The oil market is caught in a crosscurrent between fears of declining demand and the potential for global supply to come down sharply in the first few months of 2009. For at least the next two to three months, I suspect these opposing forces will keep oil locked in a range between roughly $30 a barrel on the downside and around $50 to $55 on the upside.
Vanishing oil demand is a function of a weak global economy; the US retail report released today showed a 2.7 percent decline in sales for the all-important month of December, significantly worse than the 1.2 percent decline the consensus expected.
Clearly, the US economy hit a wall in the fourth quarter of last year--a bad recession turned nastier still as the credit crunch intensified in September and October. And the constant drumbeat of bad news and talk of various government bailouts and stimulus packages certainly didn't do much for consumer sentiment, undoubtedly further impacting sales.
This really shouldn't come as a huge surprise to anyone. As I've written here before, the US is currently embroiled in the worst recession since the contractions of 1982 and 1974. This isn't another mild, shallow retrenchment such as we saw in the early 1990s and again in 2001.
Economists can spend hours discussing every obscure indicator or government release to read the economy's tea leaves. Personally, I find that too much data can actually cloud the picture; for the most part I like to keep it simple and cast a careful eye on the US Index of Leading Economic Indicators (LEI).
I've discussed the LEI here and in my subscription-based advisory The Energy Strategist; it's simply an index that summarizes the performance of 10 key, widely watched economic indicators, including consumer expectations, building permits, stock prices and money supply.
Check out the chart below of the year-over-year change in LEI.
You can clearly see that the LEI shows no sign of improvement. In fact, given recent economic data, it's quite possible we could see more near-term deterioration in this chart; the December reading on LEI hasn't yet been released.
This is exactly why the Energy Information Administration (EIA) once again revised lower its expectations for US oil demand for 2008, 2009 and 2010. The agency now sees US oil demand shrinking by 1.2 million barrels a day (bbl/d) in 2008 and a further 400,000 (bbl/d) this year followed by only a 150,000 bbl/d bounce in 2010.
For the world as a whole, the EIA is now looking for an outright decline in demand of 800,000 bbl/d this year with stronger demand from emerging markets more than offset by a collapse in consumption across the developed world.
The other factor weighing on crude oil prices is a short-term oil glut at the key Cushing hub in Oklahoma. I explained this phenomenon in a post to At These Levels and in Pay Me Weekly. For those who missed those posts, here's a review.
The delivery point for New York Mercantile oil futures is Cushing. Therefore, when evaluating weekly oil inventory reports released by the EIA, it's important to watch what's happening there as well as what's happening for the country as a whole.
In recent weeks, not only have crude oil inventories been building faster than expected but, more worryingly, the Cushing hub is nearing full capacity in terms of storage.
This has been one major factory behind what's known as contango in the futures curve. Over the past year, the crude oil market has offered examples of both a market in contango and a market in backwardation. Check out my charts below for a closer look.
The first chart shows the futures curve for NYMEX-traded crude oil a year ago and the second shows the same curve today. Basically, to construct this curve, all I did was take the futures price of crude oil for each month going out for years into the future.
Thus, this curve shows the price for which you can sell or buy crude oil on any particular month in the future. As you can clearly see, the down-sloping curve of one year ago is absolutely characteristic of backwardation, while the upward-sloping curve is a market in contango.
Consider what these curves mean. If you are facing a market in backwardation, you really have no incentive to store oil. The reason is that the prices available for oil in future months are lower than at the current time; in addition, you have to pay someone a fee to store oil.
Backwardation is typical in strong markets where there's a near-term shortage of crude or strong near-term demand--this is why the spot and near-term futures trade at such a high premium. Looking at the early 2008 curve, you can see that oil for delivery in February cost about $96 a barrel, while oil for delivery in October cost about $88.50.
But the current curve paints a very different picture. The February crude oil contract is trading in the mid $30s, while oil for delivery in December of this year fetches closer to $60--a more than $20 per barrel premium. Contango is typical when there is a near-term glut of crude oil; this is a symptom of the glut in Cushing right now.
But consider what this means. If I buy physical oil today, I'll pay $36 and can immediately sell futures to deliver that oil for close to $60 in December. If I can store the oil for the next twelve months, I can actually earn that spread of more than $20; provided the cost of storage is less that for this period, I earn a tidy profit.
