Crude Realities
Russia, Mexico and Norway have all come out over the past two months and announced lower-than-expected oil production growth. This has forced the International Energy Agency (IEA) to revise lower 2008 supply projections yet again in May; IEA projections for 2008 non-OPEC supply are now 40 percent lower than they were in November of last year.
Demand is slowing in the US and EU because of higher prices and weak economic growth. But demand in the developing world shows no sign of slowing; China continues to subsidize gasoline prices so the Chinese consumer doesn’t feel the full brunt of recent price gains. Strong growth in demand outside the developed world is swamping any US demand shortfall.
Simply put, the main reason for crude oil’s rally in recent years is basic supply and demand. Yet many have attempted to discount these factors and lay the blame on excess speculation. There’s little doubt speculators have had an impact; however, the data just don’t back up the idea that speculation is solely to blame for $130 oil.
A series of hearings on Capitol Hill seeks to determine if commodity traders are behind the rise in oil and natural gas prices over the past several months. However, traders, although influential, have rarely been the driving force behind such price movement. See Speculation or Reality?
There are some ways for noncommercials to be labeled commercials and get around the position limits placed on noncommercial traders. However, in looking at ownership data of commodities futures, the number held by traders is still such a small portion of overall demand that it’s hard to imagine any direct correlation between traders and higher prices. See Commercials or Noncommercials.
Even some commodities not tracked by the major indexes have risen sharply of late on little or no speculation, suggesting that this may be part of a larger trend outside the realm of traders. See Outside the Indexes.
For much of this year, I’ve been short-term cautious on crude oil prices and bullish on natural gas. Inventories of both had been bloated—until recently. Supply is now back in line with norms, and demand is softening. See Crude Oil Now.
I still favor natural gas over oil. Two Portfolio holdings have great leverage to the North American drilling market. And the one direct play on natural gas in the Portfolio appears to be making headway; I’m updating my recommendation to reflect that. See How to Play It.
A major offshore exploration success and increased coal demand are reasons to continue to buy and hold these Portfolio holdings. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
In addition, there has been a series of hearings on Capitol Hill on the energy markets. A significant amount of the testimony has been directed at the potential for crude oil speculation to impact prices. There also have been countless stories in major newspapers and magazines attributing the rise in oil and gasoline prices to the activity of traders.
As I’ve noted before, there’s no denying that the activity of futures traders and speculators does have an impact on commodity prices. But what I believe is a huge mistake is to attribute all of the recent rises in oil prices, or the cost of any commodity, on market manipulation. The far-more-important driver of energy prices is simple supply and demand.
Before delving into a more-detailed analysis of speculation in the oil market, it’s worth noting that speculators and traders are all-too-convenient scapegoats for those looking to place blame for rising prices. In fact, blaming speculators is nothing new at all.
Many will remember that, in the early 1990s, financier George Soros shorted the Italian lira and the British pound, making more than $2 billion in profits when those currencies were then forced out of the Exchange Rate Mechanism (ERM). The ERM was a system for pegging various European currencies to one another; it was a sort of first step toward the eventual introduction of the euro common currency.
Soros was blamed on many fronts for the devaluation of the pound and the lira. But the reality was that economic conditions in Italy were extraordinarily weak relative to the other European currencies in the early ’90s; the lira looked fundamentally weak long before Soros shorted it. Moreover, rhetoric out of the Italian government suggests dwindling support for maintaining the lira’s value.
Perhaps Soros tipped the lira over the edge. But that currency walked to the edge of the cliff on its own power.
Then there was the pound. Britain had a vicious property bust in the late ’80s and early ’90s, and in 1992, it was just recovering from the bust. It was hardly a great secret that the British government under Prime Minister John Major and the Bank of England were keen to avoid nipping a still-tentative economic recovery in the bud. Of course, maintaining relatively lax fiscal and monetary policy helped the economy recover from the doldrums but was bearish for the pound.
Again, Soros probably tipped the scale but was hardly single-handedly responsible for Britain’s economic situation.
My point in noting these examples is that speculation is an all-too-convenient excuse for market moves. But it’s worth taking a closer look at actual data in the energy markets to determine to what degree speculators are influencing crude prices.
Fortunately, we do have some direct data on speculators’ positions in the oil market—the CFTC’s weekly Commitment of Traders (COT) report. For most markets, the COT breaks traders down into three main camps: commercials, noncommercials and non-reportables.
Commercial traders use the futures market to hedge against business risks. Take, for example, an exploration and production (E&P) firm that sells oil futures to lock in a guaranteed price for the oil it produces. Alternatively, commercials may include a major consumer of crude oil looking to guard against rising costs by purchasing futures.
Noncommercial traders are larger individual traders or institutions speculating on the price of a commodity. Non-reportables are typically small individual speculators in the futures markets.
Traditionally, noncommercials are the gauge of speculative excess in the commodity markets. Check out the chart of the net position of noncommercial traders in the crude market over the past few years.
Source: Bloomberg
To calculate this chart, I simply took the total long open interest from noncommercial traders (futures and options) and subtracted the total short open interest. Noncommercials are net long futures when the value is above zero. Conversely, a negative number signals that traders have moved net short crude oil futures.
There’s really no major trend in this chart, though it’s drifted to become gradually more net long crude oil futures since 2004. In other words, it appears that noncommercials have become gradually more bullish crude oil since the end of 2003. This trend is hardly surprising, given the rise in crude oil since that time.
However, there are some notable short-term spikes and troughs in the index. For example, in late 2006 and early 2007, the noncommercials net long position dropped to its lowest level in years. Traders were as bearish on oil as they’d been since the end of 2003. In fact, if we look at simple futures data (excluding options trades), noncommercials actually were net short oil in early 2007.
This was a great contrary indicator because early 2007 marked an important low for oil: Oil prices bottomed around $50 per barrel (bbl) and have hardly looked back on their march to recent highs of more than $130 per bbl.
Similarly, note the spikes into net long territory in mid-2006. At this time, crude oil was trading in the $75 to $80 per bbl range. Noncommercial traders were heavily betting on further gains in crude; instead, from mid-2006 through early 2007, oil saw its most vicious correction in years.
As you’ve probably gathered from these examples, the activity of noncommercial traders often acts as a contrary indicator for the underlying commodity. When these speculators are heavily long a commodity, it can be an indication that traders are excessively bullish, and therefore, the underlying commodity price is due to drop. Similarly, overly bearish sentiment in the form of a large net short position often occurs near lows. Emotions tend to run high near turning points.
Of course, apart from these major spikes, noncommercials seem to more or less get the market correct. Their net long position tends to steadily increase in uptrending markets, and noncommercials bet more heavily short in falling markets. This is a fancy way of saying that the crowd is usually correct except at turning points for the market.
A quick glance at the chart above indicates that the current net position of noncommercial traders is elevated but well off last year’s highs. At one point last year, the noncommercials saw their open interest spike to record high levels. But at the current time, the net noncommercial position is at the low end of the past year’s range. At first blush, this doesn’t appear to indicate excessive speculation in the crude oil market.
The position with respect to natural gas futures is even more interesting. Below is a chart of the net position of noncommercial traders in the natural gas market.
Source: Bloomberg, CFTC
This chart shows a fairly noticeable trend. First, note that gas noncommercial commitments traded in a fairly narrow range from the starting measurement point through late 2005. Then, throughout 2006, traders became progressively more bullish on gas.
With gas prices weak in 2007, the noncommercials seemed to capitulate and have since become progressively more net short natural gas. At the current time, the net short position for noncommercials is huge at around 250,000 contracts.
This chart highlights the danger of lumping all commodities together and that speculation is excessive across the board. If anything, speculation in the natural gas market is acting as a bearish force on natural gas prices. However, I’m confident this fact won’t get much coverage from Capitol Hill; after all, it doesn’t really fit well with the speculator-scapegoat plan.
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But there is a legitimate argument that we can no longer interpret the COT report in the same manner. This basic argument was extraordinarily well articulated by Michael Masters, a hedge fund portfolio manager at Masters Capital Management, in his testimony before the Committee on Homeland Security and Government Affairs of the US Senate. For those interested, the full text of this May 20, 2008, testimony is available on the Senate Web site.
