From the February 01, 2008 issue of Futures Magazine • Subscribe!

Energy 2008: Higher prices and volatility

Prepare yourself for some sticker-shock because 2008 will be another year of eye-popping oil prices. Tightening supply/demand balances will put a floor in prices, not unlike what has been seen in the past five years, surely sending the light, sweet crude futures contract on the New York Mercantile Exchange (Nymex) easily soaring above what some would deem a magical number and what others will view as another day at the races: the $100 per barrel level.

A marked deterioration in U.S. crude oil inventories over the past six months and erosion in European stocks leave the OECD (Organization for Economic Cooperation and Development) vulnerable to any supply shock. Supply disruptions translate ultimately into price spikes. With or without a supply disruption, low inventory levels in the United States and Europe will keep oil prices well supported.

According to the Energy Information Administration (EIA), U.S. commercial crude stocks fell to 289.6 million barrels at the end of 2007, the seventh consecutive decline in inventories and the lowest level since the week ending Jan. 5, 2005 (see “Dwindling supply”).

At 289.6 million barrels, U.S. crude stocks were 6.6 million barrels below the five-year average and 30.099 million barrels below year-ago levels. Stock declines at this time of year are not out of the norm and inventories tend to replenish throughout the first quarter. However, the tightening trend that has been in place since the onset of the fourth quarter was spread across both crude and products in contrast to prior reports (see “The whole complex”). Over the past six weeks, tightness has been relatively confined to the crude sector, but a less-than-optimal rate of refinery output and a solid enough pace of demand have now eroded product inventories as well.

Market focus will remain on the U.S. Gulf Coast, the refining heartland, and on Cushing, Okla., home of the Nymex delivery point, and any stock changes in those two locations.

In May, Nymex crude went into a steep contango and was trading over $6.00 per barrel under ICE Brent — an unusual situation considering that the United States is a net importer of crude — because of a glut of light sweet barrels at Cushing. Inventories at Cushing climbed to a record 28 million barrels in mid-April 2007, and remained high through the end of the second quarter, as refinery problems in the U.S. Midwest eroded demand in the region.

The price distortion, although short-lived, was a dramatic reminder that the price of crude ultimately reflects local fundamentals. Any similar refinery snags in the near future should have a similar impact on the price of crude, as, structurally, it is much easier to get crude into the Cushing area than it is to get crude out.

Crude storage at Cushing has been growing, and will continue to expand, in response to higher demand for U.S. Gulf Coast and Canadian barrels moving into the Midwest. Enbridge was supposed to have boosted its Cushing storage capacity by 3.9 million barrels to 16.7 million barrels by the end of 2007.

U.S.-based pipeline company TEPPCO, which currently owns roughly 3 million barrels of crude storage at Cushing, plans to add another 250,000 barrels of storage in 2008.

By the first quarter of 2009, Enbridge hopes to have expanded its Chicago-to-Cushing Spearhead pipeline to 190,000 barrels per day (bpd) from 125,000. By 2010, TransCanada is planning to have its 590,000 bpd Hardisty-to-Cushing Keystone line completed. However, in late December BP dropped plans, for the time being, to reverse its 100,000 bpd Chicago-to-Cushing Viridian Pipeline after receiving tepid response from shippers.

Market sources said what was needed was not more pipeline capacity into Cushing, but out of Cushing into the U.S. Gulf Coast refining center. Don’t expect that capacity to materialize in 2008, however. In December, TEPPCO said it was in the planning stages with Kinder Morgan to build a crude pipeline that would run all the way from Alberta, Canada through Cushing and into the U.S. Gulf Coast. Exxon Mobil and Enbridge are considering a $3 billion pipeline that would ship up to 400,000 bpd to the Gulf from Chicago by 2010. TransCanada said it will study an expansion of its Keystone line to the Gulf Coast.

TEPPCO has considered reversing the direction of its 300,000 bpd U.S. Gulf-to-Cushing Seaway pipeline, but has yet to announce firm plans.

When it comes to pricing, the supply of low sulfur, high API gravity crude, (light, sweet crude) matters most. The general media has a tendency, for the sake of simplification, to talk about the price of crude as if there is only one type of grade being bought and sold on the market. Unfortunately, like any factual error, this only creates more confusion down the road, for instance when WTI crude prices continue to rise despite assurances from OPEC that it is putting more barrels on the market. The market is not short of OPEC barrels, which at this point are predominately sour, but rather light, sweet barrels. And that demand for light, sweet crude will continue to climb as demand for lower sulfur distillates expands, which leaves the market vulnerable to price spikes.

