In many ways, the 2007 energy market looks very much like it did last year. Tensions are high in the Middle East; and in the United States, where less than 5% of the world’s population continues to consume almost a quarter of the world’s crude oil, China and India’s insatiable demand continue to make headlines.
“We need to have more oil and we need to reduce consumption and increase alternative sources,” says Dominick Chirichella, director of the Energy Management Institute, “and there isn’t anything on the horizon that makes me feel warm and fuzzy.” That’s the conventional wisdom that has put crude oil into the upward trend that started in November 2001 and continues to this day, according to energy bulls (see “Crude’s rude health,” below).
However, just below the surface, bubbles change. The global economy, at least in the Western Hemisphere, is clearly slowing down. We see it in the weakening economic numbers, the growing equity volatility and mainly in the housing sector, which has led to a major liquidity crisis in credit markets. Call them bear sightings.
Energy bulls are focused predominantly on limited supply and geopolitics. “If I am going to just look at a monthly chart, then the market could certainly get to a $101 to $107 range,” says Darin Newsom, energy analyst at DTN, adding that from a fundamental standpoint, the market is still strong. He adds that in late August, the futures spreads are stable, indicating that demand is consistent and predictable, and until that changes, the market will not allow for a huge sell off. “Last year we had bearish futures spreads indicating plenty of supply,” he says, and prices then dropped into the $50 range. This year, the market has solid support and despite an equities sell-off, interventions by the Federal Reserve Bank could increase confidence in the markets, spurring more buying and a push through to new highs.
Raymond Carbone, president of Paramount Options, has been watching the difficulties in the stock market and the implosion of the subprime lenders with concern, but says that even if the U.S. economy slows, global growth will continue and Asian demand will continue to outstrip supply. “This has been a healthy pullback,” he says, and one that was necessary for the market to reach new highs.
“We still have big issues with security of supply,” Chirichella says, and lists a number of factors inhibiting production. And it’s a long list, including Iran’s and Mexico’s decrepit infrastructure, Iraq’s struggle towards stability and productivity, the ongoing insurgency in Nigeria, which is costing that country 600,000 to 800,000 barrels of oil per day, Venezuela’s belligerence towards the United States and Exxon Mobile and Conoco-Phillips’ recent pull out of that country, and the Organization of the Petroleum Exporting Countries’ (OPEC) February production cut of 1.7 million barrels per day.
Then there’s Russia, the world’s second largest oil exporter, which not only has nationalized natural gas production, but has also been accused of politically inducing the bankruptcy of Yukos Oil Company and taking it over via the state owned Rosneft Oil Company. “Any time you have nationalization, it leads to inefficiency,” Carbone says.
Another troubling trend supporting the bulls is that large producers, such as Iran, Indonesia and Mexico, are actually importing gasoline, which underscores the critical nature of the current lack of refinery capacity. Further, those governments are then subsidizing the retail prices of gasoline to their citizens. Carbone says this expensive trend will ultimately lead to less exploration and less production.
“A lot of traders who were looking at geopolitical factors were burned,” says James S. Cordier, head trader at Liberty Trading Group, and he says that while geopolitical premium is lessening, it may still account for as much as $10 per barrel.
Energy bears are focused on high inventories and falling demand. “The market is a little heavy at this point,” Cordier says. “India and China’s demand pale by comparison to the United States, and inventories are at five and six year highs.” He says that the most recent Department of Energy Report shows U.S. crude stocks at a “burdensome” 337.1 million barrels, well above the five-year average, and that compared with the prior week, crude stocks increased by 1.9 million barrels, gasoline production increased 9.3 million barrels per day and heating oil production increased 4.2 million barrels per day.
These bearish factors are hitting at the end of the summer driving season, when seasonal demand usually ebbs. Cordier says overall demand also may be dropping. “Stock markets are reeling, if the financial situation gets more bleak, that is certainly going to have ramifications for growth globally.”
Timothy P. Evans, VP and energy analyst for Citi Futures Perspective, agrees. “August and September were bearish months last year and you have more oil on hand now than you did 12 months ago. So it’s hard for me to buy into the idea that this is the second coming of the great bull market.” Evans says world petroleum demand growth peaked in 2004 at 4.1% and that the United States throttled back to 1% growth in 2006 (see “Switching to glide,” below). “Demand outpacing supply is not the story that it once was,” he says. “Nor do I believe there’s a threat to supply under every bush. No pun intended.”
On the supply side, Evans says heavy investment in non-OPEC supply is paying off and non-OPEC supply is sufficient to offset declines in OPEC production and any demand growth.
