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Conflicting Oil Price Drivers Confuse

James West
jwest@midasletter.com
www.midasletter.com
Tuesday, September 02, 2008

“Oil falls as Gustav passes”. That was today in the New York Times business section.

Well first off, Gustav did indeed pass, and was downgraded to a tropical storm shortly after it made landfall, but just like Katrina three years ago, the damage to oil refining and production infrastructure will not be apparent for a few days yet.

There is no doubt that some damage did occur, as evidenced by the predicted $10 Billion payout in insurance claims, and the logical supposition would be a decrease in production from that area, albeit temporarily. Therefore, the suggestion that the dropping price of oil had anything to do with the passage of Hurricane Gustav is inherently superficial.

Consider this statement released by the Energy Information Administration:

“As of 12:30 pm EDT (11:30 am CDT), August 31, the Minerals Management Service was reporting that about 1.25 million barrels per day (or well over 90 percent) of the federal portion of the Gulf of Mexico’s crude oil production was shut-in. As of 10:00 am EDT (9:00 am CDT), August 31, the Department of Energy was reporting that 12 refineries in the Gulf of Mexico were shutdown, representing 2.1 million barrels per day of capacity, while another 10 refineries had reduced their crude oil throughput. The 12 refineries that were shut down represent at least 700,000 barrels per day of gasoline output and at least 600,000 barrels per day of distillate fuel output, based on recent historical data.”

Despite 90% of the crude oil production being shut-in as Hurricane Gustav reached land, oil prices had already begun falling, and by 2.p.m. Sunday, prices had already dropped $4 a barrel.

Furthermore, despite weakening demand, U.S. Crude Oil stocks are still down 27.8 % versus where they were at this time last year, whereas demand for gasoline is exactly where it was this time last year.

So why the plunge? Could softening prices really be attributable to a decrease in U.S. demand that has yet to materialize?

The problem is that there are macro economic indicators suggesting both increased consumption of oil and increased supply, which you would think should have a net zero effect on prices, all other things being equal. But since it is within the interest of all parties involved in the trading of oil and its derivatives, volatility rules. Nobody makes any money when the price remains flat.

Supply Side
Well the first issue here is the idea of “Peak Oil”. A favorite buzzword of the last few years, the statistics available from the Energy Information Administration point to the fact that oil production globally on a per day basis continues to increase, with the first quarter of 2008 showing a record global production of 85.38 million barrels per day, an increase of 940,000 barrels a day over the average daily production for 2007.

The Canadian Oil Sands projects are expected to reach 4 – 5 million barrels of production per day by 2015. Second only to the Saudi Arabia reserves, Alberta's oil sands deposits were described by Time Magazine as "Canada's greatest buried energy treasure," and "could satisfy the world's demand for petroleum for the next century".

Also, the potential for large field discoveries in polar regions will increase as global warming continues to open arctic and Antarctic waterways. Don’t think for a minute that enfeebled environmental pressures will have any significant impact on exploration – especially when the nation’s economic interest is at stake.

Demand Side

Chart showing world oil demand forecast. Source: EIA

Weakening economic indicators across Europe and North America might seem to have a dampening effect on demand for oil. But really, common sense refutes any such logic.

Because the economy is contracting, does that mean people will travel less? Or is it more likely that people will find themselves having to travel further to find scarcer jobs, and have to live in cheaper neighbourhoods far from their traditional centers of employment?

I think the second statement is closer to reality. And the chart above that predicts the continuing increase globally in fuel consumption tends to bear out this prophecy.

Economic growth outside of the G8 nations, as they are now confusingly referred to, remains largely intact, and the increasing purchasing power of consumers in this economy is likely to easily outstrip the temporary absence of the G8 consumer.

Private equity has invested almost $17 Billion in Brazil, Russia, India and China in the year ending in June, which represents an increase of 80 per cent over the previous year according to Dealogic.

So if you think all this feel-good media “the sun is back for good” rhetoric has any bearing on the inevitability of a return to the reality of commodity supply and demand imbalances, don’t be immediately sucked in. Chicken Little will be back with a vengeance.

James West
Publisher
jwest@midasletter.com
www.midasletter.com


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