Three years ago, I remember seeing a fund manager being interviewed on CNBC, the financial news network. He suggested that the price of oil was going up to $100 per barrel. The interviewer spluttered at such alarmist talk and was at pains to distance the channel from this expression of opinion — as if to suggest the man was clearly demented.
Last year, when oil was hovering around the $70 per barrel level, the same fund manager was interviewed again and invited to restate his view. This time he was looking not just for $100 per barrel — he thought the price could go considerably higher than that.
Interestingly, the CNBC anchor no longer treated his forecasts dismissively; instead he hailed the man as a sage. Needless to say, the spot oil price stopped a little shy of $80 a barrel and has lost a third of its value since.
This little anecdote encapsulates a lot of what has been happening in the oil bull market, indeed, what happens in any bull market as it develops. Before a rally starts, and even through the early stages of a rally, very few people see it coming — and those that do are treated with disbelief. By the mature phase of the move, the world and his wife become convinced and understand the whys and wherefores — but these have already been fully discounted in the price and the top is near.
I last visited the subject of oil for The Zurich Club Communiqué back in June of 2004, when spot crude was trading around $40 a barrel. I made a bullish case based on the increasing demand for products — gasoline and heating oil — and the limited refinery capacity. A little less ambitious than our fund manager on CNBC, I targeted the $70 per barrel area — a revisiting of 1979 highs adjusted for inflation.
Having seen our target, is that it?
Along with my focus on the specific shorter-term catalysts of the rally, I also made the point that some major long-term factors were changing in the energy equation.
On one side, the booming economies in our old friends, China and India, are expected to boost overall Asian demand dramatically over the coming years. Even a conservative body like the Energy Information Administration, the provider of official energy statistics from the US government, envisages a 47% increase in global oil demand from 2003 to 2030. They reckon that non-OECD Asia (including China and India) will account for 43% of that increase.
Frankly, such projections are merely sophisticated guesswork, but they give us a rough idea of the trend for global demand. Unless we encounter a significant worldwide economic depression, my own hunch is that they understate the increase by some margin.
On the supply side of the equation, opinion is considerably more divided. Back in 1956, Dr. M. King Hubbert predicted that US oil production would peak sometime in the early 1970s. At the time, most experts thought the idea ridiculous, but the fact is that US output of crude has indeed been falling since 1971.
Scientists using Hubbert’s theory now believe that global oil production will peak within the next few years. In the opinion of ASPO (the Association for the Study of Peak Oil and Gas), the peak will come in 2010. The geologist Kenneth S. Deffeyes, who worked with Hubbert at the Shell research laboratory, believes the peak came on 16 December 2005.
Some are more sanguine. Those at the US Geological Survey say that the peak is still 50 years off and they look to the Canadian tar sands as a huge source of recoverable oil. However, the massively increased costs involved in producing a barrel of oil from tar sands presupposes pretty elevated oil prices to make it viable.
The legendary oil magnate, T. Boone Pickens, reckons that 84 million barrels a day is about all the world can produce. Meanwhile, another veteran of the energy world, the oil analyst Charles Maxwell, told Barron’s last year that, in 1964, 48 billion barrels of oil were discovered and 12 billion were used. In 1988, 23 billion barrels were found and 23 billion used — this was the crossover year. In 2005, he observed, we found about five to six billion barrels and used 30 billion.
The truth is that we will only know the peak with the benefit of hindsight. My guess is that it’s pretty close. What is clear right now is that oil is a finite resource and that this relentless growth in demand will not be balanced by an inexhaustible capacity to increase the supply.
A picture paints a thousand words...
Since the peak of US output at the beginning of the 70s, spot West Texas Intermediate (WTI) crude prices have spiked into the $30-$40 range only in response to Middle Eastern crises of one kind or another.
