From the February 01, 2007 issue of Futures Magazine • Subscribe!

Crude oil: It is all in the numbers

$78.40 is a fetching price tag for one barrel of the light, sweet crude oil that trades on the New York Mercantile Exchange (Nymex).

Not only is that price a milestone because it is the all-time (front month) intra-day high hit July 14, 2006, but it’s one that is likely to be short-lived as U.S. supply/demand balances tightened in the waning weeks of the year, making that an irresistible target to be challenged by energy enthusiasts in 2007.

Total U.S. petroleum inventories declined at one of the most rushed paces on record during the fourth quarter of 2006 while the Organization of the Petroleum Exporting Countries (OPEC) agreed to its first production cut in nearly two years. The cartel agreed to slash supply by 1.2 million barrels per day (bpd) in October at a special meeting in Doha, Qatar, effective Nov. 1. OPEC then agreed to another 500,000 barrel production cut at its Dec. 14 meeting in Abuja, Nigeria, this time effective Feb. 1, 2007, which is just enough time for the market to price in lower supply and to take the bullish edge off the cartel’s decision. While the world’s largest oil producers agreed to remove some supply from global markets, America, the undisputed champion of global petroleum consumption, was undergoing a marked decline in inventories during what is typically the highest demand period of the year.

Total U.S. petroleum inventories dropped 65.2 million barrels to 1,024 million barrels during the fourth quarter, leaving stocks 49.6 million barrels above the five-year average and 14.3 million barrels above year-ago levels, according to data from the Energy Information Administration (EIA). The bulk of the decline occurred in product inventories, which fell 56.16 million barrels to 704.3 million barrels during the third quarter and only in the final two weeks of the year was the trend arrested. High refiner throughputs while crude imports were at less-than-optimal levels allowed for a recovery in product output.

However, if refiners were cranking out product, then they were using crude barrels to do so, and the proof was in a reversal in stock building during the fourth quarter that was evident by the 20 million barrel drop in crude inventories during the month of December. Crude inventories were 319.68 million barrels the week ending Dec. 29, the last set of data for 2006, leaving stocks 1.9 million barrels below year-ago levels, but 25.5 million barrels above the five-year average (see “Reversing course,” below).

By comparison, total U.S. petroleum inventories the week ending Oct. 6, which was the start of the fourth quarter, were 102 million barrels above the five-year average and 91.1 million barrels above year-ago levels. The last time total U.S. petroleum inventories were at a comparable level was the week ending May 19 when the active front-month crude contract on Nymex settled at $68.53 per barrel. The active front-month crude contract settled 2006 at $61.05 per barrel, which was a gain of 1¢ year-over-year, or 0.02%.

More important, a reporting error announced by EIA Jan. 3 suggested U.S. crude inventories may have taken a nose dive in the final weeks of 2006 with the data off by as much as 10.5 million barrels. Usually a reporting error works its way through the data over several weeks, but the upshot was U.S. petroleum inventories were not quite as plush as the plummet in prices would have had people believe.

The start of 2007 saw an onslaught of selling that sent crude prices plummeting nearly $6 per barrel in the first two trading days of the year despite fundamentals that had not undergone a structural shift. The same factors that sent petroleum prices surging through the past four years were still intact: a robust global economy provided the underpinning for demand for raw and industrial materials, which thus far has shown no signs of slowing; non-OPEC supply growth had failed to meet market expectations; demand growth has consistently surprised to the upside; and Iran and Western nations were still at a stand-off over the Islamic Republic’s pursuit of nuclear capabilities.

“In our forecasts, the five largest undershoots of supply compared to the expected level as seen a year ago are Norway (-0.12 million bpd), Angola (-0.09 million bpd), USA

(-0.08 million bpd), Canada (-0.06 million bpd) and Brazil (-0.05 million bpd),” Paul Horsnell and Kevin Norrish, energy analysts at Barclays Capital, said in a report Dec. 20. “Overall, the disappointments were largely mature areas, mixed in with some new production that did not ramp up as fast as was expected,” they added.

The EIA in its December short-term outlook was looking for non-OPEC supply to grow by 1 million bpd in 2007 to 51.8 million, while total global demand is expected to increase 1.5 million bpd to 86.5 million, or 1.76% growth year-over-year. If these projections become reality and OPEC sticks to lower production quotas, the Organization of Economic Cooperation and Development (OECD) inventories will draw 300,000 bpd, according to EIA, which based on recent estimates of OPEC production is far too conservative. Platts’ most recent estimate of OPEC production was 29.06 million bpd for November while EIA reported the cartel’s supply for the same month at 28.965 million (see “Opec production gambit,” below).

