011) just as they have done on the downside (1998, 2009 and 2016) before correcting.

Typically, prices peak only once there is clear evidence of a slowdown in oil consumption growth and/or OPEC producers come under intense political pressure to increase production.

In the meantime, oil prices have risen to a level that is sending a strong signal to non-dollar consumers about the need to increase efficiency, reduce use and switch to alternative fuels.

(John Kemp is a Reuters market analyst. The views expressed are his own)