VOL. XLVII
No 11
Investment Funds Overriding Effect Of Fundamentals On Market, Says SG
Oil market fundamentals suggest an imminent decline in oil prices, yet markets are rising despite winter being almost over, according to Société Générale (SG) Economist Frédéric Lasserre. In the report Energy Specials: A Change in Reference Point, he argues that the price rises contradict the consensus of supply/demand forecasts, which envisage a market oversupply of 4mn b/d in 2Q04 if OPEC continues to produce at its current level of 28mn b/d: “The principal creators of this bull run remain the investment funds, which are maintaining and even increasing their long positions in NYMEX and IPE crude oil futures and in NYMEX gasoline. By all evidence, these heavy hitters are reading the market quite differently than analysts or physical market participants do.”
The report says that the funds have maintained and extended their long positions, reaching a record total of 145mn barrels in WTI futures alone, in the face of bearish near-term projections: “In the short term, two facts comfort them in this strategy. First, despite a market surplus averaging 1.16mn b/d since 2Q03 according to the IEA, US commercial oil stocks (of crude and products combined) are today no higher, at 896mn barrels, than in May 2003. Whether these barrels were really produced, consumed or stocked, whether in China or elsewhere, has no importance. The essential, for the funds, is that the barrels have not appeared on the US market, where WTI prices are set.”
Mr Lasserre explains: “Fund investments in oil, particularly those made by ‘global macro’ funds, result from a macro-economic scenario which is relatively insensitive to short-term market fluctuations. Their investments in oil are part of a much larger strategy to invest in commodities in general. As soon as the US economy showed the first signs of take-off, the funds took massive long positions in all commodities, comforted by the impressive acceleration of the Chinese economy. Each time that the global economic cycle has taken off, particularly when take-off has been synchronized among most large economic zones, commodities have significantly out-performed other classes of investments.”
Investment funds view commodities at the moment as markets characterized by demand strength rather than by short supply. Similarly, they view OPEC as acting in the oil market like the Federal Reserve Board would in a bullish stock market cycle: “To them, OPEC does not guarantee continued increases in price levels, but takes responsibility only for limiting the losses. This improves the risk-reward ratio of an investment in oil. By increasing, even at the margins, their portfolio allocations in favor of commodities, whether by direct investments or through commodity indices often over-weighted in energy, the funds are primarily responsible for the increases in oil prices since 2H03. So long as US economic growth remains strong, Chinese oil demand rises nearly 10% each year, and American interest rates do not increase, there is little likelihood that global macro funds will cut their long positions in oil.”
Evaluating Fundamentals
Given the funds’ dominance of the oil market, the report observes, market participants need to revise the way they evaluate fundamentals in their assessment of pricing trends: “The first step consists of recognizing that stocks are low and will remain so. Since the beginning of 2002 stocks in the Atlantic Basin (the US and Europe) have fallen by 130mn barrels, which is equivalent to nearly six days’ demand. What appeared initially to be the temporary result of OPEC’s hyper-restrictive supply policy now seems to be a permanent condition. As a consequence, the oil industry has learned to function with just-in-time stocks at the price of extremely high freight rates and increased volatility – both largely compensated by extremely remunerative price levels and refining margins. Clearly, estimates of the stock levels at which the market is at equilibrium need to be revised down.”
The second step in adjusting to the funds’ dominance, which follows from the first, would be to estimate what the market now consider to be an appropriate equilibrium level for the new, lower stocks level. Based on a comparison of similar periods of high prompt crude prices since 2000, the report concludes that the outlook for prices is stronger because of fund actions: “Today, $28/B for WTI is perceived as an objective long-term value. Clearly, for WTI, prices may be considered high if they are above $28/B. With a spread of $3/B between WTI and Brent, a spread which has itself increased with just-in-time US stocks, the corresponding equilibrium level for Brent is located, therefore, around $25/B. Integrating these new parameters in our forecasting model, leaving forecasts of supply and demand unchanged, increases our price projections by $2/B. This recalibration applies equally to our long-term forecasts. In consequence, we increase our average forecast for 2004 to $28/B for Brent, and to $25.75/B for 2005.”