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An Update on Oil

(October 14, 2011)

Dear Subscribers and Readers,

In our mid-week commentary last week, we asserted that while we are structurally bullish on crude oil prices, there remain a couple of downside risks.  One such risk is the high possibility of the Euro Zone tipping into recession as a result of the European Sovereign Debt Crisis.  In particular, this will likely result in a significant decline for Brent oil prices.  Secondly, we have also gotten more bullish on the U.S. Dollar for 2012.  Given the recent inverse correlation between crude oil prices vs. the U.S. Dollar Index, it is thus difficult to be bullish on the former.

On the other hand, the decline of OPEC spare capacity from 4.0 million b/d this time last year to just 2.8 million b/d (Saudi Arabia is now producing 9.9 million b/d—its highest production rate since the 1980s), and given the recent decline in OECD inventories, we do not see much downside in oil prices for next year.  In particular, the EIA believes OPEC spare capacity will rebound to 3.5 million b/d next year (see below chart), but this assumes that Libyan oil production will fully be back online by the end of next year:

As we mentioned, OECD inventories, as shown in the following EIA chart, have declined dramatically over the last several months, and is expected to decline further next year.  According to the EIA, days of supply will decline from 58 days during 4Q 2010 to 57 days during 4Q 2011, and to just 56 days during 4Q 2012, despite the IEA release of strategic inventories this summer, and the record 9.9 million b/d production from Saudi Arabia:

More important, as shown in the following chart (courtesy of Goldman Sachs), global demand growth over the last three months has held up rather well, despite not meeting IEA's initial projections (just 60,000 b/d below expectations).  This is in contrast to supply growth, which disappointed by 239,000 b/d, or four times that of the demand gap.

As we mentioned last week—with Brent crude oil still at $109 a barrel—there is significant downside if the Euro Zone tips 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, as long as any European slowdown does not spill over into the rest of the world, any resultant demand destruction should 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, and 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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