Oil on Fire

Barron's says oil is headed for the sky. Hmmm. Well, maybe, briefly, but those spikes don't last long, and perhaps, possibly, maybe, if oil prices soar, maybe the president will wake up and unleash the domestic oil industry.

Maybe he'll allow drillers to drill all the easy places where reserves are abundant. The Arctic National Wildlife Refuge. Off the coast of California, throughout the Gulf of Mexico. And maybe he'll wake up to the benefits of making greater use of natural gas. Maybe he'll learn that subsidizing domestic ethanol production at the expense of everyone who buys food is a bad idea. Perhaps he will eliminate the subsidy and simultaneously eliminate the tariff on ethanol imported from Brazil.

Barron's Cover | SATURDAY, JULY 2, 2011

Get Ready for $150 Oil

By GENE EPSTEIN

After a decline this summer, crude's price is likely to rise sharply by next spring. It will hurt the economy, but it won't be a disaster.

The U.S. economy is never completely ready for higher oil prices, which is one reason they take a nasty economic toll when they arrive. But readiness can be enhanced by awareness of the likely outlook for petroleum prices–and the outlook today is relatively grim, although probably not disastrous.

Despite the recent 20% decline from April highs, new highs on crude, heating oil, diesel fuel, jet fuel and gasoline seem likely over the next 12 months. Following some further easing over the summer, the second leg of the long-term bull market in petroleum–the first occurred in 2007-08–probably will begin this fall.

As oil producers' spare capacity gradually declines to worrisome levels, the average monthly price could reach a record $150 per barrel by next spring, with spikes to $165 or $170. With this, $4.50-a-gallon gasoline will become the norm. That will put a huge dent in consumer wallets, while ramping up the desirability of fuel-efficient cars.

The continued short-term easing of oil prices should benefit the economy over the summer, only to exact a much larger payback later. The projected oil shock of spring 2012 will hurt the economic expansion, but not kill it, pruning about 1.5 percentage points from quarterly growth in real gross domestic product.

While painful, this forecast isn't quite as extreme as it might appear. Short-lived price spikes and troughs make for frenzied headlines in newspapers and on the Internet as well as for hysterical talking heads on radio and TV, but what matters for the economy are average prices over at least a few months. Barron's estimates that the effective price of crude was about $110 in this year's second quarter, which just ended. So a projected increase to $150 by the second quarter of next year assumes a rise of $40. Oil is likely to stay at $150 for several months, before the promise of greater supply brings a gradual easing.

The $110 price estimate comes from taking the midpoint between the market price on West Texas Intermediate oil traded on the New York Mercantile Exchange in New York and on Brent crude traded on the Intercontinental Exchange in London. While the recent unusual 10%-15% premium of Brent over WTI, which actually is of higher quality, has puzzled many analysts, those Barron's polled agree that the lower price on WTI is potentially misleading.

According to Credit-Suisse energy analyst Joachim Azria, the U.S. is mainly paying the West Texas Intermediate price, but the cost of gasoline and diesel and jet fuel reflects the higher Brent price. James Hamilton, an economics professor at the University of San Diego, has studied the effect of oil shocks on the economy. He suggests using a midpoint between Brent and WTI to capture the effective price. That's what we've done.

Still, even a $40 rise, to $150, by next spring differs by several country miles from the oil market's own implied price outlook. Last week, futures contracts for June 2012 delivery of WTI crude were trading around $99, while Brent crude for June 2012 delivery was commanding just $112.

Steve Briese, publisher of the Bullish Review of Commodity Insiders newsletter and Website, says that commercial hedgers–who deal in the underlying commodity and thus have lots of professional experience in these matters -- are "overwhelmingly bearish" and are putting their money where their convictions are. They currently have a record net short position on the Nymex futures and options market. Because history shows that the hedgers often have been right, Briese concludes that the "short profit potential is enormous."

While Barron'ssees some short-selling potential this summer, it's not "enormous." And with all due respect to the expertise of the commercial hedgers, even pros can be wrong. We think this is a great buying opportunity for bulls on petroleum.

Cornerstone Analytics oil analyst Michael Rothman, with more than 25 years' experience calling the market, foresees an extended price plateau of $170. In support of his view, Rothman cites a comment made by Nobuo Tanaka, executive director of the International Energy Agency, the Paris-based organization that represents oil-consuming nations. Tanaka spoke on June 23, when the IEA helped cause a selloff in the petroleum market by announcing that 60 million barrels were being released from strategic reserves held by the U.S. and 27 other countries. (For more on the effects of this move, see Commodities Corner column.)

