On the basis of short term momentum with economic news, the effect of crude oil price on demand and supply and some decline in political tensions in Middle East, thus decreasing the political risk premium on risk neutral crude oil price, we expect crude oil prices to dip below U.S. $100 per barrel in Q2 2011, ending the quarter in the range between U.S. $90-$95 per barrel. As per our year start expectations, crude oil price forward has flattened to a large extent. We expect the market to go into normal backwardation by the end of 2011, which will be beneficial for funds like USO, which invests in front month rolling contracts and will be in position to take advantage from the positive roll yield. Please find below the effect of our assumptions on spare production capacity.
The world started the year with 6 million barrels per day spare capacity, which was pared down.
This added risk premium / discount on crude oil price (Chart 2). If the effect of any of the factors mentioned in chart 2 is reduced, it may reduce the risk premium on risk neutral price of U.S. $86 per barrel. If for example Middle East supply issues risk is completely taken out, it may reduce the premium by as large as U.S. $15 per barrel from current price by June 2011, taking crude oil price down to U.S. $ 95 per barrel.
1. Crude oil supply at risk: The largest part of the chart 2O is crude oil supply at risk which carries highest risk premium (chart 3O - the chart 6 showing our estimate of crude oil supply at risk from Middle East events). We consider Libya as the only oil producing country whose oil output may be out of market for some length of time. Algeria and Oman were possible candidates for possible oil output at risk and Iraq, Iran and Saudi Arabia as the countries where crude oil output may potentially be at risk. Please find the red columns in chart 6 for the portion of supply which is interrupted. Amber columns are the potential risk to crude oil supplies. Immediate level of risk is to the tune of 1.5 million barrels per day (Libya) which is 2% of global demand. If there is unrest in other parts of the Middle East / Nigeria, it can put additional supply at risk. If Algerian, Libyan and Oman supply is completely withheld, the market may face a deficit of +5% of global crude oil demand. In 1979, during the oil embargo, a 6% decrease in supply caused a four fold increase in crude oil price. We expect a decline in the GCC political risk as the situation in Bahrain, Oman and Yemen settles down. This may shift Saudi, world'd largest producer of crude oil, from amber to green and cause a decline in premium by U.S. $7-$10 per barrel. Further, a resumption of Libyan supplies will result in another decline of U.S. $3-$5 per barrel. Overall, the net effect may be negative U.S. $10 per barrel (Japan's marginal need, China's strategic reserves initiative and economic surprise being positive and decline in risk premium being negative for crude oil price). The crisis in Libya is likely to drag on. However, political risk in Oman, Bahrain and Saudi Arabia may decline by the end of Q2 2011. The combined effect of this will be a decline of risk perception in the world crude oil market. Risk premium of U.S. $15-$20 per barrel may decline to U.S. $5-$10 per barrel by the end of Q2 2011 (on the top of risk neutral crude oil price of U.S. $85-$90 per barrel). Marginal crude oil need of 0.5 -0.6 million barrels per day for reconstruction in Japan and substituting nuclear energy, which currently forms around 30% of Japan’s electricity output, may keep U.S. $2-$3 per barrel of risk premium on crude oil price.
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2. Improving economic fundamentals: The price of crude oil is closely related to macro economic news flows in an environment of tight supplies. The positive changes in these indicators (chart 7) drove crude oil price before social unrest erupted in the Middle East in late January 2011. Positive momentum in unemployment, retail sales, ISM, PMI, consumer confidence and payrolls may increase the market’s expectation of crude oil demand and hence add more demand related crude oil risk premium to crude oil price until June 2011. Elevated crude oil prices have resulted in higher input costs as shown by OECD PPI. The lag between PPI and CPI could be three to six months. We may start seeing the effect of higher oil price on consumption at the end of Q1 2011 which may result in demand related risk premium and may end up in a demand risk discount. One of crude oil’s key consumer indicators is U.S. gasoline demand use which was a negative demand surprise in the last DOE weekly data. Another data point which is likely to turn red is FHS reported billions of vehicle miles driven. Pre-Lehman, number of miles driven per capita per day is estimated to be 42 miles which when down to 32 miles by March 2009. It has recovered since then to 37 miles per capita per day (Chart 8). Higher crude oil price eats into net disposable income. Sentiment decline can lead to a drop in consumption which may stunt budding recovery and jobs growth by SME, which had been the growth engine in the last five economic recoveries. It is estimated that the market may have a premium of U.S. $3-$5 per barrel because of unanticipated demand for crude oil. This may decline and may even turn into a discount if global equity markets enter a correction.
