Why Oil Keeps Biting Bears

Investing Daily Article of the Week

by Robert Rapier, Investing Daily

Introduction

In last week’s issue of The Energy Letter, I discussed my January prediction that the average natural gas price in the US would be higher this year than last year. While that prediction is looking pretty safe because of the extremely cold winter, I also predicted that –

“Brent and West Texas Intermediate (WTI) crude prices will average less in 2014 than in 2013.”

Let’s see how that one is faring.

I also predicted lower oil prices for 2013, and ended up being only partially right. In 2013 the average price of Brent crude was 2.8 percent lower than in 2012 with an average of $108.56/barrel (bbl). West Texas Intermediate (WTI) was up 4 percent in 2013 to an average daily price of $97.98/bbl. So in 2013 I was right on the direction of Brent, and wrong on the direction of WTI. (I also predicted that the differential between the two would decline, which it did).

As I write this, the price of WTI has so far averaged $97.75 this year (only three cents lower than last year’s average), while the price of Brent has averaged $108.55 (a penny below last year’s average). At this point this year’s average is nearly identical to last year’s average. But with WTI presently trading at $102.55 and Brent at $109 it won’t take long for average prices to rise above my prediction.

The Argument for Lower Prices

Given the rapid expansion of oil production in the US, it is certainly possible that local supplies could temporarily outstrip demand in the short term, or that temporary logistical constraints could develop. Either of these factors would favor lower short-term WTI pricing. In fact, this is reflected somewhat in the price differential between WTI and Brent.

Until 2010 WTI generally traded at a slight premium to Brent, but the rapid rise in oil production in the US and the logistical constraints in getting that oil to market have had it trading at a discount since. That discount has at times exceeded $20/bbl, which has been very fortunate for oil refiners.

While there is still a federal ban in place on crude oil exports, refiners can export finished products. These finished products — fuels like gasoline and diesel — are generally priced based on Brent. So refiners can buy crude at WTI prices and sell finished products at Brent prices. A general rule of thumb I use is that when the Brent-WTI spread is over $10/bbl, quarterly results for refiners will be pretty good. If the spread is $20, results will be fantastic.

So even though growing US production is reflected in the WTI discount, the price of oil is still hovering around $100/bbl despite many predictions that prices would soften. In fact, a year ago analysts at Bank of America Merrill Lynch suggested oil could fall to $50/bbl within two years, and Ed Morse at Citi expects crude prices to average $80/bbl through 2020. At the other end of the spectrum Oswald Clint at Sanford Bernstein projects nearly double that price at $158 a barrel in 2020.

Demand Keeps Pace

Why have oil prices remained so stubbornly high, despite huge increases in US oil production? In a nutshell, it’s the demand side of the equation keeping pace with the growing supply. Over the past decade, demand in the US and the EU fell, but this was more than compensated for by growing demand in developing countries. This kept the price of oil high, despite supply/demand fundamentals that in isolated countries would have encouraged lower prices.

But the world’s oil markets aren’t local. And now demand in the US is starting to regain strength, recently rising to the highest level since 2008. The International Energy Agency has estimated that global demand for oil will increase this year by 1.2 million barrels a day. For perspective, over the past five years the world has increased oil production by nearly 3.9 million barrels (2 million of which was from the US) — an average increase each year of 770,000 barrels per year.

So the increase in oil production has been gobbled up by an energy hungry world just as fast as crude could come out of the ground, and that trend is likely to continue long-term. Nevertheless, the easing of sanctions on Iran, the continued growth of oil production in Iraq, and another year of expansion for the US oil industry could combine to oversupply the market in the short term. This may be offset, however, by deteriorating events in Venezuela and Libya.

Conclusions

For now, investors in natural gas companies can be happy that my natural gas prediction is proving to be correct, but investors in oil companies can also be happy that my prediction for lower oil prices hasn’t yet materialized.

In any event, I believe the long-term direction for both commodities is inevitably higher prices, so while I still expect a sideways to slightly negative direction for oil prices over the next couple of years, over the long haul this sector will continue to deliver.