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.
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.
Springer, on the other hand, forecasts a weakening economy based on a continued slide of GDP numbers and says crude oil should be in the low $60 per barrel range by year end, absent a geopolitical event.
“The market’s perception right now is that if the economy gets better, oil prices will go up, which is probably what will happen at least initially,” Flynn says. “[However], the economy [could] get better and oil prices go lower [because] we’re going to see the inverse of what drove oil prices up during weak economic times. If the economy gets better, [we’ll] raise interest rates, which means the dollar will get stronger, and a stronger dollar will put downward pressure on oil prices. Once we start to get out of this economic muck, we could see a break in oil prices after the initial rally.” He expects oil prices to go down into the $40 per barrel range by year end.
Analysts believe the economy is key for the dollar and equities, which will drive crude. “The market looks at equities as the leading indicator for GDP. If equities are going up, GDP is going up and oil consumption is going up and vice versa,” Chirichella says. “Unfortunately we’re in the vice versa stage right now. Equities are going down, GDP [is going down] and OPEC’s pumping away, and inventories are going up,” (see “Down and out,” below).
Chirichella is bearish on oil for the short to medium-term and says that the outcome of midterm elections in the United States could move oil. “If the Republican party takes the House and makes gains in the Senate, that could result in a decent relief rally in equities and equities are so highly correlated to oil that we could see oil prices get to $75-$80 a barrel,” he says, adding that barring that, oil will remain in the trading range of $65-80 for the rest of the year. The EIA puts an almost 50% probability that WTI crude prices will be below $80 a barrel by the end of 2010 (see “Forecasting crude,” below).
Natural gas glut
The supply story is once again the driving factor for natural gas prices. Supplies are at record highs and analysts expect them to stay that way. “Natural gas just keeps on flowing. The one constant that exists in the natural gas market is that supply is continuing to run at high levels,” Chirichella says, adding that if the economy does continue to slow, it’s going to have a negative impact on the consumption of natural gas, increasing supply even further. Unless there is a hurricane, he expects natural gas to trade in the upper $3 to mid $4 range for the rest of the year.
Patton agrees. “The supply and demand picture looks really bad, so the only thing that could save natural gas is a hurricane. Lower prices are coming soon. The only other thing that could help is if there’s a policy announcement from the White House saying natural gas is going to be more important to alternative energy (see Cover story). Prices look like they’re headed lower, and quickly.” He expects natural gas to stay in a range between $3.75 and $5 around the end of 2010.
Ilczyszyn says a stronger dollar short-term will drive down natural gas prices. He expects natural gas to be at $5-$6 at year end.
Flynn expects the hurricane season to end with a glut of natural gas supply and an uncertain economic outlook. “Manufacturing and natural gas prices sometimes go hand in hand, especially when we talk about industrial demand, and if we lower our expectations in the manufacturing sector, we could lower our prices. I’m looking for a spike below $3,” he says.
Hurricanes or geopolitical events, as always, remain the wild cards for energy prices. “Oil and natural gas were supported throughout the summer on predictions of a record hurricane season. A lot of the hurricane season has passed us by and we’ve already seen the hurricane premium being taken out of the market,” Flynn says.
Energy fundamentals, however, are a funny thing as Flynn pointed out above. While the global recession is keeping demand down, the Fed’s remedy of quantitative easing may be keeping crude prices up. While a sustained recovery may bring back demand, it also will bring the much anticipated exit strategy that would take out that support, making the energy outlook that much more difficult.