The father of modern economics, John Maynard Keynes, was once asked in a debate how he justified changing his mind on certain key issues of his day. Keynes replied “When the facts change, I change my mind. What do you do, sir?”

Some see the eminently quotable Briton’s quip as an attempt to justify a bad call. But, Keynes wasn’t just an economist but an accomplished investor and speculator. He was simply explaining that rigid thought and an inability to adjust to market conditions are the enemies of all investors.

I haven’t changed my mind on the crude oil market. But, I have always found it useful to question my forecasts and assumptions. After all, if we don’t at least understand the other side of a debate, it’s all too easy to stubbornly cling to an outlook even as that view becomes increasingly untenable. This brings me to another famous Keynes quote: “The market can be irrational a lot longer than you can be solvent.”

Since the beginning of this oil selloff in July, it’s been my contention that crude prices won’t collapse to under $80 a barrel as some bears have suggested. Nor, in fact, will oil soar to new highs this year, following the pattern espoused by some prominent bulls.

Rather, I see crude falling into a volatile trading pattern between roughly $105 to $110 at the low end and $140 to $145 at the high end. I can see that broad range persisting well into 2009.

In the very short term, I see oil heading lower, testing the lower edge of the trading range I’ve outlined. I’ve been explaining this tactical outlook on KCI’s blog, At These Levels, over the past few weeks. Simply put, oil hasn’t been able to hold a rally for more than a day despite a steady drip of bullish news.

After all, as my friends and colleagues Roger Conrad and David Dittman pointed out in this week’s issue of Maple Leaf Memo, Why Georgia Matters, Russia’s entry into neighboring Georgia has important implications for the energy markets. However, Russia’s military action hasn’t pushed up crude. Nor did this week’s oil and gasoline inventory reports, which are the most bullish I’ve seen in months; oil rallied for a day and then promptly surrendered its gains.

Selling in the face of good news is a clear indication that rallies in oil prices are unsustainable for now. I suspect that could remain the case until we begin to move into the seasonally stronger autumn months.

The Other Point of View

But, as with any forecasts, there are risks to my outlook. To frame the debate, I’ll concentrate on the longer-term fundamental risks to my forecast for crude oil; I’ll examine the natural gas market at more depth in next week’s issue of The Energy Strategist.

Right now, many bears are focused on the demand side of the oil equation. According to the EIA, US oil demand dropped by around 800,000 barrels per day year-over-year in the first half of 2008, the largest volume drop in demand in 26 years. While 800,000 barrels a day may seem like a small amount in the context of a 20.7 million barrels a day US oil market, it’s absolutely significant.

Consider that, according to BP, China’s consumption of oil grew just 325,000 barrels a day in 2007 while demand for non-Organization of Economic Cooperation and Development (OECD) countries, a proxy for the developing world, grew 1.38 million barrels a day. Therefore, an 800,000-barrel-per-day drop in demand would offset about 60 percent of the jump in non-OECD oil consumption.

The bears argue that declining demand from developed countries coupled with a slowdown in consumption growth for the developing world will spell a glut of global oil supplies and, therefore, falling prices.

On the supply side, the oil bears’ arguments center on the potential for a big jump in global oil production over the next 18 months. Specifically, there are a number of oil production projects in Organization of the Petroleum Exporting Countries (OPEC) scheduled for start-up later this year and throughout 2009. And outside OPEC, projects in Brazil, the US Gulf and elsewhere should begin to come online at some point in 2009.

This would have the effect of easing the call on OPEC crude. In other words, total global spare capacity in the oil market currently stands at 1.2 to 1.5 million barrels per day. (Spare capacity is surplus oil production capacity that can be brought online within a month and reliably produce oil for at least 90 days.)

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Spare capacity is a function of both demand and supply. If demand for oil rises and can’t be met by rising non-OPEC supplies, OPEC must pump more oil. To increase production, Saudi Arabia must put some of its spare capacity into production; as production rises, spare capacity falls.

The bears argue that declining growth in global oil demand will allow OPEC nations to cut output without destabilizing the global oil markets. This effectively means they can add to their spare capacity. At the same time, as new production projects come online in countries such as Saudi Arabia, this further adds to OPEC’s spare capacity. Rising spare capacity would ease global supply concerns.

