Oil prices are ready to fall
Posted
Jul 01 2009, 05:29 PM
by
Anthony Mirhaydari
Rating:
Over the last few months almost every asset class rose at an incredible pace as it looked as though the economy was beginning to stabilize.
Stocks are up 38% as consumer confidence swelled and earnings stabilized. Metals and other basic materials jumped on stockpiling in China and signs the world's factory were about to restart. And of course, oil prices have nearly doubled.
In their excitement, traders forgot all about the impact high energy prices would have on vulnerable and shell-shocked American shoppers. With easy money courtesy of the Federal Reserve and other central banks, the momentum trade was on. No time to think about basic economic relationships. But this is changing now. And as it does, crude oil will suffer. Here's why.
According to the Steven Kopits, a managing director at energy research outfit Douglas-Westwood, oil prices are quickly reaching levels that have historically triggered recessions. Given that we're still in the midst of a credit-fueled, asset-bubble recession, this is a very scary thought. Over the last 37 years, the United States has suffered six recessions. In each case, oil expenditures reached 4% of total economic output. The current recession started with oil hit the 4% threshold at $80 a barrel. Currently, prices are flirting with $70 a barrel.
Also, the supply/demand relationship for oil is weakening. The International Energy Agency sharply lowered its demand forecast earlier this week as the recession continues to deepen. The oil watchdog now expects global oil demand to grow at an average annual rate of just 0.6%, or 540,000 barrels per day, between 2008 and 2014. This would raise total consumption from 85.8 million to 89 million barrels per day.
This new estimate is a whopping 3.3 million barrels per day lower than the IEA's previous forecast. Under a more pessimistic outlook for the world economy, consumption would actually shrink to 84.9 million barrels over this period. This dearth of demand means OPEC's spare capacity cushion will reach nearly 8 million barrels per day next year -- or roughly 8% of total global demand. Previous estimates had the cushion contracting to just 1.7 million barrels per day.
Less demand and more supply is a recipe for lower prices. This is bad news for major oil companies like Chevron (CVX) and ExxonMobil (XOM). But here's the kicker: The IEA expects non-OPEC supply to fall 400,000 barrels per day by 2014 as exploration projects are canceled or deferred. This will further pinch revenues for the foreseeable future as production declines.
Remember that a majority of the world's untapped crude oil reserves are now controlled by state-owned corporations in unfriendly places like Russia, Venezuela, and Iran. Even the Iraqi government, which is currently fielding bids to develop its oilfields, is playing hardball and offering far less per barrel than the oil executives expected. This is a long-term problem for which there are no easy answers.
And finally, seasonal factors will start pressure crude oil as markets start looking past the summer driving season. According to Bank of America - Merrill Lynch researchers, "neither petrochemical nor industrial demand for fuel seem ready to rebound firmly…electricity generation remains depressed all around the world, and there is plenty of coal and gas to go about."
My positions
There are a number of ways to play this trend, but given my expectations of near-term weakness for stocks in general, today I added short positions in Chevron and Chesapeake Energy (CHK). I also made a number of other trades, including new short positions in heavy equipment manufacturers Caterpillar (CAT) and Deere (DE) so be sure to take a look here.
Image Credit: Smoobs
Disclosure: The author does not own or control a position in any of the funds or companies mentioned.
Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.
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