BACK TO BACKWARDATION
In contango markets, prices for more distant delivery exceed the spot market prices and it is typically associated with high inventories. The opposite is backwardation.
Craig Pirrong, professor and director of energy markets for the Global Energy Management Institute at the University of Houston, says backwardation and contango are market signals that tell producers when to add to inventory and when to draw from inventory.
In 2005, after Hurricanes Katrina and Rita took out energy infrastructure, oil and gas supplies were tight. In 2006, hostilities in Iraq and Lebanon lead to fears of a wider regional conflict and, combined with tensions between Venezuela’s President Hugo Chavez and violence in Nigeria, created an expectation of tighter supplies. Those who could hold crude oil inventories bought and stored more, Pirrong says, and the market went into contango.
The return of refinery capacity now has the market in a state of backwardation. Capacity is now approaching 93%, up from just 87%, which has started to draw down those crude oil inventories, which are still high. “Now we are going to a more typical situation,” Pirrong says. New buying has therefore slowed, even as the flow of gasoline has increased, putting downward pressure on oil and gasoline futures prices. The return to backwardation has coincided with a slow down in the stock market, “That’s going to knock off demand growth going forward,” he says and inventories are not going to be as tight.
Evans says, “I don’t think backwardation is sustainable with inventory levels higher than a year ago.” He adds that backwardation is an incentive for refiners to stop refining gasoline and is bearish for crude.
EXPORTING NATIONS
Carbone says that with oil trading at $78 per barrel, there was at least a chance that OPEC would agree to a production increase, but that is far less likely since the $10 sell off in August.
“We can expect OPEC to exercise production restraint to keep prices within their recent range because a number of OPEC members have already spent the money,” Evans says, adding that Nigeria, Iran and Venezuela need oil at $60 per barrel to avoid running fiscal deficits. “They are going to look for a production policy that will maintain that level of revenue, so the down side of prices will be limited by that OPEC restraint.” And OPEC has other reasons to keep production down.
According to the Energy Information Administration, in 2007 non-OPEC production is up by 690,000 barrels per day, and in 2008 is expected to rise by 1.1 million barrels per day (see “Another game in town,” below). Therefore, with slowing global demand, there is simply less market share available. “So you are looking at total demand minus OPEC supply to see what’s left for OPEC. They’re projecting that what’s left for OPEC in 2008 will be 239,000 barrels per day less, on average, than in 2007. This is not a strong pricing environment.”
Another issue is that with oil priced in U.S. dollars, and the dollar in a substantial long-term decline, the real price of crude is lower.
“If you look at what has happened to the EUR/USD spread, you have almost a 40% move,” Carbone says, and OPEC nations do a larger amount of trade in the Euro zone than in the United States. “They sell [oil] in dollars and buy in euros, and are therefore losing on the spread,” therefore OPEC is receiving the equivalent of $45 to $50 per barrel, which could eventually become an argument for higher prices or a push to price oil in euros. In addition, the all-time highs in the stock market coincided with crude oil highs, and from that Carbone infers that $70 oil has not been a drag on the economy, and therefore will go higher.
NATURAL GAS
The Energy Information Administration (EIA) projected annual natural gas consumption would rise 4% in 2007 based on increasing demand for electricity and the return of normal winter weather. But while increasing demand for crude has driven prices up, natural gas prices have been weak so far and trading on their own fundamentals. “These are two very different markets,” Evans says. “The natural gas market is a regional market; 95% of the U.S. consumption is being supplied from domestic sources and Canada,” he explains. In addition, according to the EIA, domestic on-shore production continues to offset declining production in the Gulf of Mexico and so far, hurricanes have been a non-event.
“You will start the heating season with record levels of natural gas in storage and sometime at the end of [September], we will put in a V-shaped bottom into the natural gas market,” says Darren Dohme, executive vice president and energy trader at Powerline Petroleum. He adds that natural gas inventories, which were 3.6 billion cubic feet in the first week of September, and milder weather have combined to depress prices. He says the bottom is not in and expects natural gas to drop to the $4.75 area. At that point, utilities and commercial end users will start buying up inventory; then prices go sideways to higher, hitting the $8 level by November. “You still have some fund shorts in there and [they] will have to cover [at] the end of this month and that’s going to help create that V-shaped bottom.”
One factor that has made trading the energy markets so difficult in 2007 is that there has been a disconnect in correlations within the sector. While seasonal supply and demand characteristics had meant certain energy products lead and others followed and diverged at regular intervals, crude oil, unleaded and natural gas often moved in opposite directions this summer. While much of that irregularity is supply chain based, it makes trading the entire sector more volatile. It is hard to say where energy goes from here, but expect volatility to continue.
