OPEC's Mountain To Climb

NEW YORK (WALL STREET JOURNAL via Dow Jones Newswires), Dec. 18, 2008

Some bullish investors still regard the oil-futures market, showing sharply higher forward prices, as a stairway to heaven.

To OPEC, though, which reduced its output quota by 2.2 million barrels a day Wednesday, it is a mountain to climb. The forward curve for Nymex crude prices currently slopes upward -- known as a "contango" -- and is extraordinarily steep. At $50.64 a barrel, the May 2009 contract commands more than a $10 premium to the "front month," or January contract. That spread has widened by about $7 in the past month. Farther out, futures rise above $70 from late 2012.

To regard that upward slope as signaling a bounceback, however, is to misread the forward curve. Up to a point, it is an aggregation of market views on the direction of prices. But, for starters, it is very focused on the near term. There is more open interest in the first six months of Nymex contracts than the next eight and a half years combined.

Moreover, futures also reflect costs. Right now, oil producers are hiring tankers to store excess oil, a more expensive approach than fixed storage. Those higher charges ought to be reflected in higher-priced forward oil contracts, steepening the contango. Financing costs, meanwhile, have soared. For example, credit-default insurance on the debt of Glencore International AG, one of the world's largest commodities traders, now costs about 2,800 basis points, according to data provider Markit.

Higher forward prices, relative to the spot market, reflect these increased costs. That is a silver lining for well-capitalized oil majors, which retain access to lower-cost funding. But it also obscures the message the forward curve is ending.

Priced in nominal terms, the curve also is sensitive to inflation forecasts. So while the contract farthest out, December 2017, commands about $77, it is worth $71 in real terms, assuming average inflation of 1%. Assume 3% and it is valued at $59 in today's money. That is a big range.

Intuitively, low prices today should curb investment, meaning dearer oil tomorrow.

But against that, no one knows where falling demand will bottom out. OPEC's savage quota cut, as it chases consumption downward, is undermined by a history of shaky compliance. Iran, which has, in a sign of desperation, just authorized its banks to issue foreign-debt instruments, and Venezuela, having suffered a second downgrade to its sovereign-credit rating, have strong temptation to keep pumping and free-ride off fellow group members.

Meanwhile, nonmember Russia's commitment to cut output in solidarity, always a smoke screen, appears to be dissipating entirely.

It is telling that oil prices continue falling despite OPEC's announcement and a weakening dollar. For oil bulls riding that forward curve, it is like trying to walk up a down escalator.


Alaska and Belarus both used to be part of Russia. (The former motherland can be seen from both, it's said.) But that isn't all they have in common. In a recent presentation, Morgan Stanley reproduced a map downloaded from the Internet comparing U.S. states with foreign countries in terms of gross domestic product. Alaska's economy, according to this, is roughly the size of Belarus's. New Jersey is compared to Russia. Wyoming, strikingly, is paired with Uzbekistan.

The earlier bubble in commodities prices has made some of the comparisons look out of date. Russia, for example, is now closer to New York than New Jersey (though perhaps not for long). Still, Georgia remains a dead ringer for, er, Switzerland. And, caveats acknowledged, the bigger point is just how big the U.S. economy remains in the global scheme of things. As Morgan Stanley puts it: "Decoupling? Wouldn't bet on it."  

Copyright (c) 2008 Dow Jones & Company, Inc.


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