But Masters’ basic thesis has been outlined by several pundits. The idea is that the excessive speculation in commodity markets today isn’t coming from the noncommercials but from a new group of passive index traders; these are funds designed to track theperformance of a broad basket of different commodities.
The idea is that, by diversifying a portfolio away from traditional stocks and bonds, it’s possible to lower overall portfolio risks and enhance returns. Most of these indexers typically track the performance of either the Standard & Poor’s Goldman Sachs Commodity Index or the Dow Jones-AIG Commodity Index. The table below offers the current composition of both indexes.
Source: Standard & Poor’s, Dow Jones
Index followers buy into commodity futures in rough proportion to the weights outlined above. Typically, these indexers aren’t actively trading but buying and holding commodities for longer periods of time—a sort of commodity investment.
But all the index traders’ activity doesn’t show up in the noncommercial COT numbers highlighted above because most futures markets have position limits for speculators (noncommercials); such traders can only buy a certain number of contracts. Many index funds would quickly hit these position limits if they simply purchased contracts on the open market.
But there’s another way. Would-be index speculators can enter into an over-the-counter agreement with a major bank to buy a large number of futures contracts. In essence, these funds can replicate the ownership of vast quantities of futures via over-the-counter (off-exchange) deals with major financial institutions.
Of course, the financial institutions don’t want to be on the hook for billions of dollars in commodity investments. To offset risk, these firms, in turn, hedge their over-the-counter positions using the financial futures markets.
But here’s the catch: Such investors can qualify as commercial rather than noncommercial traders. Commercial traders aren’t exposed to position limits. Therefore, it’s possible for index speculators to show up in the COT report as commercials despite the fact these traders aren’t commercial traders in the conventional sense. (The index speculators aren’t engaged in the act of hedging business risk.)
In addition, the CFTC has granted special wavers for about 12 commodity index funds, exempting those funds from position limits. The CFTC had planned to offer a blanket exemption for all index funds; the commission has since rescinded that proposal amid heavy resistance in Congress.
The big debate centers on just how much index speculators affect commodity prices. One way to observe this is to check out the actual data from the CFTC. Starting in January 2006, the CFTC began providing actual data on index investors for several agriculture-related products (though not crude oil).
As I detailed in the April 2, 2008, issue, Growing Fuel, the prices of many agricultural commodities have been soaring in recent years. From a fundamental standpoint, there are two main reasons for this.
First, rapidly growing meat consumption from the developing world is powering demand for feed. Second, more crop production is being diverted to biofuels production; this trend is only set to accelerate as new mandates for biofuels usage come into effect in coming years. For a more-detailed account, check it the April 2 issue.
Some contend that the action in these commodities is, like oil, driven by speculation on the part of index hedgers. The good news: The CFTC began adding a supplemental data series in early 2006 that tracks the positions of index hedgers separately from commercials and noncommercials. The bad news: The supplemental data cover only 14 agricultural futures markets and not energy markets.
Because many are also blaming the big run-up in food prices on speculation and index investors, however, it’s worth examining this data. If we can establish that index speculation is driving the rise in corn prices, it’s logical to assume that it could also be having a key impact on global energy prices. Check out the chart below
Source: Bloomberg, CFTC
This chart shows the net position of index traders as defined by the CFTC in the corn market. The chart covers only the period since January 2006 because that’s when the CFTC began releasing this data for corn.
It’s clear that generally the net index position for corn has risen over the time period covered by the chart above. That said, this position fell sharply in early 2007, remained flat for most of that year and then rose again in the first few months of this year. Check out the chart of corn futures over the same time period.
Source: Bloomberg
These two charts certainly don’t conform perfectly. Corn prices surged in the latter half of 2006 even as the net long position of index traders leveled off; they declined gradually starting in April of that year and then slumped sharply in early 2007. Corn prices also bottomed in midsummer of 2007, months before the net long position of index traders began to rise again.
If anything, rallies in the price of corn seem to lead increases in index traders’ net position by a few months. In other words, based on an extremely limited data set, it appears index traders increase their net long (bullish) position into rallies.
The other point to note from this chart is the quantity of corn in play. In early 2006, the net long position of index traders was 265,000 corn contracts. Today, that figure is closer to 430,000 net long corn contracts.
Index traders purchased a total of 165,000 corn contracts over the time period in question. Because each corn contract covers 5,000 bushels of corn, that’s equivalent to the purchase of 825 million bushels of corn from early 2006 to the present. That works out to about 330 million bushels per year in added demand.
Of course, this demand was, in reality, not evenly spread out over those two and a half years. But 330 million bushels of annualized demand from index traders gives us a reasonable annual figure to evaluate.
But total open interest–the total number of open futures and options contracts–for the corn market currently stands at 2.1 million contracts, equivalent to more than 10.5 billion bushels of corn. The net increase in index traders’ positions is less than 8 percent of open interest in the corn futures market.
The comparisons look even less daunting if we attempt to equate buying interest in the futures market with actual, real-world corn supply and demand.
For example, the US Dept of Agriculture (USDA) estimates that the nation will need 4 billion bushels of corn per year by 2011 to produce enough ethanol to meet rising government mandates. That’s about twice what the ethanol industry consumed in 2006. Therefore, 330 million additional bushels of demand per year from index speculators works out to about 8.3 percent of what the ethanol industry plans to consume annually by 2011.
And last year was a record year for US corn production, with the nation producing around 13.1 billion bushels of corn. Given that number, index traders appear to be purchasing the equivalent of 2.5 percent of the US corn crop per year.
None of these is a totally insignificant figure or percentage. But it would be ludicrous to believe that the rally in corn futures since the beginning of 2006 can be entirely blamed on index speculators. They’ve certainly had an effect, but that demand looks minor in relation to the market as a whole.
Moreover, there are other, more realistic reasons that account for the run-up in agricultural commodity prices in recent years. Here are two charts from the April 2 issue that are worth a second look.
Source: USDA
Source: USDA
The first chart shows the end stocks to use ratio (ESUR) for coarse grains. The ESUR is a measure of total inventories of a particular commodity in storage dividend by total annual demand. The higher the percentage, the more adequately current inventories cover demand.
Corn is by far the most important coarse grain in terms of international trade, accounting for roughly 80 percent of total trade. It’s clear that the ESUR supply picture for corn is ultra-tight; the ratio has dropped from near 30 percent in 1999-2000 to less than 12 percent today.
The second shows global corn imports with USDA projections out to the 2017-18 growing year. This chart shows a clear jump in imports of corn for both China and the Middle East/North Africa over the USDA’s forecast period.
These numbers are particularly striking when you consider that, as recently as the beginning of this decade, China was an important net exporter of corn. In the 2006-07 year, Chinese imports and exports became evenly balanced, and over the USDA’s forecast period, imports are likely to explode. Meanwhile, Chinese exports will remain constrained, partly because of legislation discouraging corn exports.
Even more shocking, consider that, according to the USDA, the Chinese government has made the conscious decision to encourage domestic corn production to minimize import demand. This has come at a cost because land is diverted away from the production of other crops.
It doesn’t seem at all plausible to simply discount these bullish fundamentals for the corn market and blame the entire rally on speculators. After all, it isn’t speculative demand or demand from US-based index funds that’s prompting Chinese consumers to eat more meat and import more corn.
As I noted earlier, we unfortunately don’t have direct figures from the CFTC to detail just how much oil and natural gas index funds own. So, unlike corn, I can’t put up a chart showing the action of these funds over time.
However, in Masters’ testimony before the Senate, he does offer some estimates. These figures are based on the mathematical manipulation of available data from the CFTC and the various commodity indexes. I won’t bore readers by detailing exactly how these calculations are performed; I refer interested subscribers to the appendix section of the transcript of Masters’ testimony. At any rate, I believe the numbers Masters presented represent a logical and unbiased approximation of index fund activity, and I expect the CFTC will ultimately offer more detailed figures.
If we take Masters’ figures at face value, index funds have purchased roughly 538 million barrels of crude oil futures over the past 5.25 years. If we look at the total for oil, gasoline and heating oil, that number jumps to roughly 848 million barrels. Note that this isn’t an annualized figure but a total figure for that time frame.
No doubt this is a large figure. And given the heavy weight of energy commodities in most of the commodity index funds, it should come as little surprise that index traders have disproportionately been buyers in the energy commodity markets.
