Amid Libyan sanctions, the International Energy Agency took action in June to keep the world’s oil spigot at full flow. Price swings followed this new wrinkle in supply uncertainty. But the move to open reserves was only a taste of the volatility to come.

When the International Energy Agency (IEA) tapped the strategic petroleum reserve in late June 2011, pouring some 60 million barrels of oil onto global markets to help make up for supplies lost to Libya’s civil unrest, investors and hedgers spent the subsequent weeks in a defiant drive that took West Texas Intermediate (WTI) crude futures back to $100 a barrel. It was a sign of what was to come – weeks of a volatile supply and demand push-and-pull that culminated in a price drop to 11-month lows below $80 by early August.

Price predictions now hinge on whether the globe will tip back into recession. Some analysts see WTI near current levels through year-end – a range of $75 to $102.

In addition, unusual market behavior is reflected in the ongoing futures price inversion that has WTI uncommonly trading at a record discount to European Brent crude (see a, “A Complicated Relationship” on page xx.)

That wedge held as weak consumer spending and manufacturing data compounded the jitters brought on by the 11th-hour passage of the U.S. debt-ceiling extension. Surging borrowing costs for new European bond issues had a similar effect, although a European Central Bank pledge to buy bonds did help. Now, the United States faces its own jump in borrowing costs after Standard & Poor’s downgraded its sterling AAA credit rating one notch to AA-plus.

“With the IEA move and because the Libyan production issues, while important, didn’t spill over to its neighboring producers, I think the market, at least since May, has shifted focus toward the demand side — the debt crisis in the euro-zone and the U.S,” says Robert Johnston, head of global energy and natural resources at political risk consultancy Eurasia Group. “This, of course, impacts currency markets and as a result, impacts oil markets.” Unrest continues in Syria, Yemen and elsewhere, but the production disruption did not spread as first feared.

The $100-plus territory that WTI hit after the IEA move was below the $115 of earlier in the year and the all-time record near $147, but notably was some $10 higher than where front-month futures traded as the Paris-based group approved its rarely used 30-day release. Brent futures revisited the 2011 highs near $126 a barrel as mid-summer approached but dropped below $107 in the wake of the U.S. downgrade.

Credibility compromised
Clearly, pricing volatility fueled the criticism that some market participants leveled at the IEA. Their move followed an acrimonious meeting by the Organization for Petroleum Exporting Countries (OPEC) in June, in which all of OPEC but Saudi Arabia decided against an increase in output.”.

“If OPEC bruised its reputation by its collective failure to find consensus on production policy at a June meeting, consumer countries acting through the IEA have gone a good step further, raising reasonable questions about the agency’s long-term market credibility,” says Bill Farren-Price, chief executive officer at U.K. consultancy Petroleum Policy Intelligence.

The United States opened up its own reserves in a coordinated effort with the IEA. The release’s short-term impact, according to the agency, was effective in bridging the gap until OPEC and an independent move by Saudi Arabia could make up the production difference. Libya is the world’s 12th largest exporter, pumping a pre-conflict 1.58 million barrels a day.

If anything, the IEA’s move was more an action of supply shift. Most of the crude in the release was sold in the United States, displacing its more usual imports and prompting a major rerouting of product flow, including bringing more West African crude into the global mix. Meanwhile, Saudi Arabia has increased production of lower quality crude, partly compensating for the higher quality oil that Libya had sent to European refiners.

Olivier Jakob, managing director at Zug, Switzerland-based consultancy PetroMatrix, anticipates balanced net global supplies into year-end.

“Given that the strategic petroleum reserve release is occurring now and that, as of September, the U.S. refinery crude oil demand starts to ease for seasonal reasons, we think that the SPR release will guarantee that the U.S. stays very well supplied until the end of the year,” Jakob says. He adds that he does not expect any change to OPEC output this year, but thatSaudi Arabia will act on its own.

Short-term demand in doubt
Consumer and business sentiment data from North America, Europe and China hit within a few days of each other. All missed the mark. With U.S. debt management in question, the dollar fell to an all-time low against the Swiss franc and slid against the yen, prompting Japanese currency intervention. A weaker dollar is oil-supportive because it makes crude priced more attractively on global markets. But because the decline was symptomatic of a weakening global economy, crude futures got little traction from a softer greenback.

In fact, the U.S. Department of Energy in May lowered its estimate for the country’s oil consumption to 18.36 million barrels a day, down 2.5 percent from the same month last year. Demand fell in April as well. The U.S. had not endured two consecutive months of year-on-year crude oil demand decline since October-November 2009.

China’s contribution to demand, some 11 percent of the globe’s total consumption, looks to moderate, explains Eurasia’s Johnston.

“China will still have a very stable crude and GDP outlook, but we don’t expect to have the big move of 2009 or the big up-years like in 2006 or 2004 with the power crisis there,” he says. “You’re seeing expectations for strong, steady demand growth but not the swings we had seen.”

Peter Beutel, founder of U.S. energy risk management consultancy Cameron Hanover, says that while a double-dip recession may not come to realization, a slow-growth picture could continue. Even with the latest pullback, oil prices may prove too steep to allow an economic recovery from such a deep recession.

The Federal Reserve will be the key driver of oil prices, Beutel says. Should the Fed push through another round of its quantitative easing program, Beutel would add another $25 to his current $75 to $85 year-end WTI projection.

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SIDEBAR

A Complicated Relationship

Brent crude is trading above global benchmark West Texas Intermediate (WTI) crude by as much as a record $23 compared to near parity at this time in 2010. For the past few years, falling U.S. Midwest inventories have usually resulted in a narrowing of the Brent-WTI spread, which typically stands at an average $5 in favor of WTI.

“It is a pricing relationship that the market has been able to sustain,” explains Robert Levin, managing director, energy research and product development, at CME Group.

Brent’s gap has been growing since January 2011, in part because Midwest hubs in Cushing, Okla. are receiving more supply from oilfields in North Dakota and Canada, but have not yet built enough pipeline to pump the incoming crude further south, though plans are underway to address this issue. Other analysts note tighter supplies in Europe’s North Sea, which is problematic for Brent.

Cushing, Oklahoma, has expanded its massive tank farm to help accommodate an expected onslaught of crude from further north. But production in the Bakken Shale of North Dakota has gone from virtually zero to around 400,000 barrels a day in the space of a few years, and U.S.-bound shipments from Canada have surged. Yet, observers believe greater upgrades to pipeline and storage capabilities will be necessary to ultimately provide a solution. Indeed, a massive Canada-to-Gulf Coast pipeline project known as Keystone XL will soon be voted in by the U.S. government.