Limited Downside for Oil Prices

During market hours it’s my habit to have a television tuned to a popular financial news network, though I mute the TV to avoid distraction. If I see something interesting out of the corner of my eye, I turn up the volume. 

A few days ago I caught a 10-minute discussion about the recent downdraft in global markets. I don’t tune in this sort of fare routinely, which may be why the sensationalist language struck me more than the pundits’ arguments. Granted, markets have endured heightened volatility of late, but I’ve never heard so many superlatives bandied about in such a short segment–word like “unprecedented,” “soaring” and “plummeting.”

I suppose such commentary attracts attention and boosts ratings. But these histrionics are too exciting: It’s easy to lose sight of what constitutes normal market action when every move is “spectacular” or “unheard of.”

Case in point: Some have argued that the decline in oil prices from highs around $87.50 a barrel in late April to recent lows around $67.50 represents an abnormal trading pattern or the beginning of a bear market in oil. But past experience doesn’t support that conclusion.


Source: Bloomberg

This chart tracks West Texas Intermediate (WTI) crude oil prices from the late 1990s to the present. Oil prices were mired in a lengthy bear market that started in the early 1980s and ended when crude closed at a multiyear low of $10.76 per barrel on Dec. 10, 1998. After hitting that nadir crude prices rallied for the next decade, finally topping out at $145.29 a barrel on July 3, 2008.

This 10-year rally in oil prices was among the most powerful in financial market history, but it wasn’t an uninterrupted move to the upside. As you can see in the graph, several corrections occurred along the way. The table below details these pullbacks.


Source: Bloomberg

Over the course of a 10-year bull market that saw prices jump more than 13-fold, oil endured at least five corrections of 20 to 50 percent. In fact, the average cyclical downturn in oil prices over this period resulted in a one-third decline in price and lasted about five months.

On a closing basis, oil prices have declined as much as 24 percent since topping out on April 6. The recent pullback in crude prices resembles the three smaller corrections listed on the table in terms of duration and severity. In an “average” correction oil would retest summer 2009 lows of just under $60 a barrel and would last until September.

I see a retest of the July 2009 lows as a worst-case scenario for oil this year. My base case remains that crude bottoms at $65 to $70 a barrel before rallying to new recovery highs of close to $100 a barrel by year-end.

One thing is certain: Despite what you may have heard on television, there’s nothing unprecedented or magical about the recent pullback in oil prices. It’s part of the normal trading pattern and is entirely consistent with corrections in previous bull markets.

Supply and Demand
My case that oil is nearing an important low is backed by far more than just historical precedent; the economics of supply and demand are turning in favor of crude.

As you can see in the graph below, US oil demand is on the rise.


Source: Energy Information Administration

The Energy Information Administration (EIA) releases weekly data showing the total petroleum products supplied in the US market, including motor gasoline, jet fuel and distillates such as diesel. The above graph compares the four-week average of demand to the same four-week period a year earlier.

It’s not hard to see that US oil demand declined by as much as 10 percent during the 2008-09 recession and credit crunch. The decline was of far greater magnitude and lasted for much longer than aftermath of the Sept. 11 terrorist attacks, also visible on the chart. But since the beginning of the year, oil demand is up 5 percent from a year ago.

According to the EIA’s most recent data, total US demand for petroleum products is up 4.8 percent year over year. Gasoline demand is up 2.1 percent, jet fuel demand is up 4.3 percent and distillates consumption is up 12.3 percent. With oil and gasoline prices declining from recent highs just as the US moves into the peak-demand summer driving season, I see the potential for even larger growth over the summer months.

Although oil demand is bouncing back, the flow of oil into the US market looks to be slowing. Between May 1 and May 26 there were 140 successful tanker loadings in the Persian Gulf. That means that companies contracted with tanker firms to arrange ships and then loaded those ships with Middle Eastern oil for transport. The total tonnage of these tankers is about 21 million deadweight tons.