But it’s worth keeping in mind that the world consumes about 82 million barrels of oil per day; 848 million barrels is equivalent to 10.3 days of supply. And according to figures from BP, non-Organisation for Economic Co-operation and Development (OECD) countries have seen their consumption of oil grow by more than 6 million barrels per day between 2000 and 2006. That’s equivalent to about 2.2 billion barrels of oil in additional demand per year.
In natural gas, net purchases by index funds have totaled 1.9 trillion British thermal units (Btu) over the past 5.25 years. To put that into perspective, the US consumes more than 10 times that amount in a year.
I consider these numbers significant, but the action of index funds doesn’t outweigh the fundamental increase in energy demand we’re seeing from emerging markets. Masters also made another key point with which I take major issue. Consider the following quote from his testimony:
There may be no lines at the gas pump or empty shelves in your local grocery store, but that doesn’t mean supplies are adequate or that growing supply to meet rapid demand growth will be easy. In fact, one of the longest standing themes of this newsletter is the end of easy oil—namely the idea that growing oil supplies to meet demand will be harder in coming years. I’ve highlighted this thesis on a few occasions, most recently in the March 5, 2008, issue, The Final Frontier, and the May 7, 2008, issue, Follow the Leader.
I won’t repeat all those arguments here. Suffice it to say that non-OPEC production growth continues to disappoint. Each month, the IEA releases its Oil Market Report, which offers its outlook for oil demand and supply. In the July 2007 issue of the Oil Market Report, the IEA predicted that non-OPEC oil supply would grow about 977,000 barrels per day this year. By November 2007, the IEA had upped that forecast to more than 1 million barrels per day.
But as I outlined in the May 7, 2008, issue oil supplies from two key non-OPEC producers—Russia and Mexico—have disappointed this year. Russia is a particularly big shocker; oil production appears to be dropping there for the first time in a decade. The result: In its most recent Oil Market Report, the IEA has revised lower non-OPEC oil production growth to just 680,000 barrels per day. I wouldn’t be at all surprised to see those estimates fall even further.
And then there’s OPEC. Currently, the IEA assumes that OPEC as a whole has about 2.3 million barrels per day’s worth of spare capacity—basically, oil production that can be brought on line quickly and sustained for relatively long periods of time. Saudi Arabia alone accounts for some 1.85 million barrels per day of that spare capacity.
But there are legitimate concerns as to just how reliable that capacity really is. The IEA has noted in the past that much of this spare capacity is for heavy, sour crude types that can’t be refined in all countries; increasing production of these oils probably wouldn’t be sufficient to ease supply shortfalls.
Saudi Arabia has expressed plans to increase its effective oil production capacity to 12.5 million barrels per day in 2010 compared to just less than 11 million today. Theoretically, given constant world demand, this would add another 1.5 million barrels per day to the nation’s spare capacity. But there are real questions as to whether such an increase is actually possible, given the advanced age of some of Saudi Arabia’s largest fields.
Moreover, the country hasn’t announced any plans to go beyond 12.5 million barrels per day of capacity; in fact, Saudi Oil Minister al-Naimi stated that he sees little need to expand beyond 12.5 million barrels per day. This doesn’t seem to be a logical comment in light of the obvious increase in global oil demand from emerging markets. The statement was seen by many as a sign that the country is having difficulty raising production much beyond current levels.
My point is that the argument that speculators are to blame for $4 gasoline at the pump ignores the very real supply issues in the petroleum markets.
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One example is palm oil, a commodity we play in TES via the biofuels field bet. Palm oil is an edible tropical oil produced from the fruit of palm trees. It is the most popular edible oil in China and is also popular as a feedstock for biodiesel plants, particularly in Europe. The world’s two largest producers are Indonesia and Malaysia.
There are some fairly illiquid futures contracts traded on palm oil, but these futures aren’t part of the indexes that most index funds are designed to track. Therefore, there’s essentially no index speculation in palm oil prices. But check out the chart below of palm oil prices.
Source: Bloomberg
Palm oil traded at around $425 per metric ton as recently as 2006 but currently trades at more than $1,200 per metric ton. The price has tripled even though there’s no real speculation in the palm oil market. As I highlighted in the April 2, 2008, issue, there are some very real fundamental reasons for rising palm oil prices.
Another classic example is uranium. Uranium prices aren’t included in the major commodity indexes, yet the commodity has seen a big run-up in recent years.
Uranium was trading around $10 per pound as recently as 2003. Last year, prices rallied to around $140 per pound and currently sit around $60. I highlighted this market in the April 23, 2008, issue, Electric Charge.
Neither palm oil nor uranium represents commodities that are influenced heavily by index traders. Yet both commodities have seen big run-ups in recent years.
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That said, I was correct to favor natural gas over oil. Gas prices are up more than 50 percent this year compared to a less-than-30-percent jump in oil prices.
My main reasons for being cautious on oil short term were twofold. First, on the demand front, I suspected that weaker US and EU economies, coupled with high energy prices, would create demand destruction. That means consumers would scale back on their use of oil and gasoline.
There’s some sign that this is happening: The IEA recently cut its forecast for OECD oil demand for the third time this year. Evidence of this impact has the IEA forecasting a more-than-400,000-barrel-per-day decline in oil demand for North America alone.
Of course, the big surprise is that demand from the developing world has continued to pick up the slack. If anything, demand growth from these nations has actually accelerated recently. Demand from Asia alone is expected to rise more than 700,000 barrels per day in 2008.
My second reason for cautiousness on oil had to do with short-term inventory conditions. Inventories of crude oil and gasoline looked sufficient in the US and many countries across the developed world. But there’s a notable shift underway on the inventory front. Check out the two charts below.
Source: EIA
Source: EIA
The first chart shows US crude oil inventories on a seasonal basis since the beginning of 2008. The second chart is in exactly the same format but depicts gasoline prices.
It’s clear that US crude oil inventories have been at or above average on a seasonal basis for most of 2008. On the chart, the dark-blue line representing this year’s inventories has remained above the turquoise line representing the five-year average. But recently, crude oil inventories have taken a quick dive below average levels.
Much of this quick dive is due to fog in the Houston Shipping channel that has prevented the normal flow of oil imports into the US. Nonetheless, no matter what the reason, crude oil inventories look at or slightly below average for this time of year.
The shift in the gasoline market is even more stark over the past few weeks. Note that in mid- to late March, US gasoline inventories were extremely bloated: They weren’t only above average but at five-year highs. This glut of gasoline is one reason that gasoline prices haven’t risen as quickly as crude oil prices in 2008.
As I explained at great length in the March 19, 2008, issue, bloated gasoline inventories are particularly bad news for refiners because they don’t make money from rising crude oil prices. In fact, refiners must actually buy crude oil as a raw material for their refineries. Therefore, when crude prices rise, refiners’ costs actually increase.
What refiners do sell is refined products, such as gasoline. Therefore, these companies actually profit from the spread between the cost of crude and the value of the refined products they sell.
If the price of gasoline rises faster than the price of crude, profit margins for refiners would tend to expand. And refiners can, of course, actually make money when crude oil prices are falling. For example, if crude prices are drifting lower but gasoline costs are rising or remaining steady, this will support refiners’ margins.
The basic measure of a refiner’s profitability is what’s known as a crack spread. The term comes from the fact that refiners are said to “crack” a barrel of crude to make refined products. The crack spread is generally calculated by comparing the cost of crude oil futures with the price of refined products futures–typically gasoline and heating oil futures. Check out the chart of the 3-2-1 crack spread below for a closer look.
Source: Bloomberg
The basic interpretation of this chart is simple: When the line is high or rising, that’s bullish for refiners because it implies the profit margins of running their operations is on the rise.
There’s an important seasonal trend to watch in the crack spread. In particular, note how the crack spread rose between February and early summer in both 2006 and 2007. This is normal action because refiners’ margins tend to rise as refineries gear up for the summer driving season.
But this seasonal run-up in crack spreads just didn’t emerge in 2008. The reason was that gasoline inventories were extremely bloated; that put a cap on gasoline prices. Therefore, the price of gasoline actually rose at a slower pace than the price of oil, squeezing refiners’ profit margins.
