Spot prices finish the end very low, but what about the long end of the curve, where market practitioners reflect their medium term expectation of the oil buy / sell balance?
Some would say the curve is in deep contango (i.e. future prices are higher than the spot), reflecting a strong expectation that prices will resume their upward movement as soon as the crisis is less severe.
But a close look at the forward curve suggests the contango is not that steep, and the implicit inflation calculated from the curve is much lower than what could be expected in a peak oil scenario. On 31-Dec-2008, the closing prices of oil Futures on Brent (North Sea oil) and WTI (US oil) were:
At first glance the contango looks very steep: from 45 to 80 $! But these prices are expressed in dollars of the delivery date. If we calculate a curve with constant dollars (all prices expressed as of today), we get the following curve:
The inflation-adjusted curve uses an inflation rate equal to 3% to discount all prices down to today. It is in contango only until 2012. After that date, prices increase slower than with a 3% inflation. The same calculation with a 2% inflation gives this result:
This simple example suggests that the market ‘consensus’ involves an inflation around 2%. In a preceding posting we showed how this implicit inflation moved in the past.
Here is the same view until the end of 2008:
The implicit inflation appears in green, while the other three curves (with values to be read on the right-hand scale) show the spot price (pink), the December 2015 price (purple) and the deflated December 2015 price with a 3% inflation.
Beyond the rise of the implicit inflation in 2008 (a signal that peak oil has more and more followers among market movers) we observed since October a decoupling between long dated prices and the spot. As the spot was moving down from 90 to 60 $, the December 2015 stuck around 90 $. The correlation between the spot and long dated maturities, that was extremely high in the middle of 2008, decreased brutally:
More even than the contango, this decreasing correlation reflects a decoupling in the market expectation of oil prices. This movement can be interpreted under the two supply / demand sides:
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Supply: Very low spot prices reduce the investments that would be needed to defer the production decline in past peak-oil countries such as Mexico, Norway, UK, US and Russia. Therefore low spot prices now may drive prices higher a few years ahead.
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Demand: Is the current crisis only due to events purely related to financial practices, and independent to the energy market, or isn’t it also partly due to high commodity prices? If this is true, then low prices in 2009 would fuel the next price rise. Therefore prices in 2009 / 2010 have no reason to be positively correlated with prices at the end of the curve.
In any case this roller coaster year 2008 showed that energy prices need very extreme movements to balance supply and demand. Both demand and supply move much slower than prices, because their elasticities to prices are very low and they have a high momentum.
The volatility observed in 2008 is not only due to the strength of the current crisis, but also to factors that are intrinsic to the energy market transition from the past structural surplus to the future shortage. The transition between the current oil-rich economy and the next one will not only involve high energy prices, but also very volatile ones.
Note: This posting is the third one on this topic. For past views about the shape of the oil curve and its connection with peak oil, please refer to the articles posted in August 2007 and May 2008.
Any comment: peakoil ‘at’ club.fr
