Crude price crash and the attributes

The sharp erosion in oil prices has come in spite of a signal from King Abdullah of Saudi Arabia, the world's largest oil producer, that he wanted oil prices back at $75 a barrel. According to Olivier Jakob of Swiss oil consultancy Petromatrix, the king's comments marked a significant departure from the previously held line that the price of oil is set by the market.

The pathetic state of oil prices is attributed to a massive demand slump that is believed to have taken place across the globe. According to the International Energy Agency (IEA), global demand for oil will shrink this year for the first time in a quarter century as rich nations fall in a recession and growth falls into the developing world. The IEA slashed its forecast for oil demand in Organisation for Economic Co-operation and Development (OECD) nations by 290,000 barrels a day this year and 210,000 barrels a day in 2009.

Developing countries are expected to be the only source of growth in oil demand until 2030, with China contributing 43 per cent and India and West Asia each about 20 per cent. The remainder is expected to come from other emerging countries in Asia.

Research firm Sanford C Bernstein and Co has put the oil industry's average break-even cost zone at $35-40 a barrel. In the past, $65-70 has been described as the marginal cost at which producers could earn an expected return of roughly 9 per cent on new drilling projects this year. Oil services major Schlumberger has recently stated that slow oil and gas production will make it miss analyst estimates. As margins get under severe stress, the incentive to put money in new exploration and drilling projects has got severely impacted.

In addition, the premium that the market gave on light, sweet crude oil, which is well-suited for making diesel, has now dwindled as the demand for diesel has faltered due to the overall global slowdown. Deutsche Bank analyst Adam Sieminski expects further weakness in the widely quoted Nymex and London light, sweet oil benchmarks that are generating pricing headwinds because substantial new refining capacity is about to come onstream from China and India. (Reliance's Jamnagar refinery seems to be coming onstream confronted by a glut in crude oil markets and cracking ‘crack spreads’).

Projects, which revived long-dormant wells in the US, used new technologies to salvage old west Texas oilfields or extracted oil from tar sands in Canada, require prices to be quoting at much above present levels. Some deepwater projects in the Gulf of Mexico or the North Sea would be imperiled if prices fell below $40 a barrel for an extended period. High-cost ventures, such as Canada's tar sands, were producing oil at a cost of about $80 a barrel, almost twice as much as the present market price.

After its exhaustive study on the rates of decline in production from 800 of the world's biggest oil fields, the watchdog found that even after recent investment, production from the fields was declining at an annual 6.7 per cent and that this rate was accelerating. This means 45 million barrels a day would have to be found and tapped over the next 22 years simply to meet an unchanged world demand. The IEA, however, expects demand to rise from 85 million barrels per day in 2007 to 106 million barrels in 2030, making the challenge that much greater.

The IEA believes that most of the projected increase would come from Organisation of the Petroleum Exporting Countries (Opec) members, whose global market share would jump from 44 per cent to 51 per cent by 2030. The fields experiencing the sharpest fall in production lie in developed countries.

The extraordinary weak state of demand is not only for crude oil but also for the forward contracts in crude oil. The differential between the price of oil for immediate delivery and the one-year forward contract has widened to (-) $12.50 a barrel, the largest spread since the US oil futures started trading 25 years ago in the Chicago pits. This wide negative spread, known as contango (future delivery costing more than immediate delivery), is shocking the industry, as it is reflective of a weak state of demand for oil.

(The writer is the CEO of Global Capital Advisors. Financial Chronicle does not warrant the quality or accuracy of the article. It shall not be deemed a recommendation by FC for buying or selling or investment of any kind. Investments are subject to market risks. Past performance does not guarantee future success. It is advisable to seek advice from a qualified independent advisor before investing)