“Demand to remove all sulfur from petroleum products made by the U.S. EPA, the EU, and governments of other countries have made very-low-sulfur crude increasingly valuable,” analyst Philip K. Verleger said in a Jan. 2 report. “Refiners will invest to improve product quality but will also seek out additional low-sulfur crude supplies.”

Meanwhile, a low level of stocks from which to rebuild will put the United States in the unenviable position of competing with other regions for incremental barrels, particularly if the long-anticipated economic slowdown does not materialize and petroleum demand growth accelerates. Crude stocks in the euro zone stood at 480.78 million barrels in November 2007, according to the most recent data released by Reuters on Dec. 11, down just 2.55 million barrels from the previous month, but 4% below year-ago levels.

While the United States accounts for 25% of total petroleum demand, America is not expected to drive demand growth in 2008. China, India and the Middle East will be behind percentage gains in global petroleum demand growth (see “Pulling its weight”). Global petroleum demand growth is expected to climb 2.1 million bpd to 87.8 million in 2008, or 2.5%, according to the most recent estimates from the International Energy Agency (IEA). As an aside, OPEC, in its December monthly oil report, forecast oil demand growth of 87.06 million bpd in 2008, a jump of 1.32 million year-over-year, which is 740,000 bpd below IEA’s estimates, and quite obviously, reduces the “call” on OPEC itself.

NATURAL GAS

Meanwhile, high natural gas inventories should continue to keep downward pressure on natural gas prices in 2008. At the end of 2007, U.S. natural gas inventories were at 2.921 trillion cubic feet (tcf), according to the EIA, 0.16 Tcf below the same point in 2006, but still 0.222 tcf above the five-year average.

Barring any disasters, natural or man-made, natural gas supply should not be a major concern. Warmer than normal weather patterns over the past several years have kept a lid on natural gas demand. Since 2002, the front-month Nymex natural gas contract has been stuck mostly between $5 and $9 per mmBtu, with the exception of a spike in 2005, primarily the result of Hurricanes Rita and Katrina.

British weather experts were forecasting world temperatures to cool slightly in 2008, but to remain among the 10 hottest years on record. According to the Met Office and the University of East Anglia, global temperatures are expected to average 0.37 degree Celsius above the long-term average of 14.0 degrees, which would make it the coolest year since 2000.

“However, mean temperature is still expected to be significantly warmer than in 2000,” said Professor Chris Folland of the Met Office.

The supply situation in the United States is so good that Credit Suisse analyst Jon Wolff warned that the market is in danger of crashing in the early second quarter of 2008. Not only should natural gas supplies remain high, but a seasonal demand drop in the Northern Hemisphere “will send a lot of [liquefied natural gas] to the U.S.,” said Wolff during a conference call. Wolff estimates a 300% increase in liquefied natural gas over current levels. “Couple that with a big supply growth onshore and it could be a difficult scenario,” he adds.

SUPPLY AND DEMAND

The oil markets have become hypersensitive to macro-economic developments as the subprime mortgage mess that originated in the United States spread like a virus through global credit markets. But there is little evidence that there is any fallout from the housing and credit crises in the commodity sector, and hence, there should be even less of an expectation that global petroleum demand will suffer as a result.

While oil demand is always the most difficult part of balances to wrap one’s arms around, the real wild card will be non-OPEC supply, which has sorely disappointed the past three years. The IEA is projecting a 1.07 million bpd increase in non-OPEC supply to 51.25 million, which is, again, substantially above OPEC’s estimates. IEA’s estimates are 510,000 above OPEC’s forecasts for non-OPEC supply growth of 50.74 million. OPEC may clearly be closer to the actual production number than the IEA on this projection.

Even if the United States can meet current expectations for supply growth, which will solely depend upon Gulf of Mexico production, these will be offset by additions into the Strategic Petroleum Reserve, which means less commercial crude oil available on the markets. The North Sea fields peaked years ago. Mexican production has sorely lagged. Latin American production has disappointed. This leaves the former Soviet Union as the bastion of supply growth outside of OPEC, and not one that is likely to meet expectations, as has been so often the case.

All of this adds up to another year of headline-grabbing crude oil prices. And if the crude barrel is aggressively priced, so too will the products – middle distillates and gasoline.

Linda Rafield is a senior oil analyst for Platts. Jeff Mower is the editor-in-chief of Platts’ Oilgram Price Report. For more information on OPR and the Weekly Futures and Derivatives Review, a weekly publication created by Linda Rafield, please visit www. Platts.com

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