July 27, 2006
FEAR V. FUNDAMENTALS IN THE OIL MARKET
Crude is king when it comes to bull markets in the 21st century. The price of a barrel of oil in New York futures trading has climbed some 280%, as of last night's close from January 1, 2002. As bull markets go, this one's been extraordinarily profitable for those who've ridden the wave. This year alone, crude's ascended by more than 30%, based on the near-$80-a-barrel mark set earlier this month. But every wave crashes, eventually, even one that's driven by a potent supply/demand profile that drives the oil market.
Timing, of course, is everything when it comes to making predictions, and on that score we have no more insight than anyone else. But we do have eyes in our head, which informs our ever-cautious temperament when it comes to money.
Any analysis of where oil prices are headed necessarily starts with a survey of the geopolitical tension, which is also in a bull market. Front and center is the reality that Israel's locked in a war with the Lebanon-based Hezbollah militia. A month ago it was hard to imagine how the Middle East could become more volatile, but the Israeli invasion of Lebanon has resolved that mystery. Not that there wasn't already plenty of anxiety harassing the region and raising questions about the ramifications for oil. From Iran's nuclear ambitions to the chaos that is Iraq, the Middle East had more than its share of worries. Unfortunately, the region's recently descended down another notch into what is in the running to be its worst case of disorder and confusion in the modern era.
Suffice to say, the madness is deemed sufficient to warrant a fair amount of risk premium on a barrel of oil, perhaps as much as $40 by some estimates.
Human nature being what it is, it's not impossible to imagine that that the situation in the Middle East could yet go from bad to worse in the coming weeks and months. We certainly don't minimize that possibility. The United States, as we write, isn't keen on imposing a ceasefire in the Israeli-Hezbollah fighting, and so it's a safe bet that a ceasefire isn't coming in the next few days. Forty-eight hours, we might add, can be an eternity these days in matters of Middle East politics.
The longer the war rolls on, the greater the potential that it could spin out of control and become a regional conflict involving Syria, Iran and other nations. In that case, the ceiling on oil's price could shoot up dramatically in just one trading session. A hundred bucks a barrel, in other words, could be lurking just around the corner.
But oil prices could fall sharply too. Indeed, a review of the underlying fundamentals suggests as much. Inventories of crude oil in the OECD nations are the highest in 14 years, advises a research report issued yesterday by Bernstein Research (see graph below).
The report, penned by Ben Dell, also predicts a robust rise in global spare oil production capacity for 2006 through 2008, reversing last year's dramatic drop, as the graph below from the report shows. Historically, the correlation of spare capacity to oil prices has been negative; that is, as spare capacity rises, oil prices tend to fall.
Obviously, that negative correlation has been suspended of late, although one might wonder if it's due for a return engagement. Based on Bernstein's analysis, oil prices are now more than $20 higher than the price/spare capacity correlation history implies. If spare capacity increases in the months and years ahead, as Bernstein forecasts, the current price of oil would look even more excessive.
"The unstoppable rise of the crude price has begun, in our opinion, to defy fundamentals," the Bernstein report observes.
Adding to the uncertainty of what comes next in oil prices is the rise of passive investors in the commodity. A growing number of strategic investors have come around to recognizing that a long-term allocation to commodities enhances the risk-reward profile of a traditional stock/bond portfolio. That, combined with the rise in the number of mutual funds, and more recently ETFs, catering to this new source of demand has funneled money into commodity indices, for which oil is usually the dominant component.
This relatively new demand source for oil, the Bernstein report correctly notes, has been overlooked, with the media focusing primarily on the rise of short-term speculation in oil trading. To be sure, the increase in passive investing in oil and other commodities isn't, by itself, the reason for the bull market in oil, but it's a significant driver, and an increasingly potent one. Last year, more than $80 billion was earmarked for net passive investment in the two main commodity indices, the Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index. That's up from less than $20 billion in 2003, according to Bernstein.
Perspective is important here for understanding how big passive commodity investing is on the margins of the oil market. "By the end 2006 this net investment [from passive investing] is estimated to account for over $110 billion, of which the majority is in the GSCI, which is over 74% weighted to energy and 50% weighted to crude," Bernstein advises. In fact, the report continues,
the incremental growth or funds flow in during 2006 will account for almost $21.3 billion of which $7.7 billion will flow into crude. To place this in perspective, if matched by physical barrels this would account for almost 120 million barrels annually or 320,000 barrels of daily demand. This is bigger than China’s [oil demand] growth and would be the largest source of incremental worldwide demand. The impact of this on the physical market is clear when one sees the correlation of contango to storage builds. As the futures price is increased storage operators are incentivized to fill storage and sell forward.
The bottom line is that there are at once powerful bullish and bearish forces at work in the oil market. No one knows which one will prevail, or when, although the easy assumption is that higher prices will prevail. Nonetheless, investors should recognize that this is a different oil market than the one in 2003-2005.
Yes, oil's probably in a multi-decade bull market. We've written extensively on the subject over the years, and know the details well enough not to dismiss the idea that a barrel of crude will probably go for much more in 2015 compared to today. But getting there from here promises to be volatile, perhaps much more so than the lazy bulls realize.
Bernstein, for its part, recommends taking some profits in the energy stocks. "Given the potential for a sharp correction in crude prices, we remain cautious on the group recommending a net underweight position, despite the secular bull story, believing that the commodity has overrun itself."
Posted by jp at July 27, 2006 10:02 AM