As Brent and WTI prices ebb and flow from local and global fundamentals and risk premia, Morgan Stanley notes that to be bullish from here, one would need to believe a supply disruption is coming. Considering conflict with Iran, sustained Middle East tensions, and the potential for sustained supply disruption their flowchart of price expectations notes that prices follow inventories and that as price rises, fundamentals will weaken (as without an OPEC production cut, inventories would balloon by 2Q12) and therefore to maintain current prices across the curve, supply risk premia must continue to grow. They raise their estimate for 2012 average Brent price to $105/bbl from $100/bbl which leaves them bearish given the forward curve priced around $115/bbl, as their base case adjusts to a belief that Middle East tensions persist but a conflict with Iran does not occur as they address QE3 expectations and EM inflation/hard landing concerns.
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But What Is Driving Price Higher?
1. Geopolitical tensions and supply concerns likely to persist.
Iran is one of the world’s largest oil producers with production near 3.5 mmb/d. More important, Iranian exports have averaged ~2.2 mmb/d. A complete loss of these exports would likely push effective spare capacity towards zero, leaving little buffer for future supply disruptions in other parts of the world.
An SPR release could be used to combat short-term disruptions, but not a sustained global imbalance. If demand exceeds supply, prices would need to surge to restore equilibrium. The end result would be a significant shock to the global economy, lower oil demand, and a high likelihood of a global recession.
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2. Abating EM inflation and hopes for monetary easing.
As we noted recently the relief rally in emerging markets has far outpaced the rally in developed markets. With concerns of a China hard landing subsiding, investors have been willing to take on more risk. At the same time, slowing inflation in many emerging market countries has created the expectation for additional easing to stimulate economic growth. As a result, the global risk demand index has reached its highest since 2007. Higher oil prices, however, may arrest the recent decline exhibited in EM CPI.
3. QE3 expectations and a risk-on environment.
QE3 could create a bid in commodities broadly, all else equal, but fundamentals are more important. The growing likelihood of QE3 is also supporting commodities. However, as Exhibit 8 illustrates, fundamentals are important, hence the volatility of oil price around growing money supply. In other words, fundamentals tend to trump any apparent relationship between money supply and commodity prices, and the fundamental picture for oil remains bearish near term.
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Source: Morgan Stanley