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3. China’s economic growth is becoming increasingly dependent on meeting its rapidly growing demand for oil from both domestic supply and foreign imports. China’s net crude imports in February totalled a record 23.1 million tons, or roughly 5.4 million barrels per day, and imports are expected to make up roughly 55% of its total oil consumption this year. A) Increasing oil demand is not only attributable to increased vehicle use in the world’s largest new car market, but also to industrial activity in China. At current levels i) China PMI is still supportive of industrial activity (Chart 10), ii) China input purchase orders are increasing (chart 11), iii) New export orders are increasing (chart 9), iv) order back log and deliver delays are still high (chart 9). This may cause an upside in China demand, estimated at around 0.3 million barrels per day, which is higher compared to IEA, EIA, Goldman Sachs and Credit Suisse estimates. B) Notwithstanding the fact that China RRR and interest rate hikes have not drained liquidity from system, China’s crude oil consumption is largely independent of BOC of policy stance. C) Electricity demand in China grew 22% in the first half of 2010. D) Last year China became the largest new automobile market in the world, and a recent International Energy Agency report suggests that China may now also be the top global energy consumer as well. E) In 2007, China announced an expansion of its crude reserves into a two-part system. Chinese reserves would consist of a government-controlled strategic reserve complemented by mandated commercial reserves. The government-controlled reserves are being completed in three phases. Phase one consisted of 102 million barrels, mostly completed by the end of 2008. The second phase of the government-controlled reserves with an additional 170 million barrels has to be completed by 2011. Recently, Zhang Guobao, the head of the China National Energy Administration, also stated that there will be a third phase that will expand reserves by 204 million barrels with the goal of increasing China's SPR to 90 days of supply by 2020. The planned state reserves of 476 million barrels plus the planned enterprise reserves of 209 million barrels will provide around 90 days of consumption or a total of 684 million barrels which implies a call of 0.4 million barrels per day on crude oil supplies. Only potential cause of concern can be higher level raw material and finished goods inventories (chart 12) but currently is mitigated by higher export orders, backlog and input purchases.
5. Effect of U.S. offshore drilling rules change on U.S. 2011 output: The U.S. Department of Interior (DOI) issued new rules for offshore drilling in Q3 2010. Those new rules are expected to raise the cost of drilling offshore, create delays in obtaining permits, and thus decrease oil production, even putting some small U.S. oil companies out of the offshore market. The result, of course, means more reliance on crude oil imports, most likely from OPEC. The Energy Information Administration (EIA) forecasts in its Short-Term Energy Outlook that domestic crude oil production will decline in 2011 after a modest increase in 2010. In 2009, U.S. oil production increased by 0.4 million barrels per day, and by only 0.1 million barrels per day in 2010, expected to be followed by a drop of 0.06 million barrels per day in 2011. The decline of 0.17 million barrels per day of oil production in the Gulf of Mexico in 2011 is partially made up by an increase of 0.130 million barrels per day in onshore production. Of the 170,000 barrels per day production decline in Gulf of Mexico waters, 82,000 barrels per day is due to the moratorium.
6. Spare production capacity: Crude oil spare production capacity (chart 13) had been closely correlated to crude oil price. In the times of economic expansion, spare production capacity decrease because of increases in crude oil demand. In recessions, crude oil spare production increases because of erosion of demand. However a decrease in spare production increases the drilling and marginal crude oil supplies become economical at higher crude oil prices. An increase in crude oil spare capacity reduces the E& P activity and reduces the marginal crude supplies at lower crude oil prices. Both factors tend to dampen the crude oil swings and also determine the price inflection points. The world’s total spare production capacity is 5.4 million barrels per day. However, any increase in Libya oil output affects increases the spare production capacity by around 1 million barrels per day. If Iraq’s oil production is jeopardized, it reduces the spare production capacity even further to 0.7 million barrels per day. In case the Saudi Eastern region, where Shia make a significant part of the population, is affected, that may create a crude oil deficit of 5 million barrels per day, which cannot be filled with any other available sources of crude oil supply. Higher GCC output “should keep prices from rising dramatically” (as IEA suggested) but it also pares down GCC spare production capacity which has had a close historic link to crude oil price jumps. Please find below a comparison of crude oil spare production and oil production at risk. Amber shows higher risk compared to yellow. According to above estimates, there is a an effective decrease in global crude supply capacity of around 1.7 million barrels per day and an increase in demand of around 2 million barrels per day, which results in a cumulative call of around 3.7 million barrels per day on world spare production capacity of 5 million barrels per day (EIA estimate), resulting in an effective spare production capacity of 1.3 million barrels per day. Last time spare production capacity was below 2 million barrels per day in 2008, crude oil price crossed U.S. $140 per barrel.