The markets seemed quite impressed by this infusion, even though it amounted to just a little over two-thirds of the nearly 90 million barrels the world consumes each day. At that rate of daily off-take, the total emergency stocks held world-wide, 1.6 billion barrels, come to only about 18 days of supply. Far more important is the ability of producing nations to meet needs, month after month.

The ostensible reason for releasing the 60 million barrels was to help replace the loss of production from war-torn Libya. But Tanaka, who not surprisingly said that he had been in "close consultation" with "major producing countries," also linked the decision to concern about spare capacity within the Organization of Petroleum Exporting Countries, and especially from its largest producer, Saudi Arabia. While welcoming increased production from this source, he cautioned that it "will take time" to come on line.

Comments Rothman: "Read between the lines. This raises the specter that the Saudis might have a problem raising their output."

The Barron's projection assumes that the Saudis will ramp up output this month, and that prices will continue to ease as a result. Another oil bull, Morgan Stanley's commodity research head Hussein Allidina, sees this only furthering the decline of OPEC's spare capacity to "untenable levels," and especially in the land that Allidina dubs the "kingdom of spare capacity" -- Saudi Arabia.

While Allidina is more cautious than Rothman -- his most bullish scenario projects a Brent average price of about $140 through next year -- their broad concerns are similar. Author of a September 2009 report called "Crude-Oil Balances to Tighten Again by 2012," Allidina foresaw the process by which unused capacity would eventually be reduced to puny levels, sparking higher prices.

THERE ARE FOUR MAIN PLAYERS in the global oil drama.

On the demand side are the nations of the Organization for Economic Cooperation and Development, which includes the U.S., Canada, Japan, Australia, New Zealand and most of Europe. And there are the non-OECD nations, which include India and China, currently in a phase of rapid economic growth.

On the supply side is OPEC, which includes Libya, Iraq and Saudi Arabia, and non-OPEC nations, including Norway, Mexico and the former Soviet Union.

The dynamics of both the first (2007-08) leg of the bull market and the second leg, likely to begin this year, are essentially the same. The thirst for oil by non-OECD nations puts pressure on supply, and the increase in output from non-OPEC producers is inadequate to quench this demand.

Since 2000 -- despite the post-9/11 economic downturn, the global stock-market swoon of the early 2000s, the 2008 financial crisis and the 2008-2009 Great Recession -- global oil consumption has advanced by a yearly average of 1.1 million barrels per day, while non-OPEC output has risen by a yearly average of less than 0.6 million per day. In 2000, non-OECD demand amounted to 37.7%, or a little over a third, of the world's consumption; now, it amounts to 48.5%, or nearly half.

The upswing in demand is adding urgency to concern about the availability, or lack thereof, of spare capacity, technically defined as crude that can be produced on a sustained basis within 30 to 45 days. Perhaps the most important thing to know about spare capacity is that only the OPEC producers have any. The non-OPEC gang is probably already pumping out all it can.

The 2007-08 bull market in oil peaked with an average monthly price of a record $133.40, reached in July 2008, with a short-lived spike, to $147, on July 11. While that oil shock certainly worsened the Great Recession, which struck early in 2008, the economic contraction would have happened anyway, since its main cause was the bursting of the housing bubble.

The causality also went the other way, however. The recessions in the OECD countries, including the U.S., Germany and Japan, meant weakened demand for oil that placed some drag on the uptrend and eventually helped sink the price of petroleum.

The coming second leg of the bull market, in contrast, will be sustained by steady, if modest, economic growth in the OECD world. The consensus estimate from the economists surveyed for the Blue Chip Economic Indicators is for real gross domestic product growth of 3% in the U.S. over the next four quarters, moderate growth in Germany and the U.K. and a resumption of growth in earthquake-ravaged Japan by next year.

Even if Chinese economic expansion slows–a focus of some disagreement among prognosticators -- non-OECD demand should continue to expand faster than demand from OECD countries. Result: The squeeze on spare capacity will be greater than ever before.

WORRIES OVER SPARE CAPACITY have been exacerbated by the civil war in Libya, which has taken 1.5 million barrels a day out of the supply stream. On the other hand, the OPEC meeting that broke up early last month with no formal deal to increase quotas was of no great concern in itself, because OPEC members had been openly exceeding quotas already. More importantly, the Saudis signaled their willingness to boost output from nine million barrels a day to more than 10 million this summer.

