Recently, the front-month Brent crude oil contract slipped below the $100 per barrel level for the first time since July 25, 2012. For the OPEC crude basket, the break below this level was statistically significant, given that it was the longest stretch in history that prices had remained above $100 a barrel (191 days).
The physical crude oil markets were facing pressure from a combination of factors. Firstly, close to eight per cent of refineries globally are offline for maintenance during this period. Besides, margins for refineries have weakened, giving them less incentive to run at full utilisation rates. These two seasonal factors have weighed on the demand side for crude oil. On the supply side, there has been an improvement in availability with the North Sea seeing an improvement, while previous shortfalls among the non-OPEC countries have also eased. The real trigger for the move below $100 a barrel came from the sell-offs in other asset classes, along with poor macro economic data from the US and China.
While prices have recovered now, with Brent hovering above $100 a barrel again, we do not expect oil market fundamentals alone to offer catalysts for an immediate upside retracement to the $111 a barrel range over April to May. In fact, we would not rule out further weakness in the near term.
Until we see a fundamentals-driven retracement, the pace of the downward momentum is likely to be slow. We highlight three layers of immediate support on the fundamentals side that will support prices.
The first level of support is expected to come from consumers, who have been waiting on the sidelines for a better entry point for their hedging programmes. We see a pick-up in hedging activity on the first leg of the downward adjustment from current levels.
If this fails to hold in the near term, until we see an improvement in fundamentals approaching the tail end of Q2, the second layer of support is likely to come through market expectations surrounding comfort levels for OPEC producers to continue producing above their target.
Finally, the third layer of support is expected to come from cost curves, which once again are unlikely to be brushed until the $90 per barrel mark is touched. However, the likelihood of such an extreme weakness can be ruled out for now, in our view.
The window for testing these layers of support is restricted to the end of Q2, as the weakness in fundamentals is very transient, and we do not see prices remaining below $100 a barrel for the rest of the year. Progressing through the tail end of Q2 and into the second half of 2013, we see strong indications for demand growth developing, which will keep the call on crude oil elevated. In the Pacific, we are seeing strong indications of growth in the smaller non-OECD Asia Pacific countries, along with China and India providing a healthy level of support. In the Atlantic, we see strong demand growth coming from Latin America.
Overall, we are likely to see a healthy retracement of prices by the tail end of Q2. Going into Q3, we feel the oil market will be balanced on a higher wire, with absolute global demand crossing 90 million barrels a day, and the supply system gearing itself to match this requirement, while geopolitical risks that have now faded from the headlines continue to lurk in the background.