But the contango is also filtering through into oil price weakness because it's encouraging oil storage. This is behind the bearish inventory reports released in recent weeks that have tended to put downward pressure on oil. However, it's important to note that if we look out two or three months, oil is trading at much higher prices; I suspect these futures contracts more closely reflect the intermediate term supply/demand balance.
To make a long story short, the demand picture is grim, and contango is causing a near-term glut in oil storage at the key Cushing hub. But there's a key offset in supply. As I highlighted in the Dec. 31, 2008, TEL, we're already seeing oil exploration and development projects canceled as a result of depressed oil prices both in and outside of OPEC.
The EIA's current forecast is that non-OPEC oil production will grow 180,000 bbl/d in 2009 and 90,000 in 2010 after falling by 340,000 bbl/d this year. This is a huge downward revision from its July 2008 forecast that the world would see an 860,000 bbl/d increase in non-OPEC oil output for 2008 and more than 1.5 million bbl/d in 2009.
But I suspect there could be even more downside to these production estimates; in recent years, non-OPEC oil production has consistently come in under the EIA's forecasts because of faster-than-expected production declines from maturing oilfields and delays in new projects. And the combination of the credit crunch and low oil prices is an extremely powerful one-two punch for oil producers; the pace of project cancellations and delays is accelerating. Many smaller producers just can't get access to credit and are being forced to scale back drilling plans to match internally generated cash flows.
And there's also downside risk to the EIA's OPEC supply forecasts. OPEC has agreed to a total of 4.2 million bbl/d in cuts from its September production levels, a sharp cut indeed. However, the EIA is forecasting only 50 percent compliance from OPEC members. In other words, the agency estimates that OPEC production will only fall by a bit more than 2 million bbl/d because some members will cheat on their official quotas.
With oil prices so depressed, many OPEC nations are feeling a real pinch; this may actually prompt better-than-normal compliance rather than cheating. In addition, Saudi Arabia and other OPEC nations have already announced cutbacks to planned oil production capacity expansions--I seriously doubt OPEC's spare capacity will end up rising as much as the EIA currently forecasts over the next few years.
And we are also seeing several factors that may help to revive demand. First, lower oil prices appear to be helping to revive demand in the US. For example, Wednesday's inventory report showed US oil and oil products consumption falling 4 percent year-over-year, less than half the 10 percent year-over-year declines witnessed just a few months ago.
And while overall car sales are grim in the US, it's interesting to watch the switch in consumer buying habits. Specifically, no one wanted sport utility vehicles and trucks last summer with gas at $4 per gallon--used SUVs were being sold for next to nothing, while smaller, fuel-efficient cars were trading at huge premium prices.
But looking at the most recent data for the US shows that sales of SUVs and trucks are now performing no worse than sales of smaller cars. Sales of domestically manufactured trucks in the US are running at an annualized rate of 4.2 million compared to a run rate of around 7 million in 2006, before the credit crunch started. Domestic cars sold are running at an annualized rate of about 3.6 million down from about 5 million to 6 million back in 2006. That means sales are off roughly 40 percent compared to 2006 for both cars and trucks.
In June of this year, total annualized sales of domestic and import cars was 7.6 million units against 5.2 million in December of last year, a drop of 31.5 percent. Sales of domestic and imported trucks totaled 6.0 million units in June and 5.1 million units today, a drop of just 15 percent. The premium afforded to smaller fuel-efficient vehicles over the summer has now disappeared entirely because gasoline prices just aren't the issue they were just four months ago and there are signs that some last summer's demand destruction is being thrown into reverse.
The other positive demand factor is credit. Given the injection of funds from the federal government, the interbank lending market has normalized. Some lenders are offering cheap financing once again for auto purchases.
The corporate bond market is also springing back to life. Companies looking to borrow money are paying higher rates that they were 18 months ago. But if the first full week of January, companies issued more than $40 billion in fresh bonds; this is the highest issuance in eight months. Looser credit conditions should filter through to the economy in coming months.
Bottom line: weak demand will cap rallies in oil to around the $50 to $55 area. And weak supply growth coupled with signs of a tentative stabilization in demand will put a floor under oil around $30.
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