What has happened over the past few months is that refiners, facing weak crack spreads, have scaled back their operations. They’ve literally shut down part of their operations or have chosen to undertake maintenance rather than refining more gasoline. Refinery utilization–a measure of the percentage of US refining capacity that’s actually running–has been hovering at less than 90 percent for most of this year. In a strong market for crack spreads, it wouldn’t be unusual to see refineries push utilization into the mid-90 percent range.
Refiners’ decision to reduce throughput has finally had an impact: Reduced gasoline production has brought gasoline inventories back in line with historical norms. And with gasoline inventories now below average, crack spreads are once again spiking higher.
To make a long story short, one of my major concerns for oil prices this year has been bloated inventories of oil and refined products. Now that that headwind appears to have abated, stocks are close to average for this time of year.
Bottom line: There are some key crosscurrents in the oil markets right now. I see the idea that speculators are solely to blame for a jump in crude oil prices as a red herring.
Nonetheless, there’s further headline risk from the CFTC and congressional investigations. New regulations aimed at curtailing speculation could cause a short-term dip in oil prices. Longer term, however, speculators could just move their business to foreign futures markets with lighter regulations, so the impact of any new laws would be meaningless.
Demand trends overall look weak in the developed world and, in particular, North America. However, strengthening demand from the emerging markets has offset that slack to a great degree.
Supply growth looks challenged, particularly in non-OPEC countries including Russia, Norway and Mexico. And inventories look to be roughly in line with seasonal norms.
My outlook for oil prices is that we’ll likely see crude trade in a volatile range around current prices. I can’t rule out a significant pullback; after all, that’s only natural, given the run-up in crude prices we’ve witnessed since the beginning of 2008. However, I see no fundamental reason for prices to collapse.
At the same time, prices will likely be capped by continued softness in demand from the developed world and normal inventories for this time of year.
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Meanwhile, gas is still cheap on a relative basis compared to crude oil, and the inventory picture in the US is bullish. Even better, natural gas prices in Europe are touching records and remain around $16 per million Btu (MMBtu), significantly higher than the current $12-per-MMBtu gas price in the US.
Because most North American drilling activity targets natural gas rather than oil, activity there has been weak the past few years. But with the picture for gas improving, this market is starting to really take off.
A preference for stocks leveraged to gas also includes companies with significant exposure to North America. I highlighted several of these in the May 7 issue. I’m raising my buy targets on Nabors Industries and Hercules Offshore, both contract drillers with significant leverage to North American gas drilling. Both were highlighted at some length in the May 7 issue.
In the March 19, 2008, issue, I highlighted some concerns about refining stocks and cut our only direct play on that industry, Valero Energy, from a buy to a hold. My rationale for a cautious stance on the group was that crack spreads were weak through the spring, a period during which spreads tend to widen. This scenario is clearly visible on the chart I highlighted above.
In addition, I argued that bloated gasoline inventories would put downside pressure on gasoline prices and, therefore, crack spreads. Overall, this call was correct: Refiners have underperformed the energy patch since mid-March; the Philadelphia Oil Services Index is up around 25 percent since that time, compared to just a 6 percent gain for Valero.
And longer term, I have some concerns about new refining capacity expansions due to come online over the next few years. As this supply comes online, it could put downside pressure on margins.
But over the next six to nine months, the refiners look like a compelling play. As I noted earlier, gasoline inventories are now back in line with seasonal norms; it’s likely gasoline prices will now rally further relative to crude oil. In fact, we’re already seeing an obvious spike in crack spreads.
Valero remains an outstanding play on a recovery in refining margins. Unlike most energy stocks, the company has been weak this year, and in an improving margin environment, I’d expect to see the stock play catch-up with the rest of the energy patch.
From a company-specific standpoint, Valero is attractive for three reasons: superior geographic exposure, refinery complexity and a new focus on profitability. To the first point, Valero has refineries located all over the US; because refining margins can vary greatly between regions, this ensures the company has exposure to the most-profitable markets.
Second, Valero has some of the most complex refineries in the US. I explained complexity at some length in the March 21, 2007, issue, Looking Refined.
To summarize, not all crude oils are alike. Some grades known as sour oils have a high sulphur content and others, known as heavy oil, are more difficult to refine. Lower-quality grades of crude can trade at a huge discount to West Texas Intermediate (WTI), the benchmark crude in the US used as the basis for the New York Mercantile Exchange futures contract.
Therefore, refiners with complex facilities can purchase heavy, sour oils at a considerable discount to WTI prices. This allows those refiners to earn higher profit margins. Check out the chart below.
Source: Bloomberg
This chart shows the cost of one barrel of light, sweet crude oil (WTI) minus the price of one barrel of heavy, sour crude oil (a Mexican benchmark known as Maya). When this number increases, WTI is trading at a larger premium to Maya. The higher this spread, the more beneficial it is for refiners to purchase lower grades of crude.
As you can clearly see, the spread between WTI and Maya is unusually high right now. This plays right into the hands of Valero.
Finally, Valero is executing its plans to sell off smaller, less-profitable operations and focus on investing in its most-profitable facilities. Management has been using the cash to buyback stock and increase dividend payout.
These are both shareholder-friendly moves. I’m now recommending Valero Energy as a buy under 60. If crack spreads continue to rise, as I expect, the stock could easily rally to the $70 region over the next few months.
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Tullow has more drilling licenses in Africa than any other E&P. The company noted in a statement that a well offshore Ghana encountered a lengthy column of light oil and was producing above the company’s expectations. Tullow has plans to increase oil production from the current 70,000 to 75,000 barrels per day to as high as 250,000 by the end of 2010.
Tullow drills far higher risk wells than my US-based E&P recommendations such as XTO Energy and EOG Resources. Nonetheless, it has an unbeatable position in Africa and has the potential to grow its production rapidly. Up close to 100 percent from my original recommendation one year ago, I’m cutting Tullow Oil to a hold for now.
Peabody Energy and Patriot Coal—Coal prices have been soaring recently, given strong demand for coal exports to Europe and Asia. Domestic US utilities are now in heated competition for US coal, with foreign utilities willing to pay top dollar to import the commodity.
Peabody announced in early June that its 2008 earnings could rise as much as 88 percent over 2007 levels. The company, indicating it saw strong demand for coal reaching into 2009 and 2010, also made bullish statements on coal prices. I’m raising my buy target for Peabody Energy to 75; Patriot Coal remains a hold.
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Neil, Roger and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.
Click here or call 800-970-4355 and refer to priority code 011361 to attend as our guest.
Demand is slowing in the US and EU because of higher prices and weak economic growth. But demand in the developing world shows no sign of slowing; China continues to subsidize gasoline prices so the Chinese consumer doesn’t feel the full brunt of recent price gains. Strong growth in demand outside the developed world is swamping any US demand shortfall.
Simply put, the main reason for crude oil’s rally in recent years is basic supply and demand. Yet many have attempted to discount these factors and lay the blame on excess speculation. There’s little doubt speculators have had an impact; however, the data just don’t back up the idea that speculation is solely to blame for $130 oil.
In This Issue
In this issue, we’ll take a closer look at speculation in energy markets and the current outlook for crude.A series of hearings on Capitol Hill seeks to determine if commodity traders are behind the rise in oil and natural gas prices over the past several months. However, traders, although influential, have rarely been the driving force behind such price movement. See Speculation or Reality?
There are some ways for noncommercials to be labeled commercials and get around the position limits placed on noncommercial traders. However, in looking at ownership data of commodities futures, the number held by traders is still such a small portion of overall demand that it’s hard to imagine any direct correlation between traders and higher prices. See Commercials or Noncommercials.
Even some commodities not tracked by the major indexes have risen sharply of late on little or no speculation, suggesting that this may be part of a larger trend outside the realm of traders. See Outside the Indexes.
For much of this year, I’ve been short-term cautious on crude oil prices and bullish on natural gas. Inventories of both had been bloated—until recently. Supply is now back in line with norms, and demand is softening. See Crude Oil Now.
I still favor natural gas over oil. Two Portfolio holdings have great leverage to the North American drilling market. And the one direct play on natural gas in the Portfolio appears to be making headway; I’m updating my recommendation to reflect that. See How to Play It.
