Global Crude Oil Demand
Forecast to Rise in 2010

Natural Gas Outlook Improving

by Joseph Dancy, LSGI Advisors, Inc. | March 16, 2010

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The International Energy Agency (IEA) last month updated their global crude oil forecast. Demand is expected to increase to 86.5 million barrels a day in 2010, up 1.9%. This is 1.6 million barrels a day higher than the 84.9 million barrels per day seen in 2009. Projected demand was increased from  IEA’s January report.

Higher demand should help balance the market and should support current crude oil prices - if not provide an upward bias going into 2010 (oil price chart courtesy Hays Advisory). 

Demand growth will come from Asia and developing economies according to the IEA. Demand from more developed countries in Europe, North America, and Japan should remain stagnant according to their forecast.

China, the world’s second-largest energy consumer, increased crude oil imports to a record 4.1 million barrels a day last year according to China’s government generated data. Demand is expected to continue increasing into 2010, with China oil imports expected to rise to 4.5 million barrels per day. 

Peak Demand. The chief economist of the IEA claimed crude oil demand in developed industrialized countries will never return to 2006 and 2007 levels last month because of more fuel efficiency in motor vehicles and the growing use of alternative fuels,. The prediction, while made previously by some analysts, is significant because the IEA advises 28 countries on energy policy and its oil-demand forecasts are closely watched by traders and policymakers.

"When we look at the OECD countries - the U.S., Europe and Japan - I think the level of demand that we have seen in 2006 and 2007, we will never see again," the IEA’s Fatih Birol noted. "There may be some zigzags up and down but as a trend I think it will be a downward trend in terms of oil consumption."

Developing countries are expected to increase their use of crude oil, which will increase global demand according to the IEA. Historically global crude oil use has slowly increased year after year, the trend moving upward (chart courtesy Macquarie Capital (USA) Inc.).

We are skeptical that demand has peaked at current prices in the developed world. Crude oil is the ideal fuel for transportation with a very high energy density, easy to store, stable, has few environmental effects when burned using modern environmental controls, and has a huge infrastructure to deliver the fuel in place globally. Electric, natural gas, or pure ethanol fueled vehicles will have difficulty establishing a meaningful market share absent significant price increases in the price of crude oil and gasoline.  We think the sluggish demand for oil reflects the poor economic growth seen in the developed nations. When economic growth returns we think demand will return unless crude oil prices move sharply upward.

Volatility & Price Forecasts.  The head of the IEA also warned last month that countries must brace for a return of wild crude oil price swings as the global economy recovers. He noted "the cheap energy age is over, and we have to prepare for that in the government and private sector."

IEA officials claim that "the market could easily become again more volatile once the world economy grows again and the supply tightens." They urged governments to open access to energy reserves, and said "encouraging investment on the production side could lessen volatility."

Northern Trust also issued a bullish report on the energy sector last month. They noted:

“We think energy prices, especially the price of oil, face a supply-constrained future. Already, the increase in prices had led to an OPEC quota compliance of just 60%, as the Saudis are sensitive to the risk that high oil prices pose to global economic growth. In a scenario where the global economy continues to accelerate and the dollar resumes its decline, energy prices could move significantly higher from current levels.”

On a like note Bank of America and Barclays Capital, two leading oil traders, have told clients to brace for crude above $100 a barrel by next year, before it pushes higher over the decade. This would be in stark contrast from recessions in the 1980s and 1990s, when it took years to work off excess production capacity built in the boom.

"The groundwork for the next sustained step up in oil prices is now almost complete. Global spare capacity is likely to be reduced to low levels within a relatively short time. The global economic crisis has postponed, but not cancelled, a crunch which would otherwise be starting to bite now," said Barclays.

Francisco Blanch, from Bank of America Merrill Lynch, said crude may touch $105 next year, with $150 in
sight by 2014. "Approximately 1.7 billion consumers in emerging markets with a per capita income of $5,000 to $20,000 are eagerly waiting to buy cars, air-conditioning units, or white goods," he claims.

U.K. Industry Taskforce Report.  In a report released last month by the U.K. Industry Taskforce on Peak Oil the authors claim a shortage of crude oil could be a major problem for the world within a fairly short period of time. The report concluded the global downturn may have delayed peak oil production levels for crude oil by a couple of years. They conclude the point at which global production reaches its maximum is no more than five years away. Authors include Sir Richard Branson and other U.K. executives. 

