More on Goldman’s oil price forecast

 Goldman Sachs has warned that WTI crude prices could fall below its 6 month forecast of $39 per barrel (~$43 per barrel for Brent).
To accommodate the substantial expected first half inventory build and using the storage arbitrage to the one-year ahead swap, we are revising down our 3-, 6- and 12-month price forecasts for Brent to $42/bbl, $43/bbl and $70/bbl, respectively, from $80/bbl, $85/bbl and $90/bbl, and for WTI to $41/bbl, $39/bbl and $65/bbl from $70/bbl, $75/bbl and $80/bbl. The later expected trough in WTI prices is due to excess US storage capacity.
Looking further ahead the market is expected to balance perhaps providing a floor to prices.

Once a 2H15 US supply growth slowdown is more certain and given the very high decline rates on US production, renewed Libyan disruptions and an already visible demand response in the US, we expect the market to rebalance with inventories drawing rapidly from 3Q15 onwards.

However, future rallies could be thwarted by the speed at which any lost shale output can recover.

“Shale has fundamentally changed this market…The lead time between when you put money in the ground and when you get production has collapsed from three-to-four years, all the way down to 30 days.”

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Related article: Oil price floor now $35-$40 per barrel

Copper bottom: The red metal slides to five and a half year low

Copper prices slumped to the lowest level in five and a half years yesterday (Wednesday), the metal suffering its biggest one day decline for over three years. Three-month copper on the London Metal Exchange fell as much as 6.6% to $5,323 per tonne at one point before settling at $5,552 per tonne.

Analysts have pinned the blame on the actions of Chinese funds aggressively selling copper. A downgrade to global growth for 2015 to 3% and warnings of a hard landing in China providing fuel for the fire.

Although the red metal comes with the nick name Dr Copper, a reference to its perceived status as a bellwether of economic activity the metal has become increasingly driven by demand for its use as collateral in recent years. This means that significant volatility can occur without an apparent strong fundamental reason for the price move.

Indeed, demand from China remains strong for the time being. According to figures from Chinese customs authorities, China imported 420,000 tonnes of copper in December, lifting the 2014 total to a record 4.83 million tonnes, beating the previous record of 4.65 million tonnes in 2012.

At this time of year though physical traders prefer to hold as little inventory as possible this time of year as manufacturing activity usually slows over the forthcoming Chinese Spring holiday (which starts 19th February). Taken together with the negative sentiment that is affecting other commodities the sharp drop is likely to have been an over reaction.

Although there is potential for further weakness in coming weeks the sharp drop in the copper price could be an opportunity for China’s State Reserve Bureau (SRB) to take on more copper reserves providing a floor to prices. More broadly though the sharp drop in the oil price has raised questions about what the longer term cost floor for copper prices is. The drop in the oil price will have reduced costs for copper miners and refiners.

Related article: Is $5,000 per tonne copper’s price floor?

$74 per barrel – what is the significance of the 5 year forward price of oil?

Last week Jim O’Neil wrote an article in Project Syndicate discussing the perils of oil price forecasting and his quest to determine an equilibrium oil price. According to the former employee of Goldman Sachs…

My conclusion is that a good indication of this moving equilibrium does exist: the five-year forward oil price, or the amount paid for guaranteed delivery of oil five years from now.

At the time of writing the forward price for Brent crude in January 2020 is just over $74 per barrel – almost $25 per barrel above the near term futures price. When compared to the 50% plus decline in the Brent near term futures price since June the 5-year forward price has barely budged. So whats the relevance of this apparently arbitrary date in the future? Here’s more from O’Neil.

In my ongoing quest to become better at forecasting, I began, a few years ago, to pay attention to the five-year forward oil price as it compares to the Brent crude oil spot price, the price of a barrel of oil today. I suspect that the five-year forward price is much less influenced by speculation in the oil market than the spot price, and more representative of true commercial needs. So when the five-year price starts moving in a different direction than the spot price, I take notice.

GS expand on this in their 2010 paper Commodity Prices and Volatility: Old Answers to New Questions. The cyclical component of price is determined largely by fluctuations in short-term fundamentals as captured by inventory levels. As demand adjusts over short time horizons, demand is the key driver of the cyclical component of price and typically dominates the market on a 1 – 2 year horizon.

Conversely, as supply is generally slower to adjust than demand, given the capital- and time-intensive nature of commodity production investments, these structural supply-side factors typically drive the market on a 2 – 10 year horizon. The structural component of price is usually determined by the long-term supply curve or the cost of bringing the last needed unit of the commodity to the market – referred to as the marginal cost of production.

Historically—throughout the 1980’s and 1990’s long-dated prices rarely moved, reflecting the relatively stable cost of bringing new supply into the market. Things then changed from about 2004. Given the shifting sands involved in the cost of producing a commodity (geology, other commodity prices, geopolitics, resource nationalism and not to mention the main development costs) are in a constant state of flux, so the marginal cost of production is to. It is a moving target. Although the price of a commodity can certainly fall below the marginal cost of production in the short term (the current price is an example of that), in the longer term prices should rise to at least the marginal cost.

The forward price is useful as an indicator of long term pressures in a commodity market it is by no means a forecast. There are many factors which affect the forward curve other than just market expectations of where the price of a commodity will be that far out in the future. First, the ‘cost of carry’, which includes interest rates, storage costs and insurance. Second, the physical characteristics of the commodity (whether it is easy to store, whether there are ample inventories etc). Third, the effect of John Maynard Keynes’ ‘normal backwardation’ theory. Fourth, market liquidity and finally the curve fails to account for the ‘real’ inflation-adjusted value.

So to conclude the 5-year forward price of oil may give some useful insight into long term cost pressures. But use it wisely, as it is not a forecast.

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