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The Risk to Oil Prices

(October 7, 2011)

Dear Subscribers and Readers,

With OPEC spare capacity at just one million barrels/day, and with oil inventories outside the U.S. at its lowest level in nine years (despite Saudi production of 9.8 million barrels over the summer and the U.S. SPR release of 30 million barrels), crude oil prices would likely rise into the next year.  Despite the slowing U.S., developed European, and Japanese economies, global oil demand growth would likely keep pace with supply growth next year, as consensus real global GDP growth is expected to range from 3.0% to 4.0% in 2012.  More important, crude oil traders have already discounted a potential “Lehman-like” event as a result of the European Sovereign Debt Crisis, as exemplified by the backwardation in Brent prices; compared to the contango market in 2008 (i.e. traders are now anticipating weaker oil demand in the future).  The differences between the Brent oil strip today compared to the 2008 market are evident in the following chart (courtesy of Goldman Sachs):

Interestingly, traders were still anticipating a tighter oil market on September 30, 2008—two weeks after the Lehman bankruptcy!  Today, traders have already priced in a potential European financial dislocation, along with a much slower global economy going forward.  The saying “once bitten, twice shy” certainly applies to the financial markets and speculation.

Of course, with Brent crude oil still at $105 a barrel, there is significant downside if the Euro Zone tip into recession and China slows down dramatically next year.  In such a scenario, we would not be surprised to see Brent at $80 to $90 a barrel—as this price range is still above the global marginal cost of production.  However, subscribers should note that (multiplier effects notwithstanding), European oil demand (which excludes Russia, Estonia, Latvia, Lithuania, Ukraine, etc.—these countries are categorized into “Eurasia” by the EIA) only amounts to 15.3 million barrels/day (2010), or just 17.6% of global oil demand. On the other hand, the BRICs' oil demand totals 18.0 million barrels/day alone, with Chinese demand at 9.2 mmb/d, India 3.2 mmb/d, Russia 2.9 mmb/d, and Brazil 2.7 mmb/d.  In other words, as long as any European slowdown does not spill over into the rest of the world, any resultant demand destruction could easily be offset by demand growth from the BRICs and other emerging market countries.  Over the next several years, the structural trend for oil prices is still bullish, although Brent could easily decline to the $80 to $90 range in the near-term should the Euro Zone tip into recession and Chinese GDP growth decline to the 7% area.

Another downside risk to oil prices, as discussed by the Bank Credit Analyst, is the recent strength in the U.S. Dollar.  According to the BCA (and the following chart), there has been a strong inverse correlation between WTI crude oil prices and the trade-weighted U.S. Dollar Index since early 2009.  With the recent resurgence in the U.S. Dollar, and given our relatively bullish outlook on the U.S. Dollar next year, there is certainly downside risk to Brent and WTI crude oil prices next year.  However, we believe there is strong support at a Brent price of $80 and a WTI crude oil price of $70.  Should crude oil prices experience a downside spike to near these levels over the next 15 months, we would advocate a long position in crude oil, oil drillers, or the globally integrated oil companies.

Signing off,

Henry To, CFA, CAIA

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