A major offshore exploration success and increased coal demand are reasons to continue to buy and hold these Portfolio holdings. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
- Hercules Offshore (NSDQ: HERO)
- Nabors Industries (NYSE: NBR)
- Peabody Energy (NYSE: BTU)
- Valero Energy (NYSE: VLO)
- Patriot Coal (NYSE: PCX)
- Tullow Oil (UK: TLW)
Speculation or Reality?
In late May, the Commodity Futures Trading Commission (CFTC) announced it’s been undertaking a broad, detailed investigation of the crude oil market since last December. This investigation covers the oil futures markets that are regulated by the CFTC, as well as cash oil trades, storage and transportation markets.In addition, there has been a series of hearings on Capitol Hill on the energy markets. A significant amount of the testimony has been directed at the potential for crude oil speculation to impact prices. There also have been countless stories in major newspapers and magazines attributing the rise in oil and gasoline prices to the activity of traders.
As I’ve noted before, there’s no denying that the activity of futures traders and speculators does have an impact on commodity prices. But what I believe is a huge mistake is to attribute all of the recent rises in oil prices, or the cost of any commodity, on market manipulation. The far-more-important driver of energy prices is simple supply and demand.
Before delving into a more-detailed analysis of speculation in the oil market, it’s worth noting that speculators and traders are all-too-convenient scapegoats for those looking to place blame for rising prices. In fact, blaming speculators is nothing new at all.
Many will remember that, in the early 1990s, financier George Soros shorted the Italian lira and the British pound, making more than $2 billion in profits when those currencies were then forced out of the Exchange Rate Mechanism (ERM). The ERM was a system for pegging various European currencies to one another; it was a sort of first step toward the eventual introduction of the euro common currency.
Soros was blamed on many fronts for the devaluation of the pound and the lira. But the reality was that economic conditions in Italy were extraordinarily weak relative to the other European currencies in the early ’90s; the lira looked fundamentally weak long before Soros shorted it. Moreover, rhetoric out of the Italian government suggests dwindling support for maintaining the lira’s value.
Perhaps Soros tipped the lira over the edge. But that currency walked to the edge of the cliff on its own power.
Then there was the pound. Britain had a vicious property bust in the late ’80s and early ’90s, and in 1992, it was just recovering from the bust. It was hardly a great secret that the British government under Prime Minister John Major and the Bank of England were keen to avoid nipping a still-tentative economic recovery in the bud. Of course, maintaining relatively lax fiscal and monetary policy helped the economy recover from the doldrums but was bearish for the pound.
Again, Soros probably tipped the scale but was hardly single-handedly responsible for Britain’s economic situation.
My point in noting these examples is that speculation is an all-too-convenient excuse for market moves. But it’s worth taking a closer look at actual data in the energy markets to determine to what degree speculators are influencing crude prices.
Fortunately, we do have some direct data on speculators’ positions in the oil market—the CFTC’s weekly Commitment of Traders (COT) report. For most markets, the COT breaks traders down into three main camps: commercials, noncommercials and non-reportables.
Commercial traders use the futures market to hedge against business risks. Take, for example, an exploration and production (E&P) firm that sells oil futures to lock in a guaranteed price for the oil it produces. Alternatively, commercials may include a major consumer of crude oil looking to guard against rising costs by purchasing futures.
Noncommercial traders are larger individual traders or institutions speculating on the price of a commodity. Non-reportables are typically small individual speculators in the futures markets.
Traditionally, noncommercials are the gauge of speculative excess in the commodity markets. Check out the chart of the net position of noncommercial traders in the crude market over the past few years.
Source: Bloomberg
To calculate this chart, I simply took the total long open interest from noncommercial traders (futures and options) and subtracted the total short open interest. Noncommercials are net long futures when the value is above zero. Conversely, a negative number signals that traders have moved net short crude oil futures.
There’s really no major trend in this chart, though it’s drifted to become gradually more net long crude oil futures since 2004. In other words, it appears that noncommercials have become gradually more bullish crude oil since the end of 2003. This trend is hardly surprising, given the rise in crude oil since that time.
However, there are some notable short-term spikes and troughs in the index. For example, in late 2006 and early 2007, the noncommercials net long position dropped to its lowest level in years. Traders were as bearish on oil as they’d been since the end of 2003. In fact, if we look at simple futures data (excluding options trades), noncommercials actually were net short oil in early 2007.
This was a great contrary indicator because early 2007 marked an important low for oil: Oil prices bottomed around $50 per barrel (bbl) and have hardly looked back on their march to recent highs of more than $130 per bbl.
Similarly, note the spikes into net long territory in mid-2006. At this time, crude oil was trading in the $75 to $80 per bbl range. Noncommercial traders were heavily betting on further gains in crude; instead, from mid-2006 through early 2007, oil saw its most vicious correction in years.
As you’ve probably gathered from these examples, the activity of noncommercial traders often acts as a contrary indicator for the underlying commodity. When these speculators are heavily long a commodity, it can be an indication that traders are excessively bullish, and therefore, the underlying commodity price is due to drop. Similarly, overly bearish sentiment in the form of a large net short position often occurs near lows. Emotions tend to run high near turning points.
Of course, apart from these major spikes, noncommercials seem to more or less get the market correct. Their net long position tends to steadily increase in uptrending markets, and noncommercials bet more heavily short in falling markets. This is a fancy way of saying that the crowd is usually correct except at turning points for the market.
A quick glance at the chart above indicates that the current net position of noncommercial traders is elevated but well off last year’s highs. At one point last year, the noncommercials saw their open interest spike to record high levels. But at the current time, the net noncommercial position is at the low end of the past year’s range. At first blush, this doesn’t appear to indicate excessive speculation in the crude oil market.
The position with respect to natural gas futures is even more interesting. Below is a chart of the net position of noncommercial traders in the natural gas market.
Source: Bloomberg, CFTC
This chart shows a fairly noticeable trend. First, note that gas noncommercial commitments traded in a fairly narrow range from the starting measurement point through late 2005. Then, throughout 2006, traders became progressively more bullish on gas.
With gas prices weak in 2007, the noncommercials seemed to capitulate and have since become progressively more net short natural gas. At the current time, the net short position for noncommercials is huge at around 250,000 contracts.
This chart highlights the danger of lumping all commodities together and that speculation is excessive across the board. If anything, speculation in the natural gas market is acting as a bearish force on natural gas prices. However, I’m confident this fact won’t get much coverage from Capitol Hill; after all, it doesn’t really fit well with the speculator-scapegoat plan.
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Commercials or Noncommercials
I must emphasize, however, that the analysis I presented above is a traditional interpretation of the COT report and the action of noncommercial speculators. On that basis, there can be little doubt that there’s no excessive speculation on the long side in energy-related futures markets.But there is a legitimate argument that we can no longer interpret the COT report in the same manner. This basic argument was extraordinarily well articulated by Michael Masters, a hedge fund portfolio manager at Masters Capital Management, in his testimony before the Committee on Homeland Security and Government Affairs of the US Senate. For those interested, the full text of this May 20, 2008, testimony is available on the Senate Web site.
But Masters’ basic thesis has been outlined by several pundits. The idea is that the excessive speculation in commodity markets today isn’t coming from the noncommercials but from a new group of passive index traders; these are funds designed to track theperformance of a broad basket of different commodities.
The idea is that, by diversifying a portfolio away from traditional stocks and bonds, it’s possible to lower overall portfolio risks and enhance returns. Most of these indexers typically track the performance of either the Standard & Poor’s Goldman Sachs Commodity Index or the Dow Jones-AIG Commodity Index. The table below offers the current composition of both indexes.
