GMVasey's blog

In the period after Christmas, the price of crude oil futures finally met and exceeded the $100/BBL psychological barrier prompting further cries of anguish from consumers and politicians. Turmoil in Nigeria, a weaker US Dollar and the general supply/demand picture was largely blamed for the brief spike in prices which have since declined slightly as fears over the US economy have taken center stage once more. The Energy Information Administration also reported that US crude stocks fell 4 million bbl to 289.6 million bbl during the week ended Dec. 28, well below market expectations of a 1.7 million bbl drop. It marked the seventh consecutive week that US crude inventories have fallen.

In reality, the movement beyond $100/bbl was brief and took place on an intra-day basis but analysts were quick to point to a possible $105/bbl price as the next target. But what chance has that of occurring?

An important factor will be US inventory movements and the final US weekly data for 2007 show US crude inventories ending the year at just below 290 million bbl, some 65 million bbl lower than the peak at the end of June. Crude inventories have gone from well above the 5-year average to 6.8 million bbl below that average in 2007. Should this trend continue into the new year then the impetus for price formation might well remain unchanged. Despite that, concerns over the US economy are now beginning to emerge as a stronger factor and high energy prices are seen obviously as a contributing factor to a possible US recession.

Bullish Factors

A couple of years ago I recall writing a piece for Energy Hedge about Royalty Trusts. Royalty Trusts were making a comeback as an investment in the sector and increasingly being used as a structure by those in both the midstream and E&P segments of the industry. Some tax law changes by the Canadian government put in slight ding in the attractiveness of the Royalty Trust but they remain popular and there are several hedge funds that focus on them.

I have also commented numerous times about how it is now easier to invest in energy – even commodities – as a result of new instruments and exchange clearing. For those of us that aren’t particularly wealthy but want some energy exposure nonetheless there is now the ETF.
A couple of years ago there were a small number of ETF’s in natural resources, utilities and energy. These Exchange Traded Funds were quite popular but only allowed investors to invest in an equity-oriented fund. Now that has all changed. Today, there are numerous ETFs and they appear to fall into three categories;

• Those that track an equity index;
• Those that track a commodity index; and,
• Those that ostensibly track the commodity itself.

I spoke at Commodities Week in London a few weeks ago. There were many great presentations and topics shared there but of all the presentations the one that interested me the most was by Ed Morse. Ed is Chief Energy Economist with Lehman Brothers and his presentation covered Oil supply and demand. His main thesis was that new refining capacity set to come onstream over the next few years will significantly change the supply side picture by the turn or just after the turn of the decade. In effect, by 2009, refining capacity additions should outpace demand growth by a factor of 2:1 he argued.

In making this assessment, Lehman has been conservative in looking at new refining capacity excluding projected refinery capacity upgrades in politically sensitive areas like Venezuela for example. Additionally, they see some strong political agendas to support the capacity build out that include;

• Saudi Arabia has a strong need to alleviate downstream bottlenecks which has in effect, reduced that country’s control over the oil market;

• Chinese self sufficiency;

• India’s plans to re-position as an export refining hub and its ability to bring the Reliance refinery onstream ahead of schedule; and,

• The need to process heavy oil in situ so as to get it to market more effectively in a number of producing countries.

The price of crude oil reflects many factors – both fundamental and speculative. Exactly how much of each is anyone’s guess. This last two weeks though has been interesting when looking at the price of oil and the factors at work behind that price. Let’s look at some.

Everyone knows and is aware that China’s growing demand for energy and commodities in general remains a huge fundamental factor in assessing today’s and the future’s energy markets. According to the IEA’s World Energy Outlook 2007, China and India alone will account for 45% of the increase in global primary energy use through 2030 and will account for a disproportionate amount of the increase in coal use which it forecasts will grow by 73% in that period. It also states that “China’s energy needs will continue to grow to fuel its economic development is scarcely in doubt.” The report anticipates China will surpass the United States as the world’s largest energy consumer soon after 2010.

China’s demand is fueled by the rapid urbanization of the country, increasing wealth and access to consumer goods. For example, the IEA estimates that the vehicle fleet will grow 700% and points to strong growth in housing, the use of electric appliances and space heating and cooling in the country. Let’s just list a few other IEA report considerations regarding China to build the picture more completely;

1. China became a net coal importer in the first half of 2007 and coal imports into China will reach 7% of global coal trade by 2030;

2. Conventional Chinese oil production will peak at 9.3mbd in the next decade and oil imports will jump from 3.5mbd in 2006 to 13.1mbd in 2030 (note: Saudi Arabia’s production in 2005 was between 10.5 and 11mbd);

3. It needs to add more than 1300GW to its generation capacity;

Everyone knows the theory that rising commodity prices should mean erosion in demand will occur and the price will stabilize and even fall as the supply/demand balance begins to change as a result. For the last 2-3 years, various analysts have been looking for that price effect on oil and other commodity demand. But it hasn’t actually occurred – not yet anyway. In fact, demand for just about all commodities appears to be rising despite increased prices and judging from some of the fundamental data, will continue to do so for some time to come.

The US Dollar

The oil majors who benefit from higher oil prices are seeing their profits erode as the cost to find new reserves increases too. Mind you, those profits are still pretty good! ExxonMobil today a $9.4billion quarterly profit today and BP reported lower quarterly earnings recently.

Funnily enough, the majors continue to buy back shares with their profits rather than invest it in exploration and infrastructure. In our book 'Energy & Environmental Hedge Funds: The New Investment Paradigm' (Wiley, 2006), Peter Fusaro and I pointed at 20-years of under investment and a demand-side surprise from China, India and USA as behind the rise in oil prices. We also noted that the oil majors continued to use more of their earnings to buy back stock than they did on exploring for more of the stuff. It will be the independents and minors who do the exploration, not the majors.