EIA also is projecting OPEC crude production to average 29.6 million bpd for all of 2007, suggesting that at current supply levels, inventories will fall much further and much faster in 2007, and ultimately prices will reverse back to the upside.

On the demand side: “We forecast growth in demand for transport-fuels to slow down to an average of 0.8% next year in response to high prices and a slowing economy, with +1.9% real gross domestic product (GDP) growth as the key macro-measure,” Jan Stuart, energy economist at UBS noted in a report. “In 2007, gasoline is projected to contribute +0.5% growth (the 10-year trend through 2006 is +1.7% average annual growth); diesel demand should grow +1.3% (+4.3% 10-year trend); and jet fuel grows +1.6% (10-year trend is +1.0%).” Gasoline demand in the United States represents about 46% of total petroleum product supplied, based on EIA preliminary weekly data.

While most Wall Street economists are forecasting a slowdown in U.S. GDP growth, UBS is one of the more circumspect projections. Economists at Barclays Capital are looking for U.S. GDP growth of 2.7% in 2007 while Societe Generale is projecting 2.3%. Stuart’s demand estimates could prove conservative should American economic growth prove to be stronger than a 1.9% rate in 2007, particularly with the U.S. consumer having proven to be fairly resilient despite historically high energy costs.

But oil price spikes in 2005 resulting from hurricanes Katrina and Rita, and in 2006 amidst geopolitical concerns in the Middle East, were short-lived and only rivaled by an equally steep drop in energy costs.

Stuart forecasted $68.75 oil in 2006 and is projecting an average price of $69 per barrel for WTI in 2007. Horsnell and Norrish had a price forecast for WTI of $66.30 for all of 2006; light, sweet crude actually averaged $66.25. For 2007, the two Barclays analysts are projecting an average price of $76.00.

Barclays’ estimate for 2007 was the most aggressive, but they have plenty of company. Analysts at Goldman Sachs forecast an average price for WTI of $68.50 in 2006 and $72.50 for 2007. Given the thrashing that the petroleum sector took at the start of 2007, these appear to be fairly bullish estimates, but the year is young.

If anything, the start of 2007 reinforced a trend that had been in place for the past five years, which was an influx of money across the commodity sector. The rush does not always have to be onto the long side of the markets and particularly in what appeared to be establishing shorts given the drop in prices while open interest was soaring. Through the past four years, volume growth on organized derivatives exchanges (futures and options on futures combined) in the U.S. averaged 26.28%, according to data from the Futures Industry Association (FIA). The data from FIA for the first half of 2006 suggests another year of 25.36% in volume growth on organized derivative exchanges in the United States as commodities have taken their place in the pantheon of asset classes.

Coinciding with volume growth on organized exchanges in America and internationally, was the amount of money that was put to work against commodity indexes. Goldman Sachs, in a Nov. 6 statement accompanying the release of the 2007 weightings of its commodity index, said the estimated investment level will be increased from the current $70 billion to $110 billon effective January 2007.

“The increase in the ISL (investment support level) in the GSCI [Goldman Sachs Commodity Index] reflects an increase in the general level of investment in the GSCI and other commodity indices,” the statement added. And commodity indexes do not short the cash markets — they will be less long as markets that comprise the index decline, but the only way to establish a short position is to do so in the futures markets.

Will fund managers attempt to challenge OPEC in its bid to keep oil prices supported above $50.00 per barrel? Trading activity on Nymex at the start of 2007 suggested so, but supply/demand fundamentals indicate the downside is limited.

The one wild card that has the potential to pump up prices, in addition to those already discussed, is the weather. Above average temperatures across the United States and Canada kept sentiment bearish as the weather was expected to temper distillate demand. But distillate demand is only about 20% of product supplied and heating oil represents only 6% or 7% of distillate demand, so pessimism caused by an abnormally warm winter along the key-consuming Atlantic Coast may not have been justified. Besides, what hurricane season will bring is anyone’s guess. Last year’s prediction of another in a series of active hurricane seasons was the demise of some rather seasoned traders who had placed very large bets on the weather.

Trading basic supply/demand fundamentals is less risky business than playing the weather, and checking a chart for a little technical direction wouldn’t hurt either. The technical picture looked weak at the start of 2007, but charts are as variable as the weather — the forecast is day-by-day and constantly needs to be updated.

Linda Rafield is a senior oil analyst at Platts and contributor to Platts’ Futures and Derivatives Review — a weekly roundup of developments in energy and other commodity and financial markets in the context of the U.S. and global economy. For more information on this product, visit www.platts.com.

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