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S&P Goldman Sachs Commodity Index and Dow Jones AIG Index Holdings
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Commodity
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Weight in S&P Goldman Sachs Commodity Index (%)
|
Weight in Dow Jones AIG Index (%)
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| Cocoa | 0.2 | 0.0 |
| Coffee | 0.8 | 2.9 |
| Corn | 2.0 | 5.9 |
| Cotton | 0.9 | 3.2 |
| Soybean Oil | 0.0 | 2.8 |
| Soybeans | 1.4 | 7.8 |
| Sugar | 1.9 | 3.0 |
| Wheat | 2.4 | 1.8 |
| Wheat (Kansas City) | 0.8 | 0.0 |
| Feed Cattle | 0.7 | 0.0 |
| Lean Hogs | 1.4 | 4.4 |
| Live Cattle | 2.7 | 6.1 |
| Brent Crude | 14.5 | 0.0 |
| WTI Crude | 31.3 | 12.8 |
| Gasoil | 3.1 | 0.0 |
| Heating Oil | 8.0 | 3.8 |
| Gasoline | 7.9 | 4.1 |
| Natural Gas | 10.6 | 12.3 |
| Aluminum | 3.1 | 6.9 |
| Lead | 0.3 | 0.0 |
| Nickel | 0.7 | 2.7 |
| Zinc | 0.7 | 2.7 |
| Copper (LME) | 2.8 | 0.0 |
| Copper (CMX) | 0.0 | 5.9 |
| Gold | 1.8 | 6.2 |
| Silver | 0.2 | 2.0 |
Index followers buy into commodity futures in rough proportion to the weights outlined above. Typically, these indexers aren’t actively trading but buying and holding commodities for longer periods of time—a sort of commodity investment.
But all the index traders’ activity doesn’t show up in the noncommercial COT numbers highlighted above because most futures markets have position limits for speculators (noncommercials); such traders can only buy a certain number of contracts. Many index funds would quickly hit these position limits if they simply purchased contracts on the open market.
But there’s another way. Would-be index speculators can enter into an over-the-counter agreement with a major bank to buy a large number of futures contracts. In essence, these funds can replicate the ownership of vast quantities of futures via over-the-counter (off-exchange) deals with major financial institutions.
Of course, the financial institutions don’t want to be on the hook for billions of dollars in commodity investments. To offset risk, these firms, in turn, hedge their over-the-counter positions using the financial futures markets.
But here’s the catch: Such investors can qualify as commercial rather than noncommercial traders. Commercial traders aren’t exposed to position limits. Therefore, it’s possible for index speculators to show up in the COT report as commercials despite the fact these traders aren’t commercial traders in the conventional sense. (The index speculators aren’t engaged in the act of hedging business risk.)
In addition, the CFTC has granted special wavers for about 12 commodity index funds, exempting those funds from position limits. The CFTC had planned to offer a blanket exemption for all index funds; the commission has since rescinded that proposal amid heavy resistance in Congress.
The big debate centers on just how much index speculators affect commodity prices. One way to observe this is to check out the actual data from the CFTC. Starting in January 2006, the CFTC began providing actual data on index investors for several agriculture-related products (though not crude oil).
As I detailed in the April 2, 2008, issue, Growing Fuel, the prices of many agricultural commodities have been soaring in recent years. From a fundamental standpoint, there are two main reasons for this.
First, rapidly growing meat consumption from the developing world is powering demand for feed. Second, more crop production is being diverted to biofuels production; this trend is only set to accelerate as new mandates for biofuels usage come into effect in coming years. For a more-detailed account, check it the April 2 issue.
Some contend that the action in these commodities is, like oil, driven by speculation on the part of index hedgers. The good news: The CFTC began adding a supplemental data series in early 2006 that tracks the positions of index hedgers separately from commercials and noncommercials. The bad news: The supplemental data cover only 14 agricultural futures markets and not energy markets.
Because many are also blaming the big run-up in food prices on speculation and index investors, however, it’s worth examining this data. If we can establish that index speculation is driving the rise in corn prices, it’s logical to assume that it could also be having a key impact on global energy prices. Check out the chart below
Source: Bloomberg, CFTC
This chart shows the net position of index traders as defined by the CFTC in the corn market. The chart covers only the period since January 2006 because that’s when the CFTC began releasing this data for corn.
It’s clear that generally the net index position for corn has risen over the time period covered by the chart above. That said, this position fell sharply in early 2007, remained flat for most of that year and then rose again in the first few months of this year. Check out the chart of corn futures over the same time period.
Source: Bloomberg
These two charts certainly don’t conform perfectly. Corn prices surged in the latter half of 2006 even as the net long position of index traders leveled off; they declined gradually starting in April of that year and then slumped sharply in early 2007. Corn prices also bottomed in midsummer of 2007, months before the net long position of index traders began to rise again.
If anything, rallies in the price of corn seem to lead increases in index traders’ net position by a few months. In other words, based on an extremely limited data set, it appears index traders increase their net long (bullish) position into rallies.
The other point to note from this chart is the quantity of corn in play. In early 2006, the net long position of index traders was 265,000 corn contracts. Today, that figure is closer to 430,000 net long corn contracts.
Index traders purchased a total of 165,000 corn contracts over the time period in question. Because each corn contract covers 5,000 bushels of corn, that’s equivalent to the purchase of 825 million bushels of corn from early 2006 to the present. That works out to about 330 million bushels per year in added demand.
Of course, this demand was, in reality, not evenly spread out over those two and a half years. But 330 million bushels of annualized demand from index traders gives us a reasonable annual figure to evaluate.
But total open interest–the total number of open futures and options contracts–for the corn market currently stands at 2.1 million contracts, equivalent to more than 10.5 billion bushels of corn. The net increase in index traders’ positions is less than 8 percent of open interest in the corn futures market.
The comparisons look even less daunting if we attempt to equate buying interest in the futures market with actual, real-world corn supply and demand.
For example, the US Dept of Agriculture (USDA) estimates that the nation will need 4 billion bushels of corn per year by 2011 to produce enough ethanol to meet rising government mandates. That’s about twice what the ethanol industry consumed in 2006. Therefore, 330 million additional bushels of demand per year from index speculators works out to about 8.3 percent of what the ethanol industry plans to consume annually by 2011.
And last year was a record year for US corn production, with the nation producing around 13.1 billion bushels of corn. Given that number, index traders appear to be purchasing the equivalent of 2.5 percent of the US corn crop per year.
None of these is a totally insignificant figure or percentage. But it would be ludicrous to believe that the rally in corn futures since the beginning of 2006 can be entirely blamed on index speculators. They’ve certainly had an effect, but that demand looks minor in relation to the market as a whole.
Moreover, there are other, more realistic reasons that account for the run-up in agricultural commodity prices in recent years. Here are two charts from the April 2 issue that are worth a second look.
Source: USDA
Source: USDA
The first chart shows the end stocks to use ratio (ESUR) for coarse grains. The ESUR is a measure of total inventories of a particular commodity in storage dividend by total annual demand. The higher the percentage, the more adequately current inventories cover demand.
Corn is by far the most important coarse grain in terms of international trade, accounting for roughly 80 percent of total trade. It’s clear that the ESUR supply picture for corn is ultra-tight; the ratio has dropped from near 30 percent in 1999-2000 to less than 12 percent today.
The second shows global corn imports with USDA projections out to the 2017-18 growing year. This chart shows a clear jump in imports of corn for both China and the Middle East/North Africa over the USDA’s forecast period.
These numbers are particularly striking when you consider that, as recently as the beginning of this decade, China was an important net exporter of corn. In the 2006-07 year, Chinese imports and exports became evenly balanced, and over the USDA’s forecast period, imports are likely to explode. Meanwhile, Chinese exports will remain constrained, partly because of legislation discouraging corn exports.
Even more shocking, consider that, according to the USDA, the Chinese government has made the conscious decision to encourage domestic corn production to minimize import demand. This has come at a cost because land is diverted away from the production of other crops.
It doesn’t seem at all plausible to simply discount these bullish fundamentals for the corn market and blame the entire rally on speculators. After all, it isn’t speculative demand or demand from US-based index funds that’s prompting Chinese consumers to eat more meat and import more corn.
As I noted earlier, we unfortunately don’t have direct figures from the CFTC to detail just how much oil and natural gas index funds own. So, unlike corn, I can’t put up a chart showing the action of these funds over time.
However, in Masters’ testimony before the Senate, he does offer some estimates. These figures are based on the mathematical manipulation of available data from the CFTC and the various commodity indexes. I won’t bore readers by detailing exactly how these calculations are performed; I refer interested subscribers to the appendix section of the transcript of Masters’ testimony. At any rate, I believe the numbers Masters presented represent a logical and unbiased approximation of index fund activity, and I expect the CFTC will ultimately offer more detailed figures.