Assuming that the Saudis can meet their commitment on a timely basis, OPEC's spare capacity will still continue to decline. Result: higher oil prices.

One reason the U.S. is less susceptible to an oil shock than it used to be is that, for every dollar of nominal GDP, it consumes less oil than it once did.

The top chart on this page -- in which the 2011-12 data are an average of WTI and Brent -- shows that the projected monthly average of $150 per barrel would be a record high, even though all historical prices are adjusted to 2011 dollars. For example, the actual monthly high of $39.50 through April-June 1980 comes to $93.50 in today's dollars, as the chart shows.

But the $150 price peak will not mean peak consumption in the U.S., when measured as a percentage of gross domestic product. As the bottom chart shows, spending on crude accounted for 9.5% of nominal GDP for a few months in 1980. That's substantially higher than the estimated 7% if oil hits $150, as we expect it to.

Why will the toll be lower? One big factor: Since 1980, an even larger share of America's gross domestic product comes from services rather than goods. Producing more services generally requires less energy than making more widgets does. Also, the use of oil in heating and in electricity-generation has greatly declined. In 1980, 56% of all crude purchased in this country powered vehicles (planes, cars, trucks, buses, farm equipment), while today, 70% is used for that purpose, according to the U.S. Energy Information Administration. In addition, the fuel efficiency of the U.S. ground fleet, measured in total vehicle-miles per gallon, is much higher now than it was 31 years ago.

However, given Americans' appetite for SUVs and for cars with six- and eight-cylinder engines, fuel efficiency leveled off in the late 1990s, and has made no progress since then. Underlying this splurge has been complacency over oil prices. As the price chart on this page shows, apart from the brief spike in 1991, post-1980 oil prices were pretty stable for more than 20 years, until the first leg of the bull market began in 2007.

Price punishment of the sort we anticipate next spring could restart serious progress in fuel efficiency. But with new auto sales running at about an 11 million annual rate and the American light-vehicle fleet now numbering about 250 million, significant improvement will take awhile.

The assumed 1.5 point drag on growth from the $40 price hike balances various factors. The main impact would be on the consumer. Because gasoline is a necessity for many people -- they have no alternative to driving to work -- and since it's tough to quickly reduce the amount consumed by very much, funds allocated to it must come from somewhere else. And that somewhere else could be savings or money that otherwise would be spent on clothes, restaurant meals, movies or iPads.

Estimating the consumption effect, Bank of America Merrill Lynch economist Neil Dutta calculates that every $10 price rise normally trims GDP growth by 0.25 of a percentage point, which means $40 lops off a full point. (Of course, the dynamic also goes the other way when prices fall, as will happen this summer, benefiting consumer spending and growth.)

Oil at $150 a barrel would, of course, hurt businesses, too. As the cost of jet fuel soars, airlines will boost fares. That could reduce passenger traffic, leading the companies to cut flights, reducing economic activity. And, as San Diego's Hamilton notes, there is the added risk that companies, anticipating shortfalls in consumer spending, will reduce hiring, causing a multiplier effect that could worsen a bad situation.

Morgan Stanley oil bull Allidina believes the 2012 Brent price that will ration demand is about $130 for his baseline forecast. Oil analyst Michael Rothman sees a two-tiered market: $130 would ration demand in OECD countries, but nothing less than $170 is required for "demand destruction" in non-OECD nations. And $170, as noted earlier, is Rothman's price target.

Barron's believes that non-OECD demand could be more price-sensitive than Rothman assumes. For one thing, a $150 price could motivate governments to delay projects like the building of new roads, which require a lot of oil. For another, there is the stark fact that non-OECD countries are poorer than OECD countries. While it makes some sense that their hunger for "black gold" will motivate them to pay even more for it than their richer counterparts, the lash of $150 crude will decrease their willingness to pay.

IS THE WORLD RUNNING OUT OF OIL?

Probably not. Libya can eventually bring 1.5 million barrels back on stream. There is huge potential from Iraq, even greater potential from Saudi Arabia itself -- and closer to home, more supply could come from ending the de facto moratorium on drilling in the Gulf, and from tapping Alaska's wildlife reserve.

Crude at $150 will likely encourage these and other sources of supply, bringing a gradual pullback. But none of this is like to help much by spring 2012. Get ready for higher oil prices.