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Energy Markets Remain Compelling for Investors

When you examine a one-year chart of crude oil prices it is hard not to be impressed with the upward trend. We think the long term fundamentals are very compelling for the energy markets.

Short term, many economists think crude oil prices will decline from current levels. A consensus forecast of U.S. economists released this week called for crude oil to fall back into the high-$30 a barrel range next year from the $50 a barrel level we now experience. While the consensus of economists might be right, we think the energy markets will stay stronger than many analysts expect.

Worldwide Crude Oil Demand

Demographic trends in Asia are having a much larger impact on the demand for crude oil than many investors appreciate. With the exception of several countries (Brunei, Indonesia, and Malaysia) Asians import a majority of their crude oil needs. Populations in Asia are surging, as are the economies, and as incomes rise energy use increases in lockstep.

While China recently raised their interest rates to slow their economy many forecasters expect oil consumption in that country to continue to grow. The International Energy Agency has estimated that China's oil demand will increase 15% next year, and demand this year is expected to increase at rates above that level.

While oil prices fell in the immediate aftermath of the Chinese interest rate hike, China continues to be impacted by widespread energy shortages and power disruptions. China is an inefficient user of energy, consuming 2.3 times as much oil per unit of GDP as compared to the average OECD developed country.

Increases in the open market price of crude oil have not significantly impacted Chinese demand to date, and governmental price adjustments have to a large extent protected Chinese customers from the jump in international energy prices. Due to the energy shortages, we see demand from China to continue to increase even if their economy slows.

In addition to the growth in Asian demand, fourth quarter demand from countries in the Northern hemisphere that utilize crude oil for heating purposes is also expected to grow.

In the U.S. they have had a unique situation - distillate/heating oil inventories have been declining for over 5 weeks as refinery output has been disrupted by Hurricane Ivan (see green line in the chart representing 2004 data).

Historically we have seen significant builds of distillate inventories this time of year as refineries add to stocks in preparation for winter demand (note the purple five year trend line is sloping upward this time of year, a sign that in normal seasons we are building inventories). European inventories are not excessive, which will limit the imports of heating oil. In a cold winter heating oil supplies in the Northeast U.S. might be drawn down to very low inventory levels.

Worldwide, economies continue to expand. A number of energy analysts expect fourth quarter worldwide crude oil demand to increase anywhere from 1.5 to 2.5 million barrels a day - an incredibly large increase.

So demand from Asia, and from worldwide economies in general, continues to rocket ahead. One investment banker in the energy sector called the growth in oil demand a "runaway freight train."

Worldwide Crude Oil Supplies - Russia & Yukos

Over the last five years Russia has had an incredible increase in crude oil production. Much of the increase has been exported, helping maintain relatively modest prices and a stable petroleum marketplace (see charts).

One of the main concerns of world energy markets is the outcome of the Yukos tax dispute with the Russian government. Yukos produces around 1.7 million barrels of oil per day, around 2% of the world's production and around 25% of Russia's production.

Yukos allegedly avoided paying taxes on production and income due to Enron style tax avoidance schemes, and has been billed for the tax obligations deemed owing. In addition, the government recently alleged that Yukos is in violation of some of its operating licenses which could result in some production being shut-in.

Russian officials unexpectedly demanded over $10 billion in additional taxes from Yukos on November 1st, pushing the debts of Russia's embattled No.1 oil producer over $17 billion.

The Russian president, Vladimar Putin, favors more governmental control over the oil sector and greater governmental involvement with resource development. Russia has increased the export taxes on crude oil twice in the last few months, and announced last month it will investigate other oil producers for Yukos style tax avoidance schemes.

Yukos is contesting the tax claims and the operating license issue, and opposes any forced sale of assets to meet these obligations. Due to the dispute, many analysts have been concerned about a supply interruption which would impact the world markets.

The Yukos dispute creates quite a bit of uncertainty for players in the energy sector, regardless of where they are located. Many energy analysts believe Russia's internal political questions need to be resolved before Russian output can be assured to reach the world's oil markets.

Russia also reached an agreement with OPEC last month on the issue of stabilizing the growth of world oil prices and to support energy prices at a level that would benefit both producers and consumers.

Worldwide Crude Oil Supplies - Nigeria & Gulf of Mexico

Nigeria, the world's seventh largest exporter of crude oil producing 2.5 million barrels per day, has been mired in a dispute between national unions and the government over fuel price increases. Having called a temporary cessation to a nationwide strike held earlier this month in an attempt to reach a settlement, Nigeria's unions called for a resumption of the strike on November 16th.

This time, unlike the strike last month, the unions promise to target Shell Oil Company - the top multinational in Nigeria - as an "enemy" of the people. The union aims to disrupt Nigerian petroleum production and exports. Like Russia, the dispute adds additional risks for investors in the energy sector and puts capital expenditures on hold as parties monitor developments.

Part of the recent weakness in the crude oil futures market - if you can call $50 a barrel 'weakness' - is due to the resumption last week of some production in the Gulf of Mexico that has been offline since Hurricane Ivan struck two months ago. The Minerals Management Service reported the amount of daily production shut in from damage to platforms and pipelines from Hurricane Ivan fell from about 426,000 barrels on Oct. 25 to about 224,000 on November 1st. Around 4.5% of annual oil production from the Gulf of Mexico has been lost due to the storm.

Mature Crude Oil Basins

On a global basis, investment banker Matthew Simmons of Simmons & Associates presented some incredibly interesting production statistics at a recent conference:

• 70% of daily oil supply is produced from oilfields "on production" for 30 years or more

• 20% of global supply comes from 14 giant oilfields whose average age is over 50 years

• A growing number of key production regions have passed their peak production capacity

• Modern technology drains oil from the underground reservoirs much faster

• Global reservoir production decline rates are soaring

Simmons' graphical representation of the problem is set out at right. While much of the oil we use is found in "giant" fields, the number of these fields discovered since 1980 is quite small (at least compared to historical averages).

Meanwhile worldwide demand continues to increase, in fact has accelerated the last five years. The result is that demand "is set to surge above supply" according to Simmons, a situation that can resolve itself only by rationing supplies by price or regulation.

Demand for oil is relatively inelastic. It is essentially the only fuel ideally adopted for transportation needs. The price of oil might need to increase by quite a bit to ration supplies to meet surging worldwide demand.

When the level of global supplies are so close to global demand, and where we have no organization like OPEC or the Texas Railroad Commission regulating producers with excess production capability, we can expect the markets to be very volatile.

As 2004 draws to a close, Mr. Simmons notes the energy markets are in "uncharted waters." We couldn't agree more.

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