If we take Masters’ figures at face value, index funds have purchased roughly 538 million barrels of crude oil futures over the past 5.25 years. If we look at the total for oil, gasoline and heating oil, that number jumps to roughly 848 million barrels. Note that this isn’t an annualized figure but a total figure for that time frame.
No doubt this is a large figure. And given the heavy weight of energy commodities in most of the commodity index funds, it should come as little surprise that index traders have disproportionately been buyers in the energy commodity markets.
But it’s worth keeping in mind that the world consumes about 82 million barrels of oil per day; 848 million barrels is equivalent to 10.3 days of supply. And according to figures from BP, non-Organisation for Economic Co-operation and Development (OECD) countries have seen their consumption of oil grow by more than 6 million barrels per day between 2000 and 2006. That’s equivalent to about 2.2 billion barrels of oil in additional demand per year.
In natural gas, net purchases by index funds have totaled 1.9 trillion British thermal units (Btu) over the past 5.25 years. To put that into perspective, the US consumes more than 10 times that amount in a year.
I consider these numbers significant, but the action of index funds doesn’t outweigh the fundamental increase in energy demand we’re seeing from emerging markets. Masters also made another key point with which I take major issue. Consider the following quote from his testimony:
Commodities prices have increased more in the aggregate over the past five years that at any other time in US history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: There are no lines at the gas pump, and there is plenty of food on the shelves.
If supply is adequate—as has been shown by others who have testified before this committee—and prices are still rising, then demand must be increasing.
If supply is adequate—as has been shown by others who have testified before this committee—and prices are still rising, then demand must be increasing.
There may be no lines at the gas pump or empty shelves in your local grocery store, but that doesn’t mean supplies are adequate or that growing supply to meet rapid demand growth will be easy. In fact, one of the longest standing themes of this newsletter is the end of easy oil—namely the idea that growing oil supplies to meet demand will be harder in coming years. I’ve highlighted this thesis on a few occasions, most recently in the March 5, 2008, issue, The Final Frontier, and the May 7, 2008, issue, Follow the Leader.
I won’t repeat all those arguments here. Suffice it to say that non-OPEC production growth continues to disappoint. Each month, the IEA releases its Oil Market Report, which offers its outlook for oil demand and supply. In the July 2007 issue of the Oil Market Report, the IEA predicted that non-OPEC oil supply would grow about 977,000 barrels per day this year. By November 2007, the IEA had upped that forecast to more than 1 million barrels per day.
But as I outlined in the May 7, 2008, issue oil supplies from two key non-OPEC producers—Russia and Mexico—have disappointed this year. Russia is a particularly big shocker; oil production appears to be dropping there for the first time in a decade. The result: In its most recent Oil Market Report, the IEA has revised lower non-OPEC oil production growth to just 680,000 barrels per day. I wouldn’t be at all surprised to see those estimates fall even further.
And then there’s OPEC. Currently, the IEA assumes that OPEC as a whole has about 2.3 million barrels per day’s worth of spare capacity—basically, oil production that can be brought on line quickly and sustained for relatively long periods of time. Saudi Arabia alone accounts for some 1.85 million barrels per day of that spare capacity.
But there are legitimate concerns as to just how reliable that capacity really is. The IEA has noted in the past that much of this spare capacity is for heavy, sour crude types that can’t be refined in all countries; increasing production of these oils probably wouldn’t be sufficient to ease supply shortfalls.
Saudi Arabia has expressed plans to increase its effective oil production capacity to 12.5 million barrels per day in 2010 compared to just less than 11 million today. Theoretically, given constant world demand, this would add another 1.5 million barrels per day to the nation’s spare capacity. But there are real questions as to whether such an increase is actually possible, given the advanced age of some of Saudi Arabia’s largest fields.
Moreover, the country hasn’t announced any plans to go beyond 12.5 million barrels per day of capacity; in fact, Saudi Oil Minister al-Naimi stated that he sees little need to expand beyond 12.5 million barrels per day. This doesn’t seem to be a logical comment in light of the obvious increase in global oil demand from emerging markets. The statement was seen by many as a sign that the country is having difficulty raising production much beyond current levels.
My point is that the argument that speculators are to blame for $4 gasoline at the pump ignores the very real supply issues in the petroleum markets.
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Outside the Indexes
Another point that argues strongly against the theory that index speculators are behind the moves in all commodities is the fact that commodities that aren’t even part of the major commodity indexes have also risen sharply in price.One example is palm oil, a commodity we play in TES via the biofuels field bet. Palm oil is an edible tropical oil produced from the fruit of palm trees. It is the most popular edible oil in China and is also popular as a feedstock for biodiesel plants, particularly in Europe. The world’s two largest producers are Indonesia and Malaysia.
There are some fairly illiquid futures contracts traded on palm oil, but these futures aren’t part of the indexes that most index funds are designed to track. Therefore, there’s essentially no index speculation in palm oil prices. But check out the chart below of palm oil prices.
Source: Bloomberg
Palm oil traded at around $425 per metric ton as recently as 2006 but currently trades at more than $1,200 per metric ton. The price has tripled even though there’s no real speculation in the palm oil market. As I highlighted in the April 2, 2008, issue, there are some very real fundamental reasons for rising palm oil prices.
Another classic example is uranium. Uranium prices aren’t included in the major commodity indexes, yet the commodity has seen a big run-up in recent years.
Uranium was trading around $10 per pound as recently as 2003. Last year, prices rallied to around $140 per pound and currently sit around $60. I highlighted this market in the April 23, 2008, issue, Electric Charge.
Neither palm oil nor uranium represents commodities that are influenced heavily by index traders. Yet both commodities have seen big run-ups in recent years.
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Crude Oil Now
For much of this year, I’ve been short-term cautious on crude oil prices and bullish on natural gas; I offered a summary of my outlook in the March 19, 2008, issue, Gas Over Oil. I’ve been wrong about oil: It’s continued to rise to record highs despite a relatively bearish inventory picture and, more recently, a bounce in the US dollar.That said, I was correct to favor natural gas over oil. Gas prices are up more than 50 percent this year compared to a less-than-30-percent jump in oil prices.
My main reasons for being cautious on oil short term were twofold. First, on the demand front, I suspected that weaker US and EU economies, coupled with high energy prices, would create demand destruction. That means consumers would scale back on their use of oil and gasoline.
There’s some sign that this is happening: The IEA recently cut its forecast for OECD oil demand for the third time this year. Evidence of this impact has the IEA forecasting a more-than-400,000-barrel-per-day decline in oil demand for North America alone.
Of course, the big surprise is that demand from the developing world has continued to pick up the slack. If anything, demand growth from these nations has actually accelerated recently. Demand from Asia alone is expected to rise more than 700,000 barrels per day in 2008.
My second reason for cautiousness on oil had to do with short-term inventory conditions. Inventories of crude oil and gasoline looked sufficient in the US and many countries across the developed world. But there’s a notable shift underway on the inventory front. Check out the two charts below.
Source: EIA
Source: EIA
The first chart shows US crude oil inventories on a seasonal basis since the beginning of 2008. The second chart is in exactly the same format but depicts gasoline prices.
It’s clear that US crude oil inventories have been at or above average on a seasonal basis for most of 2008. On the chart, the dark-blue line representing this year’s inventories has remained above the turquoise line representing the five-year average. But recently, crude oil inventories have taken a quick dive below average levels.
Much of this quick dive is due to fog in the Houston Shipping channel that has prevented the normal flow of oil imports into the US. Nonetheless, no matter what the reason, crude oil inventories look at or slightly below average for this time of year.
The shift in the gasoline market is even more stark over the past few weeks. Note that in mid- to late March, US gasoline inventories were extremely bloated: They weren’t only above average but at five-year highs. This glut of gasoline is one reason that gasoline prices haven’t risen as quickly as crude oil prices in 2008.
As I explained at great length in the March 19, 2008, issue, bloated gasoline inventories are particularly bad news for refiners because they don’t make money from rising crude oil prices. In fact, refiners must actually buy crude oil as a raw material for their refineries. Therefore, when crude prices rise, refiners’ costs actually increase.
What refiners do sell is refined products, such as gasoline. Therefore, these companies actually profit from the spread between the cost of crude and the value of the refined products they sell.
