(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON Feb 7 Forward oil prices are trading at record discounts as the market responds to fears about near-term shortfalls while also pricing in a big increase in supplies from the Americas and the Middle East over the next four years.
Front-month Brent futures have been trading above $116 a barrel, the highest level since November and before that September 2011, as freezing weather across Europe, signs of revival in North America and renewed interest in the Brent-WTI spread shake the oil market out of its recent torpor.
But prices for deferred futures contracts such as December 2015 have barely moved and remain firmly stuck below $100.
Throughout the boom of 2004-2008, spot and forward oil prices increasingly moved in tandem. Prices along the length of the curve became tightly integrated as well as correlated with other asset classes such as equities. But spot and forward oil prices are now segmented, both from one another and from share markets.
Four-year forward prices are trading at a record discount of $19 per barrel (20 percent) compared with oil for immediate delivery.
Deferred prices have historically been much less volatile, and analysts usually claim they are a better guide to market expectations about the long-term marginal cost of production.
During the 2008 price spike, forward prices generally rose in line with the spot market, cresting over $140 by July 2008, as traders anticipated immediate shortages and lack of spare capacity would last indefinitely in a world of peaking oil supplies.
Now the market is anticipating production costs will remain at or below $100 in the long term, even as fears about near-term tightness linked to weather, renewed economic expansion and Iran helps firm the spot market.
Market-based price forecasts drawn from the forward curve do not have a good track record. The forward curve is not a forecast. "It is what we bet against," according to one senior trader.
Nonetheless, forward prices provide some indication of where the market currently expects the spot market to be trading years hence. And at the moment it implies that prices will be lower than they are now.
Oil bulls will argue the market is too sanguine about supply and demand in the next few years - overconfident about new supplies from Iraq, Libya and unconventional plays in the Americas and underestimating potential demand growth as the global economy moves into a sustained expansion.
But there are compelling reasons to think that in this case the market is right and the real (inflation-adjusted) long-term marginal cost of supply is at or below about $100 per barrel:
(a) Fracked oil production in North Dakota has been soaring, implying output is profitable, even though transport costs mean producers receive substantially discounted prices to WTI, which is itself trading below $100 per barrel.
(b) Fracking is likely to upturn industry assumptions about economically recoverable reserves and production costs. The speed at which fracking will revolutionise the oil industry is unknown, but comparable technology was able to shift the global gas balance in just five years (2006-2010). It is not unreasonable to expect fracking to have a noticeable impact on production by 2015.
(c) On the conventional side, marginal supplies in the next few years from Libya and Iraq are from onshore fields that have been well prospected, have comparatively low development risks and have operating and capital costs that will be far below $100 per barrel. So many new fields are coming on stream that Saudi Aramco has decided not to lift its own production capacity from 12.5 million to 15.0 million barrels per day, since the company sees no need for the extra oil over the next five years.
(d) Technology for producing liquid transport fuels such as gasoline and diesel from natural gas or coal is mature and economic at oil prices of $60-80 per barrel (for gas-to-liquids) and $80-100 (for coal-to-liquids), though it produces large quantities of carbon dioxide as a by-product. Plentiful supplies of both gas and coal ensure there is no shortage of raw materials. As a practical matter, the supply of liquid transportation fuels is unlimited at prices of $100 per barrel.
(e) Forecasts of long-term oil demand have been consistently revised lower. Demand from emerging markets will continue to grow. By 2016, countries accounting for 65 percent of the world's population will enter the $3,000-$20,000 per capita income window where demand for energy, especially transport, takes off. But all forecasters agree oil consumption in the advanced economies has peaked, helping ease pressure on demand.
Back in December, David Fyfe, head of the oil industry and markets division of the International Energy Agency (IEA), cautiously predicted, "We think the market for 2011 and 2012 now looks tight to balanced and there is the prospect of it easing somewhat after that." [ID: nL6E7ND3P2]
The prevailing view in the market appears to agree with him, keeping forward prices pinned under $100.
The market could be wrong. In fact it almost certainly will be. But both supply and demand are reacting strongly to the escalation in prices over the past decade. The burden of proof therefore lies with the oil bulls. So far they have not made a convincing case why real prices need to rise further by 2015. (editing by Jane Baird)