Additionally, I wrote an IssueAlert newsletter article for UtiliPoint International, Inc a couple of years back comparing the major's increased exploration budgets for the year against what commentators saw as necessary to replace reserves...it fell far short.

As crude oil breaks the $90 barrier one must seriously consider the next ceiling and psychologically important $100 per barrel might be next?

Frankly, in looking at the fundamentals, $100/bbl seems unsustainable - as indeed does $90/bbl. In essence, not much has really changed other than the US$ which is significantly weaker. Yes, there is some renewed tension in and around the Middle East and temporary disruptions in Mexico but is this really sufficient, against the supply/demand backdrop, to justify such prices? I for one think not. In fact, other than for the weakness of the US$, I think prices are already overblown and the bubble is more likely to burst. However, all eyes are on the US Federal Reserve to see if they cut US interest rates again. If they do, all bets are off.

UtiliPoint IssueAlert by D. GM Vasey, Friday 26th October.

Most of us (especially us Brits, it seems) like to talk about the weather. We listen avidly to weather forecasts on the TV or radio and plan our day accordingly, often later cursing when it turns out that the forecast was wrong, as usual! At times, we pay closer attention to the weather forecast when tropical storms or hurricanes are approaching, or if we are planning our vacation. Weather forecasts are a basic feature of modern life that we simply take for granted but utilize in many ways. And so it seems energy companies do, as well.

Crude oil for December futures rose as high as $91.10 a barrel in electronic trading after ending at a record high of $90.46 a barrel on the New York Mercantile Exchange. The contract was recently at $90.90 a barrel, up 44 cents on continued worries over energy supply and tensions in the Middle East. It can go higher yet....

So here we are again - deja vu... the oil price goes up and who gets the blame - hedge funds and speculators! How many times have I written this article over the last 4-years and how come no one seems to listen?

OK so the oil price is going up again. I wonder why? Could it be that oil is priced in US$ and that currency is at its weakest right now? And if that was the reason for higher oil prices just exactly who is responsible? The very politicians who now want to blame speculators! OK and lets just throw in the fact that Turkey seems to be getting ready to raid Iraq...potentially disrupting oil production from the Kurdish region of Iraq as well as increasing political tensions in an already tense Middle East...and if that is helping push up oil prices then who is to blame? Yes - you got it...those same pesky politicians who like to blame speculators....

On July 1st, 2007, all member states in the European Union were supposed to have enacted certain European Union directives opening their energy markets to full retail competition. While some European countries, such as the UK, have had very active retail markets for some time, many others – most particularly those in Central and Eastern Europe have not. As of August 1st and, after a review of most European Union retail energy markets, I believe I can say that not much has really happened in terms of customer choice though, on paper, it should have. Meanwhile, the on-going deregulation, privatization and liberalization in European energy markets has had a significant impact in the merger & acquisition arena as energy companies and utilities jockey for (a dominant) position.

Customer Choice and Dominant Suppliers

The release of the EIA’s Short-Term Outlook on Tuesday September 11th provided ongoing confirmation that oil supply markets remain tight in spite of OPEC’s announcement that it will add 500,000 bbls/d to global markets in November. According to its report “World oil consumption rose by 1.2 million barrels per day in Q2 2007 compared with Q2 2006. China, the Middle East, the United States, and India accounted for most of the increase in oil consumption. EIA projects that world oil consumption will increase at a year-over-year rate of 1.8 million bbl/d during the second half of 2007.” However, it does cite recent volatility in financial markets as having an unpredictable influence on demand.

I spoke at Commodities Week in London in early November. There were many great presentations and topics shared there but of all the presentations the one that interested me the most was by Ed Morse.

Ed is Chief Energy Economist with Lehman Brothers and his presentation covered Oil supply and demand. His main thesis was that new refining capacity set to come onstream over the next few years will significantly change the supply side picture by the turn or just after the turn of the decade. In effect, by 2009, refining capacity additions should outpace demand growth by a factor of 2:1 he argued.

In making this assessment, Lehman has been conservative in looking at new refining capacity excluding projected refinery capacity upgrades in politically sensitive areas like Venezuela for example. Additionally, they see some strong political agendas to support the capacity build out that include;

A U.S. Senate report issued two weeks ago on the Amaranth meltdown makes three recommendations which call for greater oversight of energy markets. It wants Congress to eliminate the "Enron loophole" to give the Commodity Futures Trading Commission (CFTC) regulatory power over both the NYMEX and ICE (electronic, over-the-counter exchanges), allow the CFTC to monitor aggregate positions on both exchanges, and raise the CFTC's budget authorizing them to collect fees to offset the cost of the additional oversight. The Senate report, while not actually accusing the hedge fund of any price manipulation, criticized "excessive speculation" which (in its opinion) altered natural gas markets causing increased volatility and impacting consumer prices. Amaranth at one point held 70 percent or more of the outstanding contracts on the NYMEX and when told to reduce that position, it did so but then increased its holdings on the ICE instead.

On March 27, 2007, the United Kingdom-based Financial Services Authority (FSA) issued a report in which they warn about the increasing risks in commodity investing1. To briefly summarize their findings, the FSA warns that there is insufficient energy experience at many investment firms and that the existing experience is overstretched. Furthermore, they say that increased volatility in many commodity markets raises the "cost of trading and the risk of financial failure" and promote the concept of proper risk management including "thorough testing and modeling for algorithmic trading systems." But they go further in recognizing that many investment firms are now investing in commodities through physical assets (i.e., holding and trading physical position) such that their portfolios are "significantly altered and risk management systems must be appropriate and senior management must fully appreciate the risks they are assuming." Lastly, the FSA states that "consumers risk being exposed to unsuitable investments that they do not fully understand."