If the price of gasoline rises faster than the price of crude, profit margins for refiners would tend to expand. And refiners can, of course, actually make money when crude oil prices are falling. For example, if crude prices are drifting lower but gasoline costs are rising or remaining steady, this will support refiners’ margins.
The basic measure of a refiner’s profitability is what’s known as a crack spread. The term comes from the fact that refiners are said to “crack” a barrel of crude to make refined products. The crack spread is generally calculated by comparing the cost of crude oil futures with the price of refined products futures–typically gasoline and heating oil futures. Check out the chart of the 3-2-1 crack spread below for a closer look.
Source: Bloomberg
The basic interpretation of this chart is simple: When the line is high or rising, that’s bullish for refiners because it implies the profit margins of running their operations is on the rise.
There’s an important seasonal trend to watch in the crack spread. In particular, note how the crack spread rose between February and early summer in both 2006 and 2007. This is normal action because refiners’ margins tend to rise as refineries gear up for the summer driving season.
But this seasonal run-up in crack spreads just didn’t emerge in 2008. The reason was that gasoline inventories were extremely bloated; that put a cap on gasoline prices. Therefore, the price of gasoline actually rose at a slower pace than the price of oil, squeezing refiners’ profit margins.
What has happened over the past few months is that refiners, facing weak crack spreads, have scaled back their operations. They’ve literally shut down part of their operations or have chosen to undertake maintenance rather than refining more gasoline. Refinery utilization–a measure of the percentage of US refining capacity that’s actually running–has been hovering at less than 90 percent for most of this year. In a strong market for crack spreads, it wouldn’t be unusual to see refineries push utilization into the mid-90 percent range.
Refiners’ decision to reduce throughput has finally had an impact: Reduced gasoline production has brought gasoline inventories back in line with historical norms. And with gasoline inventories now below average, crack spreads are once again spiking higher.
To make a long story short, one of my major concerns for oil prices this year has been bloated inventories of oil and refined products. Now that that headwind appears to have abated, stocks are close to average for this time of year.
Bottom line: There are some key crosscurrents in the oil markets right now. I see the idea that speculators are solely to blame for a jump in crude oil prices as a red herring.
Nonetheless, there’s further headline risk from the CFTC and congressional investigations. New regulations aimed at curtailing speculation could cause a short-term dip in oil prices. Longer term, however, speculators could just move their business to foreign futures markets with lighter regulations, so the impact of any new laws would be meaningless.
Demand trends overall look weak in the developed world and, in particular, North America. However, strengthening demand from the emerging markets has offset that slack to a great degree.
Supply growth looks challenged, particularly in non-OPEC countries including Russia, Norway and Mexico. And inventories look to be roughly in line with seasonal norms.
My outlook for oil prices is that we’ll likely see crude trade in a volatile range around current prices. I can’t rule out a significant pullback; after all, that’s only natural, given the run-up in crude prices we’ve witnessed since the beginning of 2008. However, I see no fundamental reason for prices to collapse.
At the same time, prices will likely be capped by continued softness in demand from the developed world and normal inventories for this time of year.
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How to Play It
As I’ve noted in the past few issues of TES, I currently prefer stocks leveraged to the natural gas market rather than crude oil. Natural gas has been depressed for most of the past three years and has only seen real strength this year.Meanwhile, gas is still cheap on a relative basis compared to crude oil, and the inventory picture in the US is bullish. Even better, natural gas prices in Europe are touching records and remain around $16 per million Btu (MMBtu), significantly higher than the current $12-per-MMBtu gas price in the US.
Because most North American drilling activity targets natural gas rather than oil, activity there has been weak the past few years. But with the picture for gas improving, this market is starting to really take off.
A preference for stocks leveraged to gas also includes companies with significant exposure to North America. I highlighted several of these in the May 7 issue. I’m raising my buy targets on Nabors Industries and Hercules Offshore, both contract drillers with significant leverage to North American gas drilling. Both were highlighted at some length in the May 7 issue.
In the March 19, 2008, issue, I highlighted some concerns about refining stocks and cut our only direct play on that industry, Valero Energy, from a buy to a hold. My rationale for a cautious stance on the group was that crack spreads were weak through the spring, a period during which spreads tend to widen. This scenario is clearly visible on the chart I highlighted above.
In addition, I argued that bloated gasoline inventories would put downside pressure on gasoline prices and, therefore, crack spreads. Overall, this call was correct: Refiners have underperformed the energy patch since mid-March; the Philadelphia Oil Services Index is up around 25 percent since that time, compared to just a 6 percent gain for Valero.
And longer term, I have some concerns about new refining capacity expansions due to come online over the next few years. As this supply comes online, it could put downside pressure on margins.
But over the next six to nine months, the refiners look like a compelling play. As I noted earlier, gasoline inventories are now back in line with seasonal norms; it’s likely gasoline prices will now rally further relative to crude oil. In fact, we’re already seeing an obvious spike in crack spreads.
Valero remains an outstanding play on a recovery in refining margins. Unlike most energy stocks, the company has been weak this year, and in an improving margin environment, I’d expect to see the stock play catch-up with the rest of the energy patch.
From a company-specific standpoint, Valero is attractive for three reasons: superior geographic exposure, refinery complexity and a new focus on profitability. To the first point, Valero has refineries located all over the US; because refining margins can vary greatly between regions, this ensures the company has exposure to the most-profitable markets.
Second, Valero has some of the most complex refineries in the US. I explained complexity at some length in the March 21, 2007, issue, Looking Refined.
To summarize, not all crude oils are alike. Some grades known as sour oils have a high sulphur content and others, known as heavy oil, are more difficult to refine. Lower-quality grades of crude can trade at a huge discount to West Texas Intermediate (WTI), the benchmark crude in the US used as the basis for the New York Mercantile Exchange futures contract.
Therefore, refiners with complex facilities can purchase heavy, sour oils at a considerable discount to WTI prices. This allows those refiners to earn higher profit margins. Check out the chart below.
Source: Bloomberg
This chart shows the cost of one barrel of light, sweet crude oil (WTI) minus the price of one barrel of heavy, sour crude oil (a Mexican benchmark known as Maya). When this number increases, WTI is trading at a larger premium to Maya. The higher this spread, the more beneficial it is for refiners to purchase lower grades of crude.
As you can clearly see, the spread between WTI and Maya is unusually high right now. This plays right into the hands of Valero.
Finally, Valero is executing its plans to sell off smaller, less-profitable operations and focus on investing in its most-profitable facilities. Management has been using the cash to buyback stock and increase dividend payout.
These are both shareholder-friendly moves. I’m now recommending Valero Energy as a buy under 60. If crack spreads continue to rise, as I expect, the stock could easily rally to the $70 region over the next few months.
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Portfolio Update
Tullow Oil—London-based E&P firm Tullow recently surged to a fresh all-time high after the company reported exploration success offshore Ghana.Tullow has more drilling licenses in Africa than any other E&P. The company noted in a statement that a well offshore Ghana encountered a lengthy column of light oil and was producing above the company’s expectations. Tullow has plans to increase oil production from the current 70,000 to 75,000 barrels per day to as high as 250,000 by the end of 2010.
Tullow drills far higher risk wells than my US-based E&P recommendations such as XTO Energy and EOG Resources. Nonetheless, it has an unbeatable position in Africa and has the potential to grow its production rapidly. Up close to 100 percent from my original recommendation one year ago, I’m cutting Tullow Oil to a hold for now.
Peabody Energy and Patriot Coal—Coal prices have been soaring recently, given strong demand for coal exports to Europe and Asia. Domestic US utilities are now in heated competition for US coal, with foreign utilities willing to pay top dollar to import the commodity.
Peabody announced in early June that its 2008 earnings could rise as much as 88 percent over 2007 levels. The company, indicating it saw strong demand for coal reaching into 2009 and 2010, also made bullish statements on coal prices. I’m raising my buy target for Peabody Energy to 75; Patriot Coal remains a hold.
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Speaking Engagements
Be sure to wear a flower in your hair when you venture west to San Francisco. I’ll be heading to “The City” with Neil George and Roger Conrad Aug. 7-10, 2008, for the San Francisco Money Show.Neil, Roger and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.
Click here or call 800-970-4355 and refer to priority code 011361 to attend as our guest.
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