Oil's Outlook in 2007

John Lewis - Mon 12 Mar, 2007

I believe the impact of the US intending to increase its oil reserve will not be long lasting. As yet no time frame has been given for achieving such an increase and in any event new storage facilities would likely need building, and conscious of the sensitivity among voters of dearer oil, the US Administration would likely proceed cautiously with its reserve purchases, so as not to be obviously active and distort the market.....

After making a high in July of 2006 at close to US$80 a barrel, the oil market abruptly corrected lower and within 3 months the price had declined by in excess of US$20 a barrel.

Despite an attempted rally during November and December, the market made a new recent low of around US$50.55 a barrel during January of this year where it tested some key support levels which for now have held.

The correction that began almost immediately after oil hit its high in July was caused predominantly by the slowdown in the US economy. Although analysts had spent virtually the entire 1st half of 2006 debating whether a correction in the US housing market would be deep enough to infect the wider economy, it wasn’t until July that economic data was uniformly weak enough to make it impossible to argue otherwise.

Indeed shortly after, at its August FOMC meeting, the Fed began the current policy pause in what was a marathon interest rate hiking cycle, to allow the 17 25bp rate hikes previously enacted, time to combine with weaker growth and move inflation down into the Feds “comfort zone”.

The other factor which hastened the correction was optimism generated by the package put to Iran in the summer, designed to defuse the crisis over Iran’s nuclear program, which the west argue is a cover for developing nuclear weapons.

By the time it became obvious the Iranians were not going to accept the terms of the deal, the US mid-term elections had dealt George Bush and his Republicans a punishing blow, which severely restricted his ability to threaten military force against Iran if they didn’t comply.

The market subsequently received some support from OPEC as it cut production to prevent the sell off going further and that fuelled the brief rally, but with talk in the market at that time, focused on possible US interest rate reductions in 2007, the impact was short lived.

And when the Iranians recently voted heavily against the party of their President in nationwide local elections, both protagonists in the dispute had been given a rap across their knuckles; this provoked the 2nd leg of the sell off, even as OPEC was announcing an additional production cut.

Now the sell-off has stalled and the market is attempting another correction higher; fuelled by:

- George Bush announcing in his State of the Union address that he would like to double the US strategic oil reserve, and
- Increased tension in the Middle East especially with Iran. Iran has said recently its nuclear fuel production program is ready to move to an industrial scale, and it wants to launch its own space program.

This is a worry for two reasons:

1. industrial fuel production would give Iran the capability to produce weapons grade material, and
2. a space program capable of launching a satellite would give them an intercontinental ballistic missile to deliver a nuclear weapon if they developed one.

So what is the outlook for this market from here?

I believe the impact of the US intending to increase its oil reserve will not be long lasting. As yet no time frame has been given for achieving such an increase and in any event new storage facilities would likely need building, and conscious of the sensitivity among voters of dearer oil, the US Administration would likely proceed cautiously with its reserve purchases, so as not to be obviously active and distort the market.

In short I believe this is a long-term project that will soon drop off the radar screens of traders, if indeed it is ever actioned.

The Iran question is a different magnitude of problem. Again it is easy to talk of launching a space program, but another to enact it, unless 3rd party help is received, which it may have been.

But again I think this is an issue that will play out, if at all, over the longer term, and the current sabre rattling from the US with the despatch of a 2nd carrier battle group to the Gulf region, won’t easily translate into military action, for the reasons already given.

In summary, oil reached the highs it did due to strong energy demand from a rapidly growing US economy, and geopolitical tension causing fear of a wider military conflict involving Iran and perhaps Syria. Without the geopolitical tension, the oil price would likely have struggled to rally beyond US$55.00 a barrel last year, based purely on supply/demand constraints.

And now the threat of conflict is greatly reduced between the US and Iran, at least until after the next US Presidential election, and the US economy is growing materially slower than the levels seen as recently as Q1 2006, I expect the oil price to decline towards US$40 a barrel over the course of this year.

Of course there are risks to this forecast, as with any which attempts to predict the price action of a highly volatile market.

First, if the US economy shows greater resilience than expected and begins to grow at levels seen earlier in the current expansion, demand for energy and oil in particular will increase, taking prices higher, but I currently judge that to be unlikely. Although Q4 GDP was stronger than expected at 3.5%, the holiday shopping season had a strong hand here and Q1 2007 is unlikely to be as strong.

Second, if the situation with Iran deteriorates further, and Israel launch an attack on Iran aimed at destroying their nuclear facilities, causing conflict between the two and drawing in the US military, resulting in the disruption of oil supplies. But we think it unlikely that Israel would take such a risk, especially after the recent fiasco in the Lebanon.

Regards
John Lewis
for The Daily Reckoning

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