ROB Insight is a premium commentary product offering rapid analysis of business and economic news, corporate strategy and policy, published throughout the business day.
Oil prices aren't just high. They're broken.
The latest monthly oil market report from the International Energy Agency, released Wednesday, shows that the price for one of the world's most important benchmark crude grades, North Sea Brent, has surged back to nearly $120 (U.S.) a barrel despite the fact that spare production capacity at the Organization of the Petroleum Exporting Countries (OPEC) has risen substantially. Normally, rising excess production capacity puts a damper on prices – it has been a pretty reliable indicator of underlying supply-and-demand pressures. But in recent months, the price of Brent has all but ignored this signal, continuing higher even when it's clear that OPEC producers aren't strained in the least to meet market demand and make up for any temporary supply interruptions.
And OPEC and the market for Brent aren't the only places where long-standing oil market fundamentals are being shrugged off. The price for the U.S. benchmark oil grade, West Texas intermediate (WTI), has surged 14 per cent in the past two months, even though U.S. inventories of oil in storage are within spitting distance of their all-time highs, and have risen 3 per cent since the start of this year.
How do we make sense of this glaring disconnect between prices and supply fundamentals? One emerging explanation, as my colleague Carl Mortished recently pointed out, is that fast-evolving transportation and political issues have regionalized the global oil market – global benchmark prices such as Brent and WTI no longer have much bearing on the various regional grades that are closer to the source of these oversupplies. In Canada, we've seen this first-hand, as the Canadian benchmark for oil sands crude, West Canada Select, is trading at a whopping 25-per-cent discount to WTI. As the IEA report points out, price spreads for key Middle Eastern crude grades have widened relative to Brent during the recent expansion of OPEC spare capacity.
Investors and market watchers can always find entirely rational explanations, like this one, to justify disconnects between prices and historically recognized underlying fundamentals. And they're almost always wrong. Markets and investment assets only very rarely undergo such a substantial change that the very fundamentals on which their pricing is based are altered.
They're wrong this time, too. Oil is still a global market, it can still be transported with surprising efficiency over great distances. Brent is not immune to the fact that the biggest oil exporters in the world are swimming in production capacity. WTI is not immune to U.S. storage facilities that are bursting at the seams at the same time as North American oil production is surging.
No, the public markets on which Brent and WTI futures trade are reflecting a general easing in risk aversion among the world's investors. Global economic and financial risks have calmed considerably, so investors are rotating into riskier assets (such as commodities) and away from the safety of government bonds. (The U.S. 10-year Treasury has seen its yield surge more than 40 basis points since early December, reflecting this rotation away from the bond market.) This trade has, essentially, trumped oil's fundamentals.
It can't last. Eventually, the regional problems will ease, and the global benchmark prices for oil are going to more accurately reflect the global reality of oil supplies. Fundamentals always win out in the end.
David Parkinson is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights.
David Parkinson