Crude Oil at $100 per Barrel in 2011: The Hows and Whys (Part 2)


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Irfan Chaudhry submits:

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Crude oil inventories

Visible effects of market tightening in 2011 may create a call on global oil inventories in Q2 / Q3 2011, which may propel crude oil prices beyond $100 per barrel. A further crude oil price forward curve is expected to flatten by the end of 2011, as spot prices rise more and financial and storage cost increase.

OPEC output / production targets and spare production capacity

OPEC produced an average of 29.49 million barrels a day in the third quarter of 2010, up 0.4 percent from the second quarter. The figure was 29.46 million barrels for November, down from a revised 29.35 million the month before. The August total was the highest monthly rate since December 2008, the month before the final round of OPEC production cuts went into effect. Spare production capacity at current levels of production may be around three million barrels per day.

Iraq 's oil minister announced last month that Iraq may be able to increase its oil production, to eight million barrels per day from its current level of 2.3 million barrels per day, in the coming three years. However, given the political squabbles and lagging investments in Iraq 's oil sector, it is unlikely that Iraq will achieve that. Kuwait's oil ministry announced that it is investing $10 billion on energy infrastructure to increase its crude oil production to 3.2 million barrels per day from its current capacity of 2.3 million barrels per day. Saudi claims of having a production capacity of 12.5 million barrels per day should also be taken with a pinch of salt, as there will be a decline in crude oil production from its Ghawar field.

OPEC agreed to a record 4.2-million-barrel-a-day production cut in late 2008 as global demand fell 0.6%, the first decline since 1983. It is estimated that OPEC members are now adhering to about 56% of that cut, per the IEA. OPEC has raised output by 5% from a five-year low reached in March 2009 and now exceeds its own target by 1.9 million barrels a day. Spare capacity may not be above 3.5 millions barrels per day against the five-year average of 2.8 million barrels per day, and IEA estimates five million barrels per day, which should be supportive for the crude oil price.

IEA mentioned in its latest report that OPEC production is expected to increase further as crude oil prices increase further and as 2011 progresses, but OPEC has a strong will to keep oil prices between $80-100 a barrel. Since OPEC is the source of over a third of the world's oil supplies, any reduction in offshore drilling will result in even greater reliance on oil from OPEC, which has learned to control market price with production quotas. Further, any political unrest in Nigeria (2.5 million barrels per day) and Iran (5 million barrels per day) may further stress crude oil supplies. Putting it all together, we expect crude oil production to weaken from its current level of around 86.2 million barrels per day because of a further decline in North Sea and Mexican oil production.

Higher OPEC output "should keep prices from rising dramatically" (as IEA suggested) but it also pares down OPEC spare production capacity, which has had a close historic link to crude oil price jumps. Oil prices "could be significantly higher" from today's forecast, if OPEC doesn't increase production as global consumption recovers.

Risk premium on crude oil price

Another crude oil price approach is risk discount / premium approach, as argued by JP Morgan ( JPM ). Crude oil price is thought to be the sum of risk neutral price and risk premium or discount. Investors put a risk premium at the top of risk neutral price if there is a higher risk of the market tightening, and a risk discount if the market faces the prospect of loosening too much.

Risk premiums and discounts can be estimated as options premiums and implied volatilities ((COBE)). Estimated risk premium in June 2008 was estimated at around $50 / barrel and risk discount of around $50 / barrel in December 2008. It is estimated that by the end of 2011, around $20 / barrel will be tacked on top of the crude oil price, which implies a price of around $100 / barrel. The normalized, risk neutral crude oil price has been estimated at $75-80 / barrel. Our earlier statistical analysis suggested a risk neutral price of $84-86 / barrel. We expect COBE volatility to start rising by end of Q1 2011, which may result in a gradual aggregation of risk premium at the top of a fundamentally neutral crude oil price of $84-86 / barrel - which makes our estimates conservative.

Paper barrels - longs and short managed money contracts

Short-term crude oil price is determined by the flow of money into total open interest - which means the total number of crude oil contracts entered by the investors and commercial hedgers. Another factor is the number of managed money contracts; crude oil price usually moves along with the long side of managed money contracts and an estimate of reversal of these contracts. We believe that the current reversal level of long side of contracts is at 180,000 contracts, and 45,000 contracts on short side. We see a short term reversal of managed money long contracts by the end of year, with an accompanying positive momentum in crude oil price.

Effect of weakness in U.S. dollar on crude oil price

Lately there had been some divergence between crude oil prices and the U.S. dollar trade weighted index, which shows underlying strong sentiment in crude oil price. Notwithstanding that, the trade-weighted U.S. dollar had been a significant historic predictor of crude oil prices. Also, we expect the trade-weighted dollar to resume its structural slide after a current blip caused by euro weakness. That is only the path of least resistance for crude oil prices, and is likely to be a positive for those prices. While a high stocks level traps crude, the 13% decline in the Dollar Index from June to September has prompted some OPEC members to support $100 oil. For example, Bloomberg reported that Libya indicated "We would love to see $100 a barrel" to help offset the loss of revenue from the weaker dollar. And Venezuela claims the U.S. currency's weakness means the "real price" of oil is about $20 less than current levels.

GDP forecasts revision and effect on crude oil price and world crude oil demand

Global crude oil demand is expected to increase with the IMF revision of global GDP (maintaining recent energy intensity of GDP and crude oil use's percentage of energy use). If OPEC maintains its output quotas and compliance rate remains at 54%, the crude oil demand and supply market will tighten in 2011. On a quarterly basis, the euro debt situation, dollar weakness and strength, and China's buying crude oil for its new commercial reserves will all be crude oil price drivers in Q1 / Q2 2011.