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7. Trade-weighted U.S. dollar may weaken: i) Crude oil price is priced in U.S. dollars, which is facing cyclical and structural decline. We expect the trend to continue in Q2 2011, which may result in a further upside to crude oil price. ii) A revaluation of Yuan and interest rate hikes in the rest of world will make crude oil cheaper for the rest of the world which will increase its demand and price. iii) Crude oil has a negative feedback loop with the U.S. dollar. With increase in crude oil prices, U.S. trade deficit widens. As the U.S. already has a massive B/S expansion with unprecedented leverage, that may cause a hemorrhage of portfolio investors in U.S. debt and equities, which may create an additional call on the U.S. dollar. iv) Short term yield differential between EM, Euro and the U.S. dollar is likely to widen in H2 2011, which may create additional pressure on the U.S. dollar. This inexorable decline in the U.S. dollar will be supportive of crude oil price (chart 14).
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8. Loose U.S. monetary policies may continue in Q2 2011, which is positive for commodity prices in general and for crude oil in particular, given that the U.S. is the world’s largest consumer of crude oil. The ECB raised short term interest rates by a quarter of a percentage point. There are expectations of further ECB tightening which should be slightly negative for crude oil demand in the euro area and crude oil prices (chart 17 and 18).
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9. Paper barrels may remain intact in short term: Speculative investors reduced their long bets because of increasing unease about a hard landing in China and unease on abated fiscal expansion in the U.S. at the start of 2011. However, managed money funds and CPAs started increasing their crude oil positions after the Egyptian crisis in Q1 2011, as evidenced by the absolute number of managed money long contracts (paper barrels), total open interest, financially settled contracts and managed money long contracts as percent of total open interest.The funds and other large speculators increased net-long positions, or wagers on higher prices, by 27% in the seven days ended March 31 to 305,408 futures and options, the most on record dating back to June 2006, according to the Commodity Futures Trading Commission’s weekly Commitments of Traders report. As per CFTC’s April 04 2011 report, managed money long contracts swelled to 0.2977 million against an all time high of 0.3 million and managed money short contracts dipped to 28,803 contracts against an all time low of 25,262 contracts. Total open interest in futures and options (1.567 million) crossed the previous all time high of 1.544 million contracts (Sept 18, 2007). From the world’s largest managed commodity funds and commodity pools positioning and changes, it seems that long and total open interest in crude oil may remain intact for April and May 2011, which may support crude oil price (chart 20). Further, contango in NYMEX has declined. It is expected that the forward curve may flatten and may slightly turn negative by the end of 2011, which makes roll yield positive for front month future investors like USO. An increase in investment inflows in front month ETFs will result in upward pressure on crude oil price. However extreme levels of the total open interest and managed money positions is a recipe for a reversal. We expect a managed money position reversal by Mid May 2011.
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10. Refining margins, gasoline price and economics of refinery utilization: After outages for some of the refining facilities in Japan, 3:2:1 spread has widened despite high crude oil prices. Higher refining margins increases refiners' ROI and results in an increase in refinery utilization rates which are already touching the 89% level. This may create a call on global oil inventories, which may be positive for crude oil prices in short term (chart 21).
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1. Goldilocks crude oil price: Goldilocks crude oil price is the price which is sustainable and makes investment in marginal supply economical to the level where additional supply is balanced by increases in crude oil demand because of economic expansion. The estimate of goldilocks price is based on GDP energy sensitivity, crude oil supply response and potential substitution. Goldilocks price is estimated to be U.S. $96 per barrel which is risk neutral. On the basis of historical behavior of GDP growth and energy intensity of GDP, we have estimated that crude oil prices between U.S. $84-$94 / barrel do not cause a severe demand and supply reaction in an atmosphere of a slow economic recovery.