Here’s a breakdown of where those tankers were headed.


Source: Bloomberg

More than three-quarters of the tanker tonnage loaded in the Persian Gulf this month is destined for the Far East/Asia; less than 10 percent is headed to the US Gulf and West Coasts. This suggests that Chinese oil demand remains robust.

Most of the growth in global oil consumption in recent years has come from emerging markets such as China and India–a trend that should continue over the long term. Despite all the talk of the Chinese engineering a major slowdown for the local economy, there’s little evidence that its appetite for oil is on the wane. In fact, tanker data suggests movements of oil from the Middle East to China remain near record levels.

Growing energy consumption in emerging markets is a big part of oil’s long-term demand story. However, investors shouldn’t ignore the cyclical recovery in demand from the largest oil consumer in the world. Although some commentators continue to fret about high inventories of crude in the US, oil inventories usually begin to decline once the summer driving season gets underway.

Rising demand and weak imports suggest that inventories will tighten quickly over the summer. This too sets up a rally for oil into the back half of 2010.

I don’t expect Europe’s sovereign credit crisis to derail recovery. As I explained at great length in the most recent issue of Personal Finance Weekly, most of the fears of a global credit contagion akin to that witnessed in 2008 are way overblown. 

However, this fear has furnished investors an opportunity to buy into some of my favorite stocks at a discount. On the growth side, I recommend buying the oil services and equipment stocks as well as select producers.

The Philadelphia Oil Service Index (OSX) typically leads rallies in oil prices by one to three months; evidence is mounting that international drilling activity targeting oil is picking up again. Some of these stocks have the scope to double from recent lows. 

Income-focused investors should focus on master limited partnerships (MLP). 

In April I fielded a huge volume of questions from subscribers to the MLP Profits service I co-edit with Roger Conrad. Most new subscribers wanted to know if it was still okay to buy our recommendations given the big run-up in the group since spring 2009. Our response: Focus solely on the master limited partnerships (MLP) trading below our buy targets and look to use dips as an opportunity to accumulate positions.

Now is that opportunity. Some of our picks offer yields as high as 13 percent even though the EU crisis hasn’t affected the group’s ability to raise capital for growth projects. Consider the $2 billion in new bonds recently issued by Enterprise Products Partners LP (NYSE: EPD).


Source: Bloomberg

On May 20 Enterprise issued three different bonds: a 5-year, 10-year and 30-year issue with a total face value of $2 billion.

The most important column in this table is the final one, the yield spread to Treasuries at the time each bond was issued. For example, the bonds maturing on June 1, 2015, yielded 134.5 basis points (1.345 percent) more than equivalent 5-year US Treasury bonds when they were issued.

For the sake of comparison, I’ve listed other bonds issued by Enterprise over the past two years.  The six bonds issued on Oct. 27, 2009, carry much higher yields but aren’t relevant for comparison–these weren’t new bond issues. Enterprise issued these bonds in exchange for TEPPCO Partners’ existing notes when it acquired the firm last year.

The most relevant note for comparison purpose is the Oct. 5, 2009, issue of $500 million worth 10-year bonds. At the date of issue the bonds yielded 189.9 basis points above US Treasuries, or 5.216 percent. This is significantly higher than the spread on the 10-year bonds issued Enterprise issued a few days ago. Enterprise’s cost of capital is actually lower than it was last October, long before anyone was talking about a credit contagion in Europe.

The final two bonds on the table are issues from April and December 2008. The former was issued around the time of the Bear Stearns crisis; the latter was issued not long after the height of the 2008 credit crunch. There’s no comparison between the spreads on bonds the MLP issued on May 20 and the two series from 2008: Enterprise’s cost of capital has fallen sharply over the past two years and remains at rock bottom despite the EU credit crisis. There is no sign that the crisis is affecting Enterprise’s ability to access the capital it needs to grow.

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