The U.S. economy has been estimated to grow by 3.3% in 2010, and Japan 's GDP is predicted to increase by 2.4% in 2011. U.S. gross domestic product will grow 2.6% this year and 2.1% in 2011, according to IEA estimates. The IMF earlier raised its global economic growth estimate from 4.2% to 4.6% for 2010, while the growth for 2011 has been kept at 4.3 percent. The IMF has also predicted that OECD will grow by 2.6% in 2010. It is also estimated that U.S. households will spend an average of $986 between October and March to heat their homes, an increase of $24, or 2.5%, from last winter, per EIA's "Winter Fuels Outlook."

World crude oil demand is expected to climb to 87.44 million in 2011. On the basis of estimated GDP growth, U.S. oil use is estimated to average 19 million barrels a day in 2010, +0.2 million barrels from 2009. Consumption is estimated to climb another 0.11 million barrels to 19.08 million in 2011. For EU, the IMF has kept its forecast stable for 2010, unchanged at 1%, and reduced its 2011 outlook by 0.2% to 1.3 percent. China 's growth is estimated to be the fastest, at 6.8% from 6.3% in April, while India 's GDP growth is estimated at 9.4% this year. The overall growth prospects for the emerging markets maintained at 6.8 percent.

Consumption from emerging economies outside OECD may account for 52% of the world's oil use by the year 2015, compared to 47% this year. IMF feels that faster expansion in China , India and Brazil are helping the global recovery. According to OPEC, the world economy has gained momentum and is expected to grow by 3.8% this year. So far the recovery, supported by fiscal and monetary stimulus, would have to be taken over by private consumption and investment to compensate. OPEC expects the global economy to grow by 3.7% in 2011, due to the fiscal austerity measures in most of the developed world and monetary and fiscal tightening in China . OPEC has forecast world oil demand to grow by 1m barrels per day in 2011 (October Monthly Report). The growth in demand would be fuelled by non-OCED countries like China , India , Latin America and the Middle-East.

Demand for industrial fuels is expected to remain strong as a result of the economic recovery. Demand for gasoline / jet fuel (transportation fuels) is also expected to increase. Further, OPEC expects the world's oil demand to grow by 0.9 million barrels per day, with OECD seeing no growth because of decline in demand in Europe . In 2011, non-OPEC oil supply may grow by 0.3 million barrels per day because of increases in Brazil , Canada , Azerbaijan , Colombia , and Kazakhstan and decline in output from the U.S., Mexico , U.K ., and Norway . Demand for OPEC oil is expected to be in the range of 28.8m barrels per day (+0.20 million barrels per day in 2011), whereas EIA predicted world oil demand increasing by 1.3 million barrels a day in 2011.

Effect of increase in crude oil price on global / U.S. economic recovery

In the current environment of slow economic growth and a fragile recovery, it may be useful to estimate a goldilocks price -- which may not hurt the nascent economic recovery, based on estimates of consensus global GDP growth estimates and crude oil consumption, which is needed to sustain this growth. Total U.S . energy consumption (measured in quadrillion BTU) grew rapidly until the oil price shocks at the end of 1973 and 1979. Consumption was fairly stable until the late 1980's; since then it has been growing.

The rise in crude oil demand was higher in commercial and residential sectors, but was lower for industrial sectors -- although at a lower rate than in the years prior to 1973. Part of the reason was for that was the outsourcing of industrial activity to China and the developing world. As services became a bigger part of the economy, commercial use growth outstripped industrial use. Residential use, which is more defensive to higher prices, has risen with the rise in suburban sprawl and in population. Another impactful factor is that of higher crude oil prices on the U.S. trade deficit.

Our analysis shows that lower oil prices don't necessarily lead to an imminent decrease in the U.S . trade deficit, at least not in the short term. Similarly, a spike in the cost of crude oil doesn't immediately hike import costs into America . The U.S. has contracted out much of its manufacturing to developing nations; the impact of higher oil prices will be less visible on American consumer behavior (gasoline) before the muted longer term effects on the U.S. trade balance become apparent.

Looking at trends of crude oil product and segment demand between 1970 and 2010, total energy consumption grew at an average annual rate of 1.2 percent. Growth was slow during the first third of the period and has been more rapid recently: The annual average growth between 1980 and 2000 was 1.4 percent. Average annual rates of growth by end use are shown below for those periods. An important lesson from history is that energy prices matter a lot, but the effect of an increase in crude oil prices on GDP growth is dependent on the level of GDP / capita, level of crude oil use (gasoline, heating oil, and distillates), suburban sprawl, social and demographic conditions, weather and productivity of a country. The least energy-efficient countries are the ones which are highly productive (highest GDP / capita), are located in the colder regions and have higher suburban sprawl (U.S.).

According to some recent reports, China aims to reduce energy use per unit of GDP by 17.3% from 2011 to 2015, and by 16.6% from 2016 to 2020 (per Shanghai Securities News , citing Huang Li, an official at the National Energy Administration). However, it may be a hard target to achieve, as China is becoming increasingly urbanized, its number of cars is increasing, and its people are driving more miles per car. If anything, energy use per capita in China may increase with an increase in GDP per capita. On the basis of historical behavior of GDP growth and energy intensity of GDP, we have estimated that crude oil prices between $80-100 / barrel do not cause a severe demand and supply reaction in an atmosphere of slow economic recovery. We are of the view that the U.S . economy now could absorb that crude oil price and still post some GDP growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

See also If a Stronger Yuan Is Good, Can a Weaker Dollar Be Bad? on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Commodities , US Markets
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