2. Effect of higher crude oil prices on demand: An important lesson from history is that energy prices matter a lot (chart 22). Before 1973, U.S. energy consumption appeared to be growing exponentially at a rate of 3.2% per year. Total U.S. energy consumption (measured in quadrillion BTU) grew rapidly until the oil price shocks at the end of 1973 and 1979. Consumption was fairly stable until the late 1980s but declined after that (chart 25). U.S. energy consumption by end use is shown in chart 24. Growth in all uses was rapid until the first oil price shock in 1973. After that, residential, commercial and transportation energy use has grown more slowly and industrial energy use has remained essentially constant (chart 24). Another impact is the higher crude oil prices on the U.S. trade deficit. The U.S. has contracted out much of its manufacturing to developing nations. The impact of higher oil prices will be more visible on American consumer behavior (gasoline). The gasoline segment, the largest product segment of crude oil (at 8 mbpd) is susceptible to higher crude oil prices. Higher crude oil prices may result in a demand reaction in the form of a decrease in total energy use as well as substitution of crude oil by other cheaper sources of energy. Gasoline, which accounts for 40% of U.S. oil use, If measured by billions of vehicle miles driven, has already started showing the effect of high pump prices (+3.5 U.S. $ per gallon) on number of miles driven per capita per day (chart 26). If crude oil prices stay elevated, it will result in a further increase in gasoline pump prices by the end of Q2 2011. That may result in stunting the upside in crude oil prices.
3. The latest BCA research (Dated March 29, 2011) and earlier research notes by Goldman Sachs and Credit Suisse discounted the effect of oil shock on the global economic recovery, inflation, consumption, disposable income, corporate margins and consumer confidence. Goldman Sachs predicted a U.S. $200 per barrel crude oil price. We think that there is a lag between higher energy prices and the effect on consumption as energy forms around 30% of OECD consumer expenses. Crude oil prices have triggered recessions in +80% past instances (Chart below). In 2008, oil prices approached U.S. $150 per barrel. Shortly afterward, the global economy collapsed. There were, of course, other problems at the time – an imploding U.S. housing market, the beginnings of a securitization crisis, the collapse of Lehman Brothers – but events three years ago nevertheless offer plenty of evidence that substantial changes in oil prices are big news for the global economy. Events in 2008 simply confirmed a pattern seemingly in place since the 1970s. The chart shows the level of oil prices in real terms (adjusted using the U.S. consumer price index) tracked against U.S. recessions. Regular as clockwork, increases in oil prices of more than 100% lead to declining GDP. Although, we’re not quite there this time around: oil prices would have to rise to U.S. $150 per barrel – a return to its 2008 peak - to have doubled in real terms. On the chart, there are some (modest) exceptions to the 100% rule of thumb: The 2008/09 recession (which merely supports the idea that oil was not the only, nor indeed the main, influence on events at the time), the 1991 recession (which was probably more affected by the credit crunch than by the temporary spike in oil prices following Iraq’s invasion of Kuwait), and the 1987 experience, when real oil prices did indeed double but there was no recession. That doubling came from a very low level (oil prices had collapsed in 1986) and, although a recession was avoided, a stock market crash wasn’t. The market may start anticipating the economic effect of elevated crude oil prices by end of Q2 2011. Although the full effect may become visible by the end of 2011, it will be negative for global equity markets and crude oil price as demand price premium will disappear from the trading price. It is unlikely that crude oil prices can sustain above U.S. $140 per barrel. Such a high price may cause a double dip and commodity prices will collapse as focus will shift to demand from supply.
