From the October 01, 2010 issue of Futures Magazine • Subscribe!

Energy outlook: Economy rules

Oil prices have remained stable in 2010 after several wild years and have settled in a pretty high range -- $65 to $85 -- despite record inventories and a stubborn global economic downturn (see “Oversupplied,” below). However, for the rest of the year analysts agree that the most important factor for energy prices will be economic recovery (or lack thereof).

Recent economic news remains somber. U.S. Gross Domestic Product (GDP) for the second quarter of 2010 was revised lower to 1.6% after initially coming out at 2.4%, which is down from 3.7% in the first quarter. New and existing home sales dropped dramatically in July. The Federal Reserve has held interest rates at near zero since late 2008 and maintained its quantitative easing process by reinvesting in mortgage-backed securities in August long after its exit strategy was expected to begin.

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Government stimulus has actually altered oil prices from where they should be, says Phil Flynn, senior energy analyst at PFGBest Research. “Every time it looks like the oil market’s going to give in to the weight of over supply or it looks like the economy’s going to start to get weak, we either hear from the Federal Reserve [that] they’re going to keep interest rates low or they drop hints that they’re going to print more money, so those threats keep a floor under oil,” Flynn says. “There’s a $20 premium in oil because of economic stimulus. If we looked at real supply and demand numbers, oil prices wouldn’t be flirting with $70, they’d be flirting with $40.”

Inventories for crude oil are at record levels, with the Energy Information Administration (EIA) reporting an increase of 4.1 million barrels in stockpiles for the week ended Aug. 20. “There’s too much oil coming into the marketplace for the demand scenario that’s out there. Summer driving season [ended] with gasoline inventories higher than where they were going into the Memorial Day weekend. That’s pretty bearish,” Dominick Chirichella, founder of the Energy Management Institute, says.

And some analysts say there’s no end in sight for production, which will keep supply high. “Yemen, Saudi Arabia and Iran are not going to cut back production because that’s what their economies run on. Inventories are going to remain high because of supply and demand. World economies are [growing] much slower than expected, therefore you’re going to see less demand for oil,” Keith Springer, president of Capital Financial Advisory Services, says.

However, an excess supply in crude hasn’t affected prices as much as it should because of Fed policy and dismal economic conditions. A weak economy usually equals less demand for oil. “The market is telling us that this economic slowdown is going to go on a lot longer than we had originally anticipated. Even the International Energy Agency warned that we could see a substantial demand drop in oil if the economy takes a turn for the worse,” Flynn says.

Chirichella says of oil prices, “It’s all about the economy. The whole mentality of the U.S. and global economy recovering has been more than enough to keep the attention away from the fact that oil fundamentals are still relatively bearish. No matter where you look right now the global economy is slowing, which means that the consumption of oil is likely to slow accordingly,” he says.

The Fed’s buyback of Treasuries is another indicator that economic recovery may take longer than originally believed, Rich Ilczyszyn, senior market strategist at Lind Waldock, says. “The prospect of economic growth in the next year [is] subdued from [early 2010]. So as the Fed makes a statement, that shifts all currencies and crude is selling off. Oil has run its natural course. The wild card for energies may be geopolitical tension and hurricanes, but if you’re looking at it on a demand basis, oil may retest $70 and it’s close to breaking below that,” he says. He expects oil to be at $60-70 a barrel by year end, with slower economic recovery and slower manufacturing keeping crude prices relatively low.

Spencer Patton, chief investment officer of Steel Vine Investments, disagrees, and expects crude to go up to $80 a barrel. “Probability favors an economic recovery through the end of the year. A lot of negativity has been priced into the market. I expect the market to be stronger through the end of the year with gains in the S&P 500 which should be positive for crude oil,” he says, adding that a lot of negative news has already been priced in for crude, meaning it could have already hit its lows for the year.

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