Oil is liquid money

Led by OECD, global oil consumption contracted in 4Q11…

After two quarters of meagre growth, global oil demand contracted by 300 kb/d in 4Q11 for the first time since 2009, led by declines in Europe and North America. Why aren’t oil prices coming down? First, inventories have failed to build despite steep demand declines as supply remains very scarce. Second, high liquidity has likely helped prevent a drop in oil prices. In part, 2011 was a year mired with both OPEC and non-OPEC supply shocks. With the exception of the US, Saudi and Russia, oil production in almost every other major producing country was weaker than expected. Net, non-OPEC oil supply growth in 2011 showed only 40 k b/d growth from 2010 while total OPEC crude output growth came in at 509 k b/d.


…but Brent held above $100, boosted by ECB & Fed actions

How is high liquidity supporting oil prices? First, oil should be more impacted by easy money than other prices in the economy due to supply constraints. Second, oil producing nations have little incentive to hike output beyond their budgetary and current account needs if returns on risk-free assets drop below expected inflation. Using historical data, we estimate that a 100bps decrease on USD real rates typically pushed Brent prices up by more than 6% in the subsequent year. Looking at previous episodes of Fed easing, we estimate that a third round of QE amounting to $600bn would bring Brent oil prices above $120/bbl.


Net, we keep a negative bias on oil prices on fundamentals

So where does this mix of money and fundamentals leave us? We have revised up our 1Q12 Brent and WTI crude oil price forecasts to $108/bbl and $100/bbl respectively (from $100/bbl and $92/bbl prior) to reflect the much stronger oil price environment. But demand is decelerating sharply and our supply models indicate a ramp up in volumes as we head into 2Q12, so we leave our projections for the rest of the year unchanged. For natural gas, we mark to market our 1Q12 US Henry Hub natural gas price forecast to $2.90/MMBtu, from $3.40/MMBtu. Against our fundamental views, we acknowledge the Fed’s commitment to hold rates near zero until the end of 2014 and more QE could lend support to Brent oil prices.



source: BofA ML