Have We Passed the Turning point for Oil?

Oil futures fell by about $16 over the last four days and about $11 this week, the largest weekly oil price fall in dollar terms. So is the beginning of the end of the oil surge of recent months?

It could be. Fears of long-term scarcity have made oil seem like a more and more attractive financial asset, especially in current market conditions. But if this bet starts being questioned, with fears that high prices and a slowing economy might erode oil demand growth, it could lead to a significant selloff.

Until now mostly its been a supply story, but the demand side may now be drawing more attention - or rather the prospect of lower demand. U.S. economic weakness, and a build in crude oil (and gasoline) inventories this week looked pretty bearish to some. Also this week OPEC suggested that a decrease in demand was imminent for 2009, the first such decline in demand for its oil since 2002.

Furthermore, others suggested that the 'geopolitical' premium might be decreasing - News that the U.S. was considering opening an interests section in Iran may be a strategic opening or at least a sign that a strike might occur in the near future. The fear of ever rising gas prices might have prompted a more pragmatic approach towards Iran and a more pragmatic approach towards its role in the oil market. While Iran is unlikely to hesitate to defend itself, it needs to export oil as much as the world needs its oil, particularly as oil revenues have offset the effect of sanctions.

The big story of the past few years has been the steady slowing of supply growth (particularly lackluster non-OPEC growth) and erosion of OPEC surplus capacity at the same time that demand continued to grow sharply, driven in large part by emerging markets in Asia and increasingly from oil exporters themselves. This erosion of surplus capacity made any supply disruptions (especially any concerning light sweet crude) that much more concerning. So the prospects of more supply in the short term as demand falls, plus the potential strategic opening between Iran and the U.S. may have contributed to this weeks sell-off

But even if demand is getting attention, just as fundamentals didn't seem to explain the whole story of the price surge, neither did its decline. The sell-off wasn't necessarily triggered by a decrease in demand but rather worries about future demand, something that's harder to predict. And while demand seems to be slowing, it might not fall that much. Some portion of oil demand is inelastic in the short-term at least.

In fact we may be seeing non-traditional fundamentals come into play. Investors may be taking a microscope to the drivers of the oil boom – limited surplus capacity today, scarcity in the future, dollar weakness contributing to a higher oil price in dollars to pay for non-dollar imports – and a set of calculations based on the relative return from converting resource assets into financial ones (a topic much discussed on the RGE Economonitors)

With interest rates low and the dollar weak, and prospect of more oil scarcity in the next 5+ years and thus higher prices, many oil producers may prefer to keep the oil in the ground not to invest in finding and extracting it. This perpetuates supply pressures (discouraging investment) keeping the price strong now and in the future. It also means that oil market dynamics decouple from old signals, potentially leading to a new set of fundamentals.

There are some caveats to such a scenario - global growth and oil demand might slow less than expected (the IMF just revised its 2008/9 forecasts up, suggesting that many economies might take longer to slow than expected). Despite its costs, oil demand from emerging markets could remain strong. On the supply side, unanticipated supply disruptions or delays could support a higher oil price. And the uncertainty of information, and current financial climate, it seems like a no-brainer to assume more volatility ahead.

Costs have risen. Production costs in all countries are rising, even in countries like Kuwait. And restrictions on investment mean that many of the most expensive sources are receiving a lot of investment. See for example the new investment in Canada's oil sands – or the attention being paid to shale oil in the U.S. the latter is very costly and not yet commercially viable . Yet the rising cost of an additional barrel of oil does not seem to explain recent prices. It does likely mean that we may have a new price floor, much higher than that of 5 years ago.

But we don't really know how these fundamentals will interact – but if demand for oil falls and all indications suggest it might, lower prices will be the result - the question is how far they will fall. Another somewhat related pressure point concerns demand for the dollar particularly from emerging market central banks and sovereign wealth funds, the largest financiers of the U.S.

Some of the largest central banks are now publicly questioning the value of their amassed dollar assets. Henny Sender of the FT reports that several sovereign funds have cut dollar holdings and others are publicly questioning the value of amassed dollar assets. While it surprised me to think that any GCC government investment funds still had over 80% of its assets in U.S. dollars as recently as last year, her article illustrates a key trend – the attempts to diversify the sovereign wealth of nations and the strains on the dollar pegs and heavily managed currencies of many emerging economies. Overall sovereign wealth funds have been diversifying and will try to continue to diversify. Yet, with dollar pegs, the overall asset allocation is constrained. So the actors to watch are actually the central banks. For example assets accumulated by the central bank of the UAE grew by about $50 billion or about as much as the assets of non-reserve official assets. China's central bank assets also grew faster than the CIC. Any significant shift away from dollar assets could put even more downward pressure on the dollar. Lots of breaking points to watch but the transition might not be in a clear trajectory either for fx markets or oil. If the U.S. and global economies, slow, its hard to imagine commodity prices staying strong.

One thing seems likely, recent oil prices are high enough to start changing behaviour. People are using more transit, trying to decrease gas. U.S. oil imports were down in June (though they may be up in July.) and this downward shift in demand, coupled with inventories that are on the high side for the season in Europe and Asia, as well as the fact that an increase in regulated prices might slow the pace of demand growth in emerging markets – does suggest a decrease in the demand for oil. But that aside, expensive oil (if not $140+ oil) is here to stay in part because of rising costs of new supply and because oil exporters require an increasingly higher sum to settle their import bills and pay for imports. But that doesn't mean it will necessarily be over $130...