By Craig Stanley
16 Jul 2005 at 12:39 PM EDT
TORONTO (ResourceInvestor.com) -- Prognostications on the future direction of any asset price tend to be a mug’s game, generally exposing the soothsayer to eventual ridicule.
A year-and-a-half ago, most analysts featured in the mainstream ‘financial’ media were talking as if a rise in long-term bond yields was inevitable. Late last year, it was a foregone conclusion that the U.S. dollar would plummet early in 2005.
So guessing where oil prices are headed after hitting a nominal, U.S. dollar denominated, record high north of $60 a barrel appears fruitless.
Yet that is partly what analysts are paid to do.
Looking at some recent reports, the factors being put forth to explain the high prices are both rational and logical, and they could provide indications on where oil could go from here. What’s lacking is equal space devoted to possible causes, and guesses to their likelihood, of a downslide.
In a July 4, 2005 report, TD Newcrest revised their average 2005 and 2006 estimates for WTI at $53 and $50 respectively. Analysts at the firm say the forces that have pushed crude prices to new highs remain “firmly in place,” including:
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Heavy demand for heating oil and diesel, which is supporting demand for grades of crude that yield larger middle distillate cuts, such as West Texas Intermediate (WTI) and Brent.
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Rising prices for diesel and jet fuel, more so than heating oil and kerosene, that reflects a perceived shortage of global refining capacity, pushing crack spreads to near record highs. Since no new refining capacity is expected anytime soon, crack spreads should remain high, pulling crude prices up along with them.
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A strong forward pricing incentive in the futures market.
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As OPEC members are believed to be producing at near full capacity, the market will guard against possible supply disruptions by buying up any available crude, keeping demand strong.
The last point explains why the market shrugged off reports of the recent rise in inventories, both in and outside the U.S. - demand hasn’t slowed, it’s just the market protecting itself from additional price increases.
Is there any spare capacity?
Martin King at FirstEnergy Capital Corp. estimated in a June 20, 2005 report that average global productive capacity for crude oil and natural gas liquids combined in 2005 is about 85.9 million barrels per day (bpd).
Productive capacity is the volume of crude oil and natural gas liquids that could be produced if all the world’s wells were pumping at full tilt. In contrast, spare capacity is the difference between productive capacity and how much is actually being produced.
The analyst wrote that due to rising prices, spare capacity in non-OPEC countries has been effectively nil since 2003, a situation he forecasts will last for the rest of the decade.
As a result, the baton of marginal pricing was placed firmly in the grasp of OPEC. Yet its members have failed to expand and upgrade their production capacity in line with the increase in global demand.
King believes OPEC could boost its spare capacity to more than 3 million bpd in five years. However, this would require members to open up their borders to more foreign investment and/or their state-owned firms to increase the pace in expanding infrastructure, both of which, in the past and at present, have not shown a willingness to do.
King foresees global spare capacity at just 700,000 bpd in 2005 and 800,000 in 2006. When taking into account production of 500,000 bpd of heavier sour crude, mostly from Saudi Arabia, these forecasts drop perilously close to nil.
Could anything cause prices to fall?
On June 7, 2005 the U.S. Department of Energy (DOE) estimated third quarter world oil production to be 85.1 million barrels per day, exceeding demand by 600,000 barrels per day. For all of 2005, the DOE is forecasting supply to exceed demand by 200,000 barrels per day.
This indicates we could be in for higher future spot prices. But is there anything that could derail oil prices?
Most analysts are taking only a cursory look at such possible factors. These include the end of the U.S. Strategic Petroleum Reserve fill-up and a slowdown in economic growth resulting from higher oil and distillate prices.
The big variable, though, would be less-than-expected demand from China.
In a June 27, 2005 report, Desjardins Securities estimated that were it not for Chinese demand, oil prices would drop to $15 a barrel sometime between now and 2007 at the latest. In effect, demand from China is acting as a floor for prices.
Yet the Xinhua news agency recently reported that Chinese crude oil imports in the first half of the year rose only 3.9%, a tenth the size of the increase in the same period a year ago. Imports of petroleum products declined 21%.
In a June 28, 2005 report, Scotia Capital analyst Greg Pardy wrote that China’s secular oil demand growth story appears far from over, but a visit to the country in May pointed toward decelerating consumption growth in 2005 toward 500,000 bpd.
Another source of trouble could come from the ‘hot money’ chasing oil’s returns.
According to Bloomberg, Mike Rothman of International Strategy & Investment wrote in an early July report to clients that $18 to $20 of the cost of a barrel of oil is the result of pure speculation. He noted that from January 2000 to March 2004, more than half of the changes in crude’s price could be explained by the variation in U.S. inventories. If the same relationship still held, the analyst feels current U.S. inventories would produce a price of around $25 a barrel.
This begs the question - what happens if U.S. short-term interest rates keep rising, making it more expensive for hedge funds and other speculators to make leveraged bets on future price increases?
So where to now?
As Scotia Capital’s Pardy so adroitly put it, “we can humbly admit that there is no magical formula to nail down crude prices.”
His own outlook for WTI is $51.75 in 2005 and $52.50 in 2006.
The analyst believes that OPEC’s power to influence crude prices through quotas and production levels has been undermined by its lack of spare capacity, which has severed the direct relationship between inventories and prices. And going forward, “pure market forces remain firmly in control of crude oil prices.”
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