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2012 Crude Oil Outlook

Last updated 1/4/2012 4:22 PM ET (GMT -5) 0 Comments - Add your comment

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Boris Schlossberg

Director of Currency Research, GFT

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Looking Back

At the beginning of 2011, crude oil had broken out of a trading range which had lasted for just under a year. For the twelve months from October 2009, prices on both WTI and Brent rarely fell below $70 per barrel and only broke above $80 for a brief period at the end of the first quarter in 2010. But crude prices began a steady rally once the U.S. Federal Reserve indicated its willingness to launch an additional program of asset purchases in August 2010. This policy shift saw the dollar weaken sharply, while crude and other U.S. dollar-denominated assets shot higher as investors sought out protection from inflation. The rally accelerated following the outbreak of civil unrest across North Africa and the Middle East. Prices peaked around April/May with WTI over $114 and Brent at $126 per barrel. Crude then fell sharply in May along with other “risk assets” as global economic data pointed to a worldwide slowdown and the Arab Spring saw a change of leadership in Tunisia, Egypt and Libya. The fall was exacerbated by the surprise release by the International Energy Agency of 60 million barrels of oil from the Strategic Petroleum Reserve. Then prices declined steadily into the third quarter as the European debt crisis escalated. However, these falls were soon checked as geopolitical tensions rose again on fears over Iran’s nuclear intentions and renewed unrest in Syria and Egypt.

Current Assessment

As we approached year-end, traders were torn between the worries of a global economic slowdown, which are exerting downward pressure on the oil price, and heightened geopolitical concerns due to continued instability across North Africa, the Middle East, and Syria. These conflicts helped to put a floor under crude. There has also been a breakdown of diplomatic relations between the UK and Iran. Iranian protestors stormed the British Embassy in Tehran and the UK government retaliated by ordering the closure of Iran’s embassy in London. This followed concerns about Iran’s nuclear ambitions after the UN’s watchdog, the International Atomic Energy Agency, reported that the country was working on a nuclear weapons program.

Geopolitical Concerns

Growing tensions between Iran and the West are likely to be the major geopolitical issue in 2012. Iran has been hemmed in geographically with U.S.-led coalition forces occupying Iraq to its west and Afghanistan to its east. In December, however, President Obama began withdrawing “all” U.S. troops from Iraq; at the time of this writing, this was to be completed by the end of 2011, leaving a power vacuum in the region that Iran will be anxious to fill. At the same time, Iran has close ties with Syria and President Assad, which strengthens its position to the north of Iraq. The growing unrest in Syria is destabilizing the region. Turkey is also involved due to its shared borders with both Syria and Iran and its close ties to the West. Turkey has joined with the U.S. in calling for President Assad to step down and imposing sanctions on the country. Yet this move has caused a rift between Turkey and Iran. Turkey currently imports 200,000 barrels of oil per day (about half its consumption) from Iran and had plans to increase its imports of gas from the country.

The Brent-WTI Spread

One of the interesting features of the oil market this year has been the premium of the Brent contract over West Texas Intermediate (WTI). Although there are a large number of different types of crude traded around the world, the two largest futures markets are WTI and Brent. Both are light, sweet crudes, which means that they require less processing than heavier and sourer counterparts. They have low sulfur content and can be refined into higher value products, such as aviation fuel. Brent comes from the offshore oil fields in the North Sea, while WTI comes from fields in the U.S. and Canada. WTI is generally lighter and sweeter than Brent and has typically commanded a premium over it. But by August this year, Brent was trading at a $25 premium to WTI. There are a number of theories for this. It could be due to complex strategies employed by large commodity trading firms attempting to take advantage of arbitrage opportunities between the physical market and the forward contracts. However, the divergence can also be explained by supply issues. The existing North Sea fields are now past their peak production while the unrest across the Middle East and North Africa (and Libya in particular) has also boosted the price of Brent. Meanwhile, new technologies are now employed to extract oil from fresh fields in North America and the Canadian oil sands. This crude is sent to the Cushing hub in Oklahoma and so stockpiles of WTI have been building. However, the Brent-WTI premium collapsed to less than $10 in November. A major reason for this compression was the announcement that the Seaway pipeline which takes oil from the U.S. Gulf Coast to Cushing, Oklahoma will be reversed. This would allow oil to be piped out of Cushing and down to the Gulf from where it can be refined and transported more easily.

Looking Ahead

The questions for oil traders for the year ahead are pretty much the same as always; these focus on supply, demand, geopolitical risk, and pure speculation. The longer term demand from developed countries has been leveling off and there is a growing move away from fossil fuels towards alternative energy sources. Technology gains have meant a more efficient use of fossil fuels by the developed world. Any increase in demand has (and may continue to) come from emerging markets – China, in particular. This demand is cited by many analysts as providing support to prices and should also be the main driver to further increases. However, crude oil provides just 20% of China’s energy needs with the majority being provided by coal. China is also moving towards greener fuels and has invested heavily in its nuclear energy program. Consequently, it is far from certain that demand from emerging economies will continue to grow at its previous rate. Although OPEC and the International Energy Agency have both reduced their forecasts for oil demand growth, they both expect demand to grow by 1 and 1.2 million barrels per day respectively over the next year.

We need to consider the prospects of a slide back into recession for the developed world and the danger of a Chinese hard landing. We could be looking at a period of slowing growth as deleveraging takes hold. Meanwhile, central banks and policymakers still seem determined to counter any slip in economic activity with further stimulus. But we may be reaching the saturation point in terms of the effectiveness and acceptability of additional central bank interventions.

The price of oil is a major consideration for everyone. It directly affects our cost of living – not just in our personal motoring costs or heating, but in every aspect of commerce and trade. Higher oil prices are a tax on everyone and they directly affect manufacturing costs and transportation of goods (including clothing and food) and services. If crude resumes its upward trend this year, then we can expect these costs to be passed on or corporate margins to take another hit. Given a number of factors − the low level of consumer confidence across Europe as austerity measures bite harder, a dismal unemployment outlook for developed countries, high levels of debt, and low wage growth − companies will struggle to pass on rising fuel costs to their customers. Also, it is worth remembering that while slower economic growth supplies its own break to higher crude prices, an increase in geopolitical tension does not.

- David Morrison contributed to this article

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.