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Oil Not a Concern (Yet)

(February 24, 2012)

Dear Subscribers and Readers,

We gave our 2012 outlook on crude oil and natural gas in our January 8, 2012 commentary (“2012 Outlook on Oil and Natural Gas Prices”). At the time, we stated:

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 Red 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.


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 I am penning this commentary, April 2012 WTI Crude Oil contract is trading at $108.48 a barrel—near the midpoint of our projected range for the average crude oil price this year. Obviously, higher crude prices have already translated into higher US gasoline prices (I saw a gas/petrol station selling premium gasoline at over $5 a gallon in West LA yesterday). Already, there is talk of an adverse economic impact because of higher crude oil and gasoline prices, especially since many economic slowdowns and recessions were preceded by a spike in oil/gasoline prices. However, subscribers should note that the latest run-up in oil/gasoline prices is still small compared to previous run-ups. Again, note that the current crude oil price falls within our projected range for the average oil price this year; the following chart (courtesy puts the latest run-up in perspective:

Moreover, as Ed Yardeni points out, oil demand in the US, Western Europe, and Japan have continued to trend down, due to a recession in the Euro Zone and the adoption of more fuel-efficient vehicles in the US. That means any further spike in oil prices (I don't expect WTI oil to rise above $110 a barrel on a sustainable basis unless Israel bombs Iran—which is not our base case) will not have as much of an adverse impact on the US economy as it has in the past. In addition, the US is producing about 750,000 barrels more on a daily basis compared to just a couple of years ago (as shown in the following chart)—meaning that more oil revenues are staying in the US for domestic consumption.

Finally, insofar that rising oil prices are a function of global GDP growth (although we recognize that the Iranian nuclear program remains a problem), higher oil prices tend to correlate with higher GDP growth, profit margins, and stock prices. In particular, Goldman calculates that the correlation between commodity prices and European stock prices (see below chart) has generally been positive, with the following notable exceptions: late 2000 to 2001 (bear market in technology stocks and the aftermath of 9/11); early 2003 (the beginning of the second Gulf War, coinciding with the beginning of the March 2003 to October 2007 cyclical bull market in stocks); late 2004 to early 2005 (when crude oil prices decidedly broke through $40 a barrel) and the summer of 2008 to early 2009, when oil experienced a “super spike” to $147 a barrel, and subsequently crashing to just $30 a barrel.

Today's action in oil prices simply does not justify a correction in stocks, unless oil spikes to over $120 a barrel in the short-run. As an interesting side note, the following exhibit (courtesy Goldman Sachs) shows the US sub-sectors that are most sensitive to changes in the Brent oil price.

Signing off,

Henry To, CFA, CAIA


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