How the energy landscape will impact the election

September 18, 2008 07:00 PM

In the first six months of this year the moves in oil were just stunning. Oil surged from around $91 per barrel to a high of $147.24, the biggest six-month move in the history of the oil market. The move was explosive, but the larger question remains as to why oil made this historic run. Because if you want to predict where oil will go in the last quarter of this year, you have to understand why oil did what it did the first half of this year.

So why did oil make that historic run? Was it all about supply and demand? Some people will tell you that the move defied rational explanation and was speculation run amok. Still others claimed it was evidence of peak oil. But because the move in oil was so far out of the historical norm, these explanations do not adequately explain the gravity of what happened. The truth is much deeper and more reflective of the larger economic world around us. Oil rose in large part because people used oil as a hedge against systemic risk in the economy.

Anyone who follows the oil market even remotely is now somewhat familiar with the long-term fundamentals that have sent oil up through this decade. The rising price of oil has been a story of worldwide economic growth, especially in the developing world and specifically in India and China.

Yet this year things were different. Oil ran up not so much because of strong oil demand but because of an economy in crisis. This became clear when oil soared after the Federal Reserve surprised us with a 50 basis point interest rate cut in September 2007 (see “Black gold”).

It was at this point the market started to realize that this subprime credit crisis might be a bigger problem than once feared. We were facing our biggest crisis since the Great Depression and oil became valued not so much via supply and demand but as a commodity that would still have worth even if the U.S. financial system were collapsing.

Consider that before the Fed made that controversial 50 basis point rate cut, oil was adding roughly $10 to $13 to the highs per year. Yet in 2008, in just six months, we added $47.98 to the high for the year, almost three times more than the average for the previous five years. It was clear that there was something different going on.

People bought oil after September not because of strong demand or tight supply. They bought oil as a hedge against a total breakdown of the U.S. economic system. They bought oil as a hedge against a falling dollar but in a larger sense, they bought oil as a hedge against bank failures and as a currency of last resort.

This was not just simple speculation, but the total reevaluation of oil in uncertain economic times. This was not a case of speculators driving the market but about changing fundamentals. You just have to make sure you are looking at the right fundamentals.

NAT GAS

The picture in natural gas is also bearish. Natural gas supplies, which started the season well below normal, have risen to above normal levels. This has been an incredible comeback as many thought that gas would never reach the levels of adequate supply this refill season.

However, while crude oil demand is expected to continue to wane, down 3% with a continued drop in 2008, according to the Energy Information Agency natural gas consumption is expected to grow 2.7% for 2008 and by 2.2% in 2009.

OIL CRISIS

This year we had an “oil crisis” because oil soared mainly as investors went to seek a safe haven away from the credit crisis that gripped the nation. Oil moved more on news out of the Federal Reserve and words from Ben Bernanke than it did on inventory numbers from the Department of Energy. People bought oil as they feared bank failures and the failures of Fannie and Freddie. They bought oil as a safe haven from the falling dollar.

Oil rose this year, but it flew for the wrong reasons. It exploded not because of strong growth in the world, but as the market adjusted to the U.S. economic crisis. Oil became a hedge against uncertainty.

But going into the last quarter of this year, it is clear that this hedge is coming off. It is coming off in part because most if not all the bad economic cards are on the table, but mainly because the rise in price caused demand to fall. In fact, for the first time in this incredible decade-long run in oil, we are seeing that the high price of oil is causing destruction of demand. This demand destruction will become clear as we move forward and pressure prices into the end of the year.

How clear? Take for example the news that the EIA, the statistical arm of the Department of Energy, revised downward its June oil demand by a whopping 1.17 million barrels per day from the same period a year ago. That was the lowest level for any June since 1998. Overall oil demand during the first six months of this year fell 5.6% from the year before and saw the greatest rate of decline since the dark days of 2001 (see “I'll take the bus”). U.S. drivers for the first time in 16 years drove less and demand growth for gasoline did not exist. The U. S. Transportation Department reported that U.S. motorists drove 12.2 billion miles fewer than the year before, taking the demand pullback level in the United States to historic proportions.

Earlier this year, the market dismissed weakening U.S. demand. The mantra was that even if oil demand fell in the U.S., it would not matter because the world’s economies had “decoupled” from the United States and demand in Europe and the developing world would continue to drive prices. Some thought that high prices did not matter in a world of declining oil production and consumption in the oil hungry developing world. Some openly said that the increase in oil prices was a sign that the U.S. empire and its influence on global oil demand and the global economy has waned. They thought that even though the United States is still the world's leader in oil consumption, it would take a back seat to places like India and China, and that the credit crisis was a U.S. problem and the dollar would get weaker and weaker to accentuate the point.

And demand in other places is staring to falter as well. China’s oil buying ahead of the Olympics has been well documented, but as we know the Olympics are over. Japanese refiners hoping to make up lost sales from Japan’s recession by selling oil to China are now cutting back on production. It is clear that the economies of Europe are slowing as well as growth in the OECD countries. High prices are causing many countries that had subsidized oil to lift subsidies. The consumers in those countries will cut demand as they feel effects of high prices.

And while the United States has taken steps to fix the credit crisis, the rest of the world is just facing up to it. Not only will that cause demand to weaken globally, but at the same time the dollar should continue to gain ground. We should see oil inventories start to rise as well. That means that oil should be back in the double digits and could go as low as $80 per barrel. Next year, oil could even dip to the mid-sixty dollar range.

OIL AND THE ELECTION

Republicans were actually chanting drill, drill, drill at their recent convention and even Barack Obama has moved to support controlled domestic drilling. But will this newfound consensus survive if crude dips back below $100? A major correction may put the issue of drilling for oil on the backburner. It may seem that any price less than $100 per barrel is suddenly somehow cheap. But the drop in demand does not mean that we should not prepare for oil demand growth in the future. The drilling debate should really be a serious discussion of energy planning. Any comprehensive energy plan must include more domestic oil production as well as serious investment and development of alternative fuels.

Hopefully our next president will form a comprehensive energy plan that will move in the direction of energy independence and not simply pay lip service to it until the current crisis is over, as seems to have been the case since the first oil shocks of the 1970s.

Phil Flynn is vice president of Alaron Trading and a Fox Business News contributor.

About the Author

Phil Flynn is a senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. Phil is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets.