Not Yet Time to Sell Oil

by: Kenneth D. Worth

On January 18, I recommended oil (NYSEARCA:USO), refined products ETFs (NYSEARCA:BNO) (NYSEARCA:UGA) and energy sector ETFs including the service companies (NYSEARCA:OIH) exploration and production companies (NYSEARCA:XOP) and the majors (NYSEARCA:XLE).

Let's see how those ETFs have done since then:

USO (Cushing crude) +15%
BNO (Brent crude) +26%
UGA (unleaded gasoline) +25%
OIH (oil service co's) +9%
XOP (oil and gas E&P) +14%
XLE (major energy co's) +10%

Not bad.

Compare the S&P 500 - up around 4% - during that same time, in no small part due to the performance of energy stocks themselves. I don't need to point out that there were many oil bears growling in January as oil approached $100 a barrel for Brent crude.

Is it now time to sell oil? Or even go short maybe?

I don't think so, and here's why:

The global recovery continues. The IMF predicts global GDP growth of around 4% this year. The income elasticity of demand figures published by the IMF indicate that global consumers will desire an additional 3% in refined products as the global economy grows, or approximately an additional 2.2 million barrels per day each year. That's roughly 180,000 additional bpd each month.

Meanwhile, on the supply side, we see Saudi Arabia announcing production cuts of 800,000 bpd due to "oversupply" concerns; cough, cough. Libya and its 1.6 million bpd of production is still largely out of commission. Global supply, especially global supply available for export to importing nations, seems to be falling at what might even be described as an alarming pace.

Elasticity of demand figures published by the IMF recently indicate that global consumers are, at least in the short run, extremely price insensitive, especially in the developing world. Global demand elasticity is -.02. (See Table 3.1 in the IMF report cited above.) A 10% increase in price would cause demand destruction of only .02%, or about 15,000 bpd.

What all this means is that falling global production combined with continued global economic growth would almost certainly result in very, very high prices for oil and refined products.

As a ballpark figure: the loss of Libya, declines in Saudi Arabian production, together with continued global growth, would according to global price elasticities published by the IMF, put the price of oil, at least in the short term, at around $250 a barrel. Non-OPEC production has been falling for years and probably won't be any help anytime soon. OPEC ministers seem to think the market is oversupplied.

OK, sure. Peak oil, anyone?

Two hundred and fifty dollars for a barrel of oil will obviously create problems for the global economy, and I'm not saying we will get all the way there before the next global recession. However, in the short term, BNO, UGA, OIH, XOP and XLE should perform very well, indeed.

Disclosure: I am long UGA, OIH, XOP, XLE.

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