The problem with crude oil

David Guthrie - Fri 18 Jun, 2004

...The story of crude oils raging bull market is now spilt all over the press and TV news. A sure sign of this bull run reaching its end, you might think. But think again, says the Zurich Clubs hedge-fund strategist...

 
 
One year ago, a barrel of crude cost $26. Today, you’ll have to pay $37 or more. The reasons for this dramatic rally have been comprehensively reported, but many commentators miss the point.

The popular media has focused too much on supply issues - tension in the Middle East and the role of Opec - rather than the real key to this new bull market in black gold...runaway global demand.

Of course, terrorist assaults on oil facilities in the Persian Gulf - and the possibility of massive political upheaval in Saudi Arabia - should not be underestimated. These are real dangers.

The problem with crude oil: OPEC

As for Opec, the cartel controls less than 40% of global oil production, but it has all the spare capacity. It also continues to seek to influence the world oil price through its quota system. Some Opec members are obviously quite happy with the current high price; they have no desire to open the spigots and watch the price slip. The Saudi princes, on the otherhand, are clear in their intention to increase output, in an attempt to ease the tension and pressure on their political position.

Yet the plain fact of the matter is, as Opec’s president Yusgiantoro stated in an interview last week, the price of crude oil is out of OPEC’s control.

In fact, if you speak to oil traders - as I do every day - they will tell you it’s not crude that’s really driving prices higher. It’s the lack of products derived from crude - and in particular right now, gasoline.

Traders will also tell you that raw crude oil itself is available and easy to buy. Thus so many of the professionals have had such a difficult time getting bullish and staying bullish on the physical market. Indeed, the price of physical crude - rather than the futures contracts derived from it - saw a sharp drop this week. On Wednesday, Reuters reported a deal from Monday setting a price level not seen since 2002. A fall last week of $2 in the differential for Russian Urals put that grade at its lowest relative to the benchmark North Sea grade in four years.

“Physical oil traders in London say the market for North Sea, Mediterranean and West African crude looks weaker than at any time since the middle of 2003,” the news agency reported, “just before futures prices began a relentless 50 percent upward march to this month's record highs above $42 per barrel for US oil.”

So much for the soaring price of oil, you might think. But traders of oil product, on the other hand, have had no such problem chasing the bull market higher. Gasoline traders see the real shortages of product in the marketplace; and they know this shortage won’t be corrected in the near-term.

The problem with crude oil: Low inventories

The truth is that inventories of product - particularly in the US - are low, demand is high, and refinery capacity is stretched to the limit. This is clearly reflected in the gasoline “crack” spread - the spread between the price of crude oil and unleaded gasoline - which is at extreme levels. While crude oil is just testing the price highs we saw in 1980 and 1990, spot unleaded gasoline has soared to new record highs of $1.47 a gallon - way surpassing the previous record high of $1.29 achieved back in 1979.

You can produce as much crude as you like. But if you can’t turn it into product, it’s not much use to anyone. This is not simply a problem of supply, but one of demand outstripping the physical limits of the world’s refineries. Refinery capacity cannot be increased overnight. It costs over $4 billion to build a new plant.

Now, as we enter the so-called summer “driving season” in the US - when American consumers burn up something like one barrel in every 8 of the world’s oil production - it is difficult to see gasoline demand diminishing in the near term. Professional oil traders tell me that shortages of gasoline over the coming months may in due course be compounded by shortages of heating oil as we head into winter. This can only send prices higher.

Where is this record demand coming from? First of all, the renewed economic growth in the US and Japan - historically, the world’s two largest consumers of oil - has pushed up their requirement.

The problem with crude oil: Asia

Secondly, we must address Asia - in particular China and India. Chinese demand alone is increasing at an annual rate in excess of 20%. This year, it will over-take Japan as the world’s second thirstiest market for oil.

It’s also in Asia that we see the confluence of short- and very long-term factors continuing to drive the oil price higher. After all, a squeeze of prices driven by immediate lack of refinery capacity will only be medium-term at most. Eventually, refinery capacity will be increased to cater for the demand. However, as that eminent Asia watcher and Daily Reckoning regular, Dr Marc Faber, has pointed out, unless the entire Asiatic region goes into prolonged depression, its oil demand is bound to continue rising significantly.

Based on current trends, Dr Faber argues, Asian demand will double in the next six to twelve years from its prevailing level of 20 million barrels per day. Given that current total world demand for oil is around 80 million barrels per day, that represents one heck of an increase - fully 25% in a decade.

Nor should we forget that oil is a finite resource. The work of American geophysicist M.King Hubbert led him to predict in 1956 that oil production in the US would peak in the early 1970s. At the time, most energy experts pooh-poohed the idea. But Hubbert was proven right - output of crude has been falling in the US since 1971.

Scientists using the ‘Hubbert’s Peak’ theory now believe that global oil production will peak within the next five years. This becomes less hard to believe when you think that the last great oil field, the Ghawar field in Saudi Arabia, was discovered 45 years ago.

Yet despite the media attention and daily headlines, the new bull market in oil has yet to change the way the City views crude oil. As someone who started his professional investment career twenty-five years ago - right at the top of the last major commodity bull cycle - my experience has taught me to be a bear of all commodities by general inclination. This is a difficult worldview to change.

But cycles move, and so must we as investors. It looks today as though we have entered a new long-term phase in which the old $30-$40 a barrel ceiling on oil will prove to be the floor from now on. We’ve got to change our mindset from being sellers on rallies above $30, to being buyers on all dips below this level.


Regards,
David Guthrie
for the Daily Reckoning

P.S. So acute is the shortage of product, that traders who a few months ago couldn’t bring themselves to be bullish now concede that it could feed through to a possible $10 or even $20 a barrel spike in crude prices very soon. Some on the wilder fringes anticipate $100 a barrel being paid for crude within 12 months.

Even simply allowing for inflation, the peaks of nearly twenty-five years ago would equate to $70 a barrel today. There’s plenty of scope on the upside. This week’s setback should provide an opportunity to profit as the price of oil resumes its rise.