4. Risk premium will decline in Q2 2011: Crude oil price is thought to be sum of risk neutral price and risk premium or discount. Investors put a risk premium at the top of risk neutral price if there is higher risk of market tightening and a risk discount if market faces prospect of loosening too much. Risk premiums and discounts can be estimated by options premiums and implied volatilities (COBE). This risk premium / discount can be related to spare production capacity. By June 2008, global crude oil spare production capacity has gone down to 2 million barrels per day. Risk premium in June 2008 was estimated at around U.S. $50 / barrel (crude oil price of U.S. $147 per barrel) (chart 29). In December 2008, global crude oil production capacity had expanded to 6 million barrels per day and the risk discount was estimated to be around U.S. $50 / barrel (crude oil price U.S. $34 per barrel). Our earlier statistical analysis suggested a risk neutral price of U.S. $84-$95 / barrel. From a non-parametric analysis it appears that risk neutral spare production capacity of 4 million barrels per day with a risk neutral price of U.S. $90 per barrel. In the case crude supply from North Africa is interrupted (chart 29A), this may decrease the crude oil spare production capacity to 2.4 million barrels per day. In that case, it may be fair to expect a risk premium of U.S $38 per barrel, which implies a crude oil price of U.S. $118 per barrel. On the other hand, if the global economic recovery keeps on track, around U.S $20 / barrel will be tacked at the top of crude oil price by the end of 2011, which implies a crude oil price of around US$100 / barrel. On one hand, if supply from Iraq is affected, it may erode the spare production capacity to almost none, which should add +U.S $70-80 per barrel to the risk neutral price, implying a crude oil price of U.S. $170 per barrel. In the case crude oil supply from Saudi Arabia is jeopardized, that may create a real panic in the market and the lid on the price may fly away. On the other hand, an increase in crude oil price ahead of U.S. $150 per barrel and possibly more than U.S. $120 barrel will create a worldwide tsunami of inflation, will decrease the disposable income and hence impact consumption, seriously affecting the companies’ top line despite increase in prices. Further, because of the inability to pass 100% of inflation, the companies will feel the margin squeezes. This may create a serious confidence deficit which may bring the budding global economic activity to a halt. This will bring on another worldwide recession which may hit the developing, low to middle income countries first and hardest. This may create substantial uncertainty about global crude oil demand and will create a risk discount on crude oil price. If this demand uncertainty creates a potential discount of U.S. $40 per barrel, it will bring crude oil prices down to U.S. $40 per barrel. In the short term, the Middle East supply risk premium will decline from the current U.S. $15 per barrel to U.S. $5 per barrel as political discontent will decline in intensity with the advancing summer. Demand risk premium will decrease by U.S. $ 2-$3 per barrel as marginal crude oil demand will be counter balanced by a decline in U.S. consumption (FHA’s miles driven will decrease with an increase in gasoline price to U.S. $4 per gallon). However we will like to watch the economic response to an oil shock before assigning any discount to crude oil price in Q3 / Q4 2011.
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5. Substitution of crude oil by coal and natural gas: Higher crude oil price may result in substitution of crude oil by other sources of energy like natural gas, coal and nuclear energy. Simply rising NG and coal consumption offset what was at the minimum optimization of oil consumption to the transport sector if not an outright decline. We may also see a shift in a portion of fuel oil based U.S. electric generation to natural gas. This may save 1.8-2 million barrels per day of crude oil used for furl oil based electric generation. Any shift of transportation from gasoline to natural gas may further decrease crude oil and product demand with higher crude oil prices. The case for substitution may become even more compelling when seen in the light of oil equivalent price of coal (U.S. $26.4 per barrels of oil equivalent – U.S. $129 / ton) and natural gas (U.S. $24.2 per barrel of oil equivalent – U.S. $4.09 /mmbtu). This has happened before as during previous oil shocks as use of crude oil as percentage of U.S. energy use slid from 43.4% to as low as 40.5%. If crude oil price remains elevated, crude oil use may decline below 42% of U.S. energy use in Q3 / Q4 2011, which is equivalent to a decline of +3 million barrels per day of world crude oil demand (chart 30). This will result in a demand risk discount if U.S. $20 per barrel (charts 1 and 2). Conservative estimates of EU / US / Japan and China GDP / crude oil consumption (i.e. increasing) and higher crude oil substitution flexibility to crude oil price may result in a decline in crude oil price.
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6. Draining global liquidity: i) Euro tightening and the future of QEII in the U.S.: One of the risks is discontinuation of QE2, which is running out in June 2011. It is expected that the interest rate will remain low for a longer period of time (more than the markets’ expectation ... meaning probably through 2012 instead of 2011). Such policy typically should further weaken the U.S. dollar, while artificially pushing up prices of dollar-denominated commodities such as crude oil. However, a drain of liquidity in H2 2011 may be negative for crude oil prices. On the other hand ECB interest rate hikes should be negative for crude oil prices. ii) Fiscal and monetary tightening in China and East Asia: China needs to raise interest rates far more aggressively to curb inflation, given existing excess liquidity. Although the government has implemented a series of measures, including increasing interest rates, RRR and raising margins for certain commodity futures, the impacts on inflation are not significant. Although crude oil consumption in China is less sensitive to oil shocks because of lower per capita use, interest rate hikes can be negative for crude oil price in short term (chart 35).
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7. Oil inventories may cover short term interruption: We feel that U.S. crude oil and gasoline inventories are sufficient to fill up any short term interruption. The inventories are still higher than the five year average. We expect a gradual draw down in the coming six months (chart 37).
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