Oil price floor now $35-$40 per barrel

The marginal cost of production is often thought to be the floor for commodity prices, but in reality this may not be true, at least not in the short term. As a general rule of thumb, if prices start to fall below the 90th percentile in the cash cost curve (also known as the operating cost) then production is likely to be curtailed. Morgan Stanley estimate this price in the oil market at $35-$40 per barrel.

“In commodities without a cartel, existing production must be shut-in. If true, marginal cost of investment is not the relevant metrics, it’s variable operating cost, which is closer to $35-$40/bbl on the high end.”

Even if a particular oil well is operating at a loss, there is a good chance it will continue to operate. Once the initial investment has been made, the incentive remains to continue producing as long as the price remains above the project’s operating cost. This will usually be much lower than the break even rate or marginal cost of production.

If the oil market is now operating as a ‘real’ market, i.e. not being controlled by OPEC then this would provide more of a fundamental basis for their argument that Brent crude prices could fall to as low as $43 per barrel in 2015. However, as we saw in 2008 when prices fell to a similar level, oil prices quickly rebounded to cover the marginal cost of production.

Related article: Oil market suffers “unprecedented speculative sell-off”

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Oil market suffers “unprecedented speculative sell-off”

In March 2008 Goldman Sachs outlined a ‘super-spike’ view of oil prices in which a major oil supply disruption could lead oil prices to rise to $150-$200 a barrel. At the time of the report Brent crude was just over $100 per barrel. It eventually peaked four months later, 45% higher. Today, Morgan Stanley issued a report warning that Brent crude prices could fall to as low as $43 per barrel in 2015, almost 40% below the oil price.

Is the oil market now trapped in a negative bubble, an inverse version of the type the oil market experienced in 2008 when oil prices spiked and oil was seen as a one way bet? Now though participants in the oil market are locked into a downward cycle of uncertainty, not knowing where the limit is that marginal producers start to shut-in production or that OPEC producers will react with production cuts.

According to Citi the oil market has now suffered “an unprecedented speculative sell-off”, of a level that even exceeded the post-financial crisis rout. The net long position through futures and options held by hedge funds and other money managers have slumped by two thirds since June. Oil prices are now vulnerable to ‘short-covering’ if geopolitical risk escalates, demand jumps or OPEC responds with a large cut.

The essence of a bubble is that prices tend to overreact and overshoot the level needed to re-balance the market in the short term. As with March 2008 prices could move sharply lower before a sustained platform towards higher oil prices is built. Unless you are trading the oil price it might pay to take a longer term outlook of whats sustainable and factor that into your hedging strategy.

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Wheat market has little to fear from possible Russian export ban

The Russian government was expected to meet today (Weds 3rd Dec) to discuss the introduction of wheat export restrictions. The 62% depreciation in the Russian rouble against the US dollar since the start of the year has resulted in Russian farmers being reluctant to sell wheat domestically, holding onto the grain as insurance as their currency plummets, resulting in higher domestic prices. Higher wheat prices are one factor contributing to higher consumer price inflation in Russia, reaching 8.3% in October.

Russia last imposed an export ban in late 2010 after a severe drought devastated crops risking domestic supplies. In contrast to 2010 the country has just had a bumper wheat crop of 104 million tonnes. However, concerns over the impact of cold weather and rising costs due to sanctions may see Russian output drop sharply in 2015.

Global wheat stocks are in a healthy position though, the International Grains Council predicting that global wheat stocks are predicted to grow by the end of the season compared with last year. Even if Russian exports do slow or come to a halt, Europe (the largest global supplier) is thought to have enough supply to be able to pick up any unfulfilled demand.

According to Rabobank wheat prices are forecast at $5.25 per bushel in Q4 2014 (over 10% down on current levels), rising to $5.60 per bushel by the end 2015. Its low case scenario sees wheat prices falling to around $5 per bushel by the end of 2015 – around 20% below current levels. In contrast, adverse weather and increased geopolitical risk in the Black Sea could push wheat prices as high as $7 per bushel.

Wheat prices (cents per bushel)
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