Oil falls further on economic concerns; technicals weigh too

Energy prices, apart from natural gas, extended their losses this week, finding no support from the US Federal Reserve - despite the door being left open for additional stimulus should this be required.

Brent crude led the downward slide with the premium to WTI crude narrowing to 11 dollars, the lowest level since January. Since a shift towards ample supply, following tightness during the first quarter - which primarily impacted Brent’s role as the global seaborne benchmark - the front end of the Brent forward curve has moved into contango for the first time since January 2011. 

The dramatic shift in current and forward price expectations, as seen below highlights the fact that most of the selling has occurred at the front end. This is natural enough as it is primarily here you will find speculative investment flows and where previous tightness would have been priced in. A move from backwardation, where the spot price is higher than deferred, to contango - where the opposite occurs - makes passive long investments in crude oil less attractive as the investments will begin to accrue a negative roll yield just like we have witnessed in WTI crude for most of the time during the last four years.

Geo-political risk should not be ignored
The geo-political risk which helped drive prices higher during the first quarter has not gone away as the meeting between Iran and the five permanent members of the UN Security Council, plus Germany, in Moscow yielded no result. The planned EU and US sanctions will now take effect on July 1 and this will halt some of Iran’s exports. Importantly it will also ban EU insurance companies from covering Iran’s exports which could create a headache for Asian buyers such as Japan, South Korea, India and China. The lack of progress at the negotiation table over Iran’s nuclear intentions once again raises the risk of an Israeli military strike, something that will ensure a continued geo-political risk premium - despite the ongoing economic slowdown and its impact on global demand. 

Weak global demand backdrop
The main focus in commodity markets, however, and in oil markets in particular, remains on the current deterioration of the economic outlook for several major economies. American stockpiles of crude oil have risen the most in 22 years while manufacturing activity in China, the world’s biggest consumer of base metals and second-biggest consumer of oil after the US, continued to slow in June. The HSBC Purchasing Managers Index fell to a seven-month low of 48.1 in June with a reading below 50 signalling contraction. China still has several tools available for stimulating the economy so a further deterioration in activity will increase the chance of this happening, which in turn should help support commodities, such as copper and other base metals (which rely heavily on Chinese demand).

Technical and fundamental outlook not aligned
The oil outlook from a pure technical perspective still points towards lower prices with the break out of the USD 100 to 126 trading range signalling a technical move towards the USD 74 area. The fundamental picture, however, still points towards continued demand growth which could signal that current levels are too low and primarily a result of risk aversion and long liquidation. But with the current sense of unease there is no doubt that oil prices can easily overshoot to the downside before fundamentals will begin to reassert themselves.