Embargoes by Arab countries after the Yom Kippur war in 1973 saw prices quadruple from $3 to $12, and then the Iranian revolution and subsequent Iran/Iraq war provoked our first test of $40 in 1980. We retested this level in 1990 when Iraq invaded Kuwait. Even as recently as 2003, we see prices spiking to $40 on the back of the coalition forces moving into Iraq.
These rallies have all been driven by disruption to supply, or fear of disruption to supply. In what we might call normal circumstances, the price of oil has tended to be around $20... until now.
As I wrote back in 2004, it is clear that the supply demand balance has shifted in the longer term, and this fundamental shift is as much based on increased demand as it is on supply concerns. It remains my view that the $30-$40 per barrel price ceiling that repelled rallies for 25 years has now become a floor in a secular bull market. We have to change our mindset from that of being a natural seller of rallies, to being a buyer of dips.
Why has oil fallen by a third in the last 6 months?
No market goes up in a straight line forever and, with its move above $70 last year, oil was getting a little ahead of itself and was due a normal correction. A variety of factors contributed to this.
Firstly, crude oil inventories in the US have built up considerably over the two years into the middle of 2006, from 270 million barrels to over 340 million barrels, and are still running at historically high levels. Gasoline and distillate inventory numbers are also reasonably comfortable right now.
Although we have not seen any increase in the overall operating capacity of the US refinery system (new capacity will only appear in 2008/9 onwards), we are not witnessing any of the bottlenecks that led to the real tightness in the market for oil products a couple of years ago. Pressure has been considerably relieved by the unusually mild winter that has been experienced in America as well as here. Also we have seen few disruptions to the refinery process, certainly nothing of the order of Hurricane Katrina.
That said, we still see utilisation of available refining capacity running close to maximum levels. This tells us that although the situation is currently stable, underlying conditions remain very tight and any pickup in demand for refined product will find us running into exactly the same capacity restraints we did in 2004-6.
It is also true that the oil price over the past three years has included a risk premium. A whole variety of potential geopolitical threats loom over the market, from Venezuela to Nigeria to Russia — never forgetting the myriad problems across the Middle East. So far, none of the possible catastrophes have materialised. But nor have they gone away — the market has just got bored with waiting and taken off that uncertainty premium.
Alongside and allied to this last factor is the diminished speculative interest we see in oil. Although in the view of Lehman Brothers we will see upwards of $25 billion of passive investment allocations to commodities this year, the more frenzied participation by hedge funds and others of a few months ago has abated.
There has been much recent speculation that the Saudis are playing a complicated political game and trying to depress the oil price in order to squeeze the Iranians financially. This appears to be nonsense, as the Saudis have, in fact, been rigorous in fulfilling their share of agreed OPEC production cuts. If anything, Saudi policy would seem to be one aligned with other OPEC countries of now defending the $50 per barrel level.
The outlook from here...
In big picture terms, oil is firmly established in my mind as a secular bull market. The floor for oil is now that $40-$30 area and any approaches towards that level should be used as strategic buying opportunities for the product itself, its futures and derivatives, and for those big and smaller oil companies with long-life reserves proportionate to their size. Price will probably continue to find a ceiling at $70-$80 in the near term, particularly if the pace of growth around the world slows a little this year, as seems likely. However, two to five years out I fully expect to see the long-term supply/demand balance driving prices to well over $100 per barrel.
As far as the immediate future is concerned, although US gasoline inventories are towards the upper end of their historic range, that range is fairly narrow and we have reached the top of it only five weeks after being at the bottom end. According to the Energy Information Administration, gasoline demand in March has averaged 200,000 barrels a day higher than February over the last three years, so we may see a turning point there. A prolonged colder spell could increase demand for heating oil. OPEC (including the Saudis) looks committed to defending $50 per barrel.
Those familiar geopolitical worries are still there and a rising price will of itself bring them back into focus — and, of course, tempt the speculators back to boot. It looks increasingly as though we may have hit a significant low at $50 in January.