The report recommends that governments and corporations use the next few years to speed up the development of alternative energy, and move toward technology that will increase energy efficiency.

The Taskforce report highlights how much modern economies depend on oil, whether for transport, heating, chemicals, or fertilizer. Demand may have peaked in the developed world according to the report (although we find this claim difficult to accept), but any shrinkage in demand in developed economies is likely to be more than outweighed by growth in demand in the developing countries with their rapidly expanding appetite for energy to fuel industry and consumer aspirations.

The IEA projects global demand for oil in 2010 will be 86.5 million barrels a day. The Taskforce, assimilating various opinions, believes 92 million barrels a day will be the most that global supplies will be able to generate, "unless some unforeseen giant, and easily accessible, finds are reported very soon."  What lies ahead is a mismatch between supply and demand, and much higher and more volatile prices (chart courtesy Macquarie Capital (USA) Inc.).

Stock Market & Energy Prices.  Stock prices have had a very low correlation, and in some cases a slight negative correlation, to energy prices historically. But over the last 18 months the price of U.S. stocks and the price of commodities as measured by the S&P GSCI index (mostly an energy index) are moving together more closely than at any time in the last 20 years. The GSCI index is weighted 70% in the energy sector and 19% in the agricultural and livestock sector.

The correlation coefficient between the S&P 500 and the S&P GSCI index has spiked upward to 0.58 based on a 250-day average, meaning 58% of the movement in the S&P 500 is statistically explained by the movement of the commodity index. The correlation is at its highest level since it began its surge in September, 2008. The upward movement of the correlation coefficient between the two statistical measures is quite striking when charted (chart courtesy Globe & Mail).

We also examined the correlation between the Russell 2000 Small Cap Index and the price of crude oil as measured by the U.S. Oil Fund ETF (USO) using a 250-day average and found a similar relationship. In the week ending February 26th the price of crude oil explained 59% of the movement of the Russell 2000 index. A month earlier the price of crude oil explained 71% of the movement of the Russell index. A year ago the correlation between oil prices and the Russell 2000 stock index was negative. 

One train of thought regarding the high correlation is that the statistical relationship will revert to normal. The performance of the S&P 500 and commodities prices will ‘delink’. In most of the time since 1991 there is zero correlation, or even a slight negative correlation, between the commodities index and the S&P 500. 

From an investment standpoint we would like to see the relationship between commodity prices and stock prices delink. We think the pricing relationship will gradually return to ‘normal’ over the next year. The lower correlation between the commodity and equity asset classes allows investors to better manage risk, and can be used to reduce portfolio volatility. It also assists active portfolio managers in their quest to generate excess returns without taking undue risks.

U.S. Natural Gas Markets Improving

The Energy Information Administration released natural gas production data late last month for the month of December. Their EIA 914 report indicated U.S. natural gas production decreased by 0.7 percent for the month. While production has declined, some expected declines to be much larger due to the slow drilling activity over the last 18 months.

Some experts claim that natural gas production declines will accelerate into 2010. Other experts claim the new economics of the shale formations mean that fewer wells can produce much more natural gas. We agree with the former opinion, natural gas production declines will accelerate. Time will tell who is correct.

The weekly draw reports from storage have been bullish. To date we have withdrawn 2,100 bcf this heating season versus 1,695 bcf in the previous season – a 23.8% increase. The current storage level is below last year’s at this time, and nearing the average storage level for the last five years.

Longer term, the declines in storage could place a floor under the price of natural gas. It appears that if current trends continue the amount of natural gas in storage could fall to levels near the low of the 5 year averages—although much of the remaining draw this season will depend on weather conditions and heating loads.

Many of the analysts we follow are forecasting natural gas prices in the $6 to $7 per mcf range in 2010 – although credible reports have forecast much higher and much lower prices based on production and drilling data. The front month futures contract is now selling for $4.75, so we see some upside going forward in both the commodity price and in the stock prices of natural gas producers.

Copyright © 2010 Joseph Dancy
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Joseph Dancy Adjunct Professor, SMU School of Law | Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter | Email | Website

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