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Crude oil and natural gas seem to be sputtering, as traders focus on the short to intermediate term supply and demand picture. But, if you look out over the next several years, factoring in the historical tendencies of the oil industry toward short term thinking and costs, you could envision a scenario where tight supplies and rising prices make a great deal of sense.
The International Energy Agency’s most recent forecast (June 2009) concluded that oil demand will decrease at a less rapid rate than its previous estimate, while the consensus view of economists is that the global economy will recover in fits and starts with different global regions, especially the U.S. and China likely to fare better than other areas such as Europe. Somewhere in the mix, Brazil and India will likely contribute to any growth. Yet, the chance of a major and synchronized recovery is not widely expected, or showing signs of emerging at this time.
More interesting are the IEA numbers with regard to production. OPEC estimates that global oil demand is 27.7 million barrels per day (bpd), while its own production is currently just over 28 million bpd. Non-OPEC production is estimated to have grown as well this year, as Russia’s output has been better than earlier estimated and Colombia and the North Sea are producing more than expected as well. The flip side is that demand remains subdued due to the global economy.
Other short term influences that seem to be cancelling each other out are the problems with militant initiated supply disruptions in Nigeria, a very subdued Gulf of Mexico hurricane season, and the glut of natural gas that is ongoing across the United States as a result of huge shale deposits that are being exploited and are projected to be plentiful for anywhere over the 50 to 100 years, with current technology expected to improve and possibly improve yields further.
Throw in the situation in Iran, North Korea’s nuclear threat, Pakistan’s run on the Taliban, and you should have a huge run in oil. Yet, over the last few days, the market has been fairly soft in oil, gasoline, natural gas, and heating oil. This is another indication that the short to intermediate term economic expectations are the key to prices at the current time.
That’s now, but who knows where things will be in the next 12-24 months. Assuming that the oil industry does what it’s done with every other significant downturn, it will decrease investment. That means that when demand increases, the industry could be behind the 8-ball, and we could see another huge run up in prices, as we did in 2008.
In fact the IEA has called for $26 trillion in new investments by the oil industry over the next two decades. But what is currently happening is the opposite, as OPEC is holding back on new expenditures as it waits out the current scenario and tries to manage the short term swings in prices and profits with a combination of decreased production while putting off investments in infrastructure.
To be sure, in some countries, such as Mexico, investment is on the rise. But that's to make up for lost production from fields that are rapidly on their way to depletion. So at best, if and when this new production comes on line, you'd presumably be back to break even.
Chart Courtesy of StockCharts.com
The charts of oil (XOI) and oil service (OSX) indexes have been forecasting trouble for the commodity for some time. This was more pronounced in XOI, which houses the likes of Exxon Mobil (NYSE: XOM) and Chevron Texaco (NYSE: CVX). Yet, this was followed a few weeks later by the lack of follow through in the rally in oil service stocks.
Chart Courtesy of StockCharts.com
Perhaps more important is the effect of the ample supplies of natural gas at the moment, which sets up the potential for fairly low prices in the winter, and competition for heating oil as colder weather returns. There is also a move toward liquified natural gas (LNG) with major players starting to increase their involvement. Although LNG is not a major fuel source in the U.S., it is significant in many other parts of the world, where demand for the fuel is stable and likely to increase.
Chart Courtesy of StockCharts.com
For investors, the current action in natural gas is not much different than that for oil, as supply gluts and stable to shrinking short term demand seem to be the major factors influencing prices at the moment.
Conclusion
The market is focusing on the short term supply and demand for energy, with the global economy and expectations for continued weakness or a slow recovery being the major influence on prices at the moment.
Traders are ignoring geopolitical problems, and the long term status of oil production. Yet, history shows that any major disruption to supply, such as a major geopolitical event, could change the trend, both in perception and prices, as the long term production issues of the market will come to the surface.
Central to the concept is the fact that there isn't enough production and refining capacity in the world to supply a full demand market such as one which could emerge if there is a robust rebound in the global economy, or one brought on by a major global conflict which raises military demand. Too little has been made of the effect of the Iraq war on the demand side of the equation for oil.
China has been stockpiling oil over the last several months. The U.S. oil strategic oil reserve is presumably full. And other countries, in one way or another, are likely to have made provisions for emergencies. But most emergency supplies are good for 30-60 days. Which means that any major supply disruption would start the clock.
It takes a while for refineries to start up and for fuel production to reach levels of increased demand, such as those brought on by a rise in the economy, or a major global emergency.
In such situations, history shows, prices rise rapidly and gain momentum. Meanwhile, the effects of higher energy prices will eventually be felt by the global economy, which has little room for error in its current state.
For investors, it's important to understand both the short and the long term. Currently, avoiding energy makes sense, especially if prices continue to fall, as the charts of XOI and OSX suggest that they will. Yet, over the long term, history, and the fact that nothing has changed in the way the oil industry conducts itself, suggest that at some point in the not too distant future, another long term price hike in the price of energy will appear.
And as history shows, a rapid rise in prices can start just about any time. Those who are ready and identify the trend early will likely profit significantly.
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