Is it end of down-hill or more to go?
Brent Crude failed thrice at $115-120 resistance (and high-valuation) zone post the intra-year rally from 36.20 to 128.40 (between December 2008 to March 2012). The trigger for this bullish momentum was from pick-up in growth momentum across the Globe led by China and India. The resultant demand push and supply side concerns from geo-political tensions emerged as catalyst to bullish momentum. Now, the situation is reversed since June 2014 to push Brent sharply down from 115.71 to 63.56 by over 45% in 6 months time in steep down-hill one-way move. The trigger obviously is from the reversal of the two major cues that caused earlier bullish undertone; this time, the growth pressure is from across the Globe largely from heavyweights - Euro zone, Japan and China. Despite sharp cut in demand, supplies are in plenty as producers are unable to readjust their budget financials for lower Crude Oil price to accommodate top-line reduction in production; rubbing salt to injury is from shift to alternate energy input diluting the excess dependence on imported Crude oil. All taken, the major two drivers setting up directional bias is from growth and geo-political tensions. Unfortunately, Oil producers do not have mitigation plans to protect downside risks, while enjoying the joy-ride when going is great! What next?
There is no great optimism on growth revival in the global economy in the near future. There is also no great risk from geo-political issues in the Middle East to get concerned on the supply side till there is voluntary cut in production by OPEC and non-OPEC suppliers. The probability of demand pick-up and supply-squeeze is very low, thus ruling out significant reversal from here. The cost-revenue equilibrium adjusting for inflation (and time value on investment) is the only option to figure out a long term base for the Brent Crude. Most see 85-120 as extremes for long term price equilibrium. The current level of sub 65 is more than asked for by major oil importers, more so for India when under pressure from inflation and twin deficits on elevated cost of Crude oil. It does make sense for importers to hedge 50% of long term exposure at $65 and balance at either $35 or $85 giving an average cover at $50 or $75 (both below the comfort level of $85). It is important for large PSU entities to stay comfort in Balance sheet financials (and its long term beneficial impact on macroecomic fundamentals) rather than worry about missed opportunities from extended weakness below $65. All taken, current price valuation covers most (if not all) of cues that cause downside pressure, while positive cues that can cause swift U-turn around have not been considered.
The outlook for the near term is not clear on whether or not 63.50-65.00 is strong enough to trigger recovery, but long term bias is for recovery into 85-100 as most economies work over time on growth turnaround; and when it happens, producers would be positioned for managing the supply side better to mitigate financial risks from excessive downside price move. The first signal for unwind of excessive weakness is from back into consolidation at 65-75. It is good to stay fleet-footed (on shorts) at/below 63.50-65.00 and great to start hedging risks at/below 65 in phased manner for freezing cost side of the P&L by alignment with the revenue to provide long term fixed price contracts to distributors and consumers. This will remove the worries on inflation, CAD and fiscal deficit in the event of sharp price-turnaround, when past experience suggest that directional bias can't be taken for ground and is subjected to sudden mood-swings on impact from various unforeseen cues in play; take note of price fall from 147.50 to 36.20 (between July - December 2008) before swift turnaround to 127.02 by April 2011. Is there a similar move in the making? Only time can say! Caution and Prudence are the buzz words for those who are heavily dependent on imported Crude oil? Are Petroleum Minister and Finance Minister listening? Please do! Working overtime for rate cut from RBI Governor is not significant compared to the long term beneficial impact on growth if focused on getting the best out of $115 to $65 bonanza!
Moses Harding
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