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2012 Outlook on Oil and Natural Gas Prices

(January 8, 2012)

Dear Subscribers and Readers,

I will update the performance of our DJIA Timing System in our mid-week commentary (we were in 100% cash during the entirety of 2011 so there's nothing much to update) but let's begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

As Iran continues to rattle its saber, it is important to keep track of events in the Strait of Hormuz—the “Chokepoint” of over 20% (17 million barrels a day) of the world's total oil supply and about 35% of all seaborne traded oil. On average, 14 oil tankers pass through the Strait on a daily basis (with the same number returning for fill-ups). More than 85% of these tankers went to Asia, such as Japan, India, South Korea, and China. As shown in the following illustration (courtesy of the EIA), the Strait sits between Iran and Oman—and at its narrowest point, is 21 miles wide, but the width of the shipping lane in either direction is only two miles wide (with a corresponding two-mile buffer zone).

Map of Strait of Hormuz

Iran certainly has capacity to “close off” the Strait should it choose to—at the very least, halting all shipping in the area for a significant chunk of time. Unfortunately, there aren't that many alternate routes for the oil. The one big candidate is the 5 million barrel/day East-West Pipeline, which runs across Saudi Arabia from Abqaiq to the Read Sea. The UAE is completing a 1.5 million barrel/day pipeline that will cross Abu Dhabi (delayed until June); two alternative routes would involve reactivating the Iraqi Pipeline across Saudi Arabia and the Tapline to Lebanon—these two combined would provide over 2 million barrel/day in capacity. All in all, these alternate routes would create a shortage of over 8 million barrels/day.

Note that the closure of the Strait is not our base case scenario; however, the underlying threat would provide a sustained risk premium for oil prices at least through the first half of 2012. On the other hand, OPEC surplus capacity is expected to increase by about one million barrels/day this year—thus providing more of a cushion as European demand helps sink overall global demand and as more Libyan production comes back online.

This is confirmed by relatively robust OECD Commercial Inventories (on a Days of Supply basis):

In 2011, North Sea Brent shot up to average $111 a barrel; while US benchmark WTI averaged just $94.86 because of transportation bottlenecks out of Cushing. Nonetheless, WTI averaged $15 higher than it did in 2010. I expect WTI crude oil to average about $10 to $15 higher this year—i.e. about $105 to $110 a barrel, with risks to the upside if the U.S. economic growth surprises on the upside. Alas, there will be more advances in solar efficiency and second-generational biofuels this year; but I don't anticipate any major commercialization efforts or the proliferation of solar panels/electric vehicles until the 2013 to 2015 timeframe at the earliest (Nissan will start producing of its all-electric 150,000 Leafs by the end of this year). As such, there would be no dent in oil demand as a result of new technologies this year, or 2013.

As for natural gas—while risks are to the upside (due to ongoing environmental/earthquake concerns of shale gas “fracking”)—supply remains rampant. As we discussed in our December 18, 2011 commentary, natural gas is no longer as volatile as it was in the early parts of this decade, primarily because of new sources of supply and more underground storage availability. Furthermore, the current winter has proved warmer than usual—as a result, natural gas storage levels are now making record highs (as seen in the following chart courtesy of the EIA).

Working Gas in Underground Storage Compared with 5-Year Range

With supply from the Haynesville Shale still growing, and with the Marcellus Shale now ramping up, natural gas prices should remain subdued this year—even in the event of an upside surprise in US GDP growth. Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:

For the week ending January 6, 2012, the Dow Industrials rose 142.36 points, while the Dow Transports rose 49.34 points.  Both the Dow Industrials and the Dow Transports made fresh six-month highs—which is technically bullish. More important, the contagion risks from the European Sovereign Debt Crisis is now off the table, given the ECB's renewed commitment to reliquify the European banking system, the availability of the Fed's cheap US$ swap lines to the ECB, as well as the resilience of the US economy. We are now bullish on US and US financial stocks, but given that we are dissolving over at the end of this month, we will not make any future moves in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators increased from 9.3% to 12.2% for the week ending January 6, 2012.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:

Since hitting a multi-year low of -11.3% in early October, the four-week MA has surged by 23.5%. While it is slightly overbought in the short-run, it is about neutral in the long-run  With the European Sovereign Debt Crisis now on the backburner—and combined with cheap US$ swap lines and the resilience of the US economy—we are now looking for the market (and US financial stocks) to rally over the next several months.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

Ever since breaking 100 a month ago, the 20 DMA has been on an upward tear, and remains solidly above its 50 DMA. Such a breakout from a highly oversold condition is definitely bullish—all the more so since the Euro break-up scenario is now off the table. We are now bullish on US stocks and US financial stocks.

Conclusion: I do not see any surprises in WTI oil or Henry Hub natural gas prices this year—despite Iranian threats and the ongoing environmental/earthquake concerns over “fracking” of shale gas. Again, I am looking for WTI crude oil to average about $10 to $15 higher than last year (i.e. $105 to $110 average); and for natural gas prices to remain subdued as domestic supply and storage levels continue to make record highs.

Signing off,

Henry To, CFA, CAIA

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