My Counterpoints

All of these bearish arguments have some grounding in reality and are worthy of consideration. However, I don’t see the bears’ case coming to fruition.

On the demand front, I have no argument with the concept of a decline in US demand. In fact, I was surprised by the degree to which oil prices rose in the first half of this year even as it became clear developed world oil demand was falling.

Nonetheless, a few points are worth noting about US demand. First, even as the market has become fixated on the fall in US oil consumption, that decline has begun to moderate. Consider this quote from the Energy Information Administration’s (EIA) Short-term Energy Outlook (STEO) released on Monday:

Total US petroleum and other liquids consumption is projected to shrink by almost 500,000 barrels per day in 2008…..Preliminary June and July 2008 weekly survey data indicate that year-over-year declines in total consumption, which began in August 2007, have narrowed since earlier this year. During the first 5 months of 2008, total petroleum consumption fell by an average of 900,000 barrels per day from the same period in 2007. During June and July, the year-over-year declines narrowed to just over 400,000 barrels per day.

Source: Energy Information Administration (EIA), Short-term Energy Outlook (STEO) August 2008

Let’s examine that weekly data that the STEO report highlights in graphical form.


Source: EIA

This chart shows US motor gasoline demand over the past few months. Specifically, I depict the year-over-year change in gasoline demand based on the EIA’s weekly survey data. This data isn’t as accurate as the numbers EIA releases in its monthly reports and is subject to revision. However, it’s more immediate and gives us the quickest read on trends.

In this case, it appears that the falloff in demand for gasoline is actually decelerating, not accelerating. In other words, a few weeks ago the year-over-year fall in gasoline demand was running at a greater-than-3-percent rate; now, that’s closer to 1.9 percent.

This is entirely consistent with the EIA’s comments in the STEO I quoted above. My point is simple: US gasoline demand is falling and fell sharply as prices ran up earlier this year. But the pace of that decline has moderated, perhaps because of the recent dip in gasoline prices. The data doesn’t support the idea that US demand has--or soon will--collapse.

Since late January, I’ve been writing in my paid newsletter, The Energy Strategist, that I believe the US economy is in a recession or soon will be. I also doubt that the major European Union (EU) economies can skirt a recession or, at least, a severe economic slowdown. This is becoming increasingly obvious in light of recent economic data out of the EU. It’s also increasingly being reflected in global currency markets.

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I’ve been watching the British pound particularly carefully lately. The pound sterling has collapsed from late 2007 highs around $2.10 to the $1.85 to $1.86 level more recently. I suspect sterling will ultimately retest at least the $1.75 level as Britain’s housing market continues to worsen; if anything, the market there is more vulnerable than the US to a bust. I can think of no better signal of the spread of US economic weakness to Europe.

Historically, this would have been consistent with a fall in oil prices. But, the US and Europe are no longer the drivers of oil demand growth. About 80 percent of global oil demand growth in recent years has been coming from the developing world. In fact, US and EU demand has been falling or, at best, flat in recent years.

In that regard, the developing world isn’t showing signs of faltering. In the first half of 2008, a jump in developing world consumption of 1.3 million barrels per day offset the decline in developed world demand. Thus, oil consumption globally grew by 500,000 barrels a day despite a recession in the US and growing economic dislocations in Europe.

The International Energy Agency (IEA) actually recently revised higher its expectations for global demand growth in 2009. Therefore, the data also doesn’t support the bears’ contention of a catastrophic drop in global oil demand because of a weakening global economy.

I’ve highlighted my view on global oil supply in the past so I won’t belabor the point here. Suffice it to say that expectations for growth in non-OPEC oil production have consistently disappointed expectations. Consider the pattern in non-OPEC production growth estimates for 2008.


Source: IEA

The IEA begins estimating non-OPEC production growth for the following year in July; the agency began estimating 2008 production growth in July 2007.

Last July, the IEA first published 2008 forecasts for non-OPEC production growth of nearly 1 million barrels a day. That figure has once again steadily dropped, reaching 422,000 as of the most recent report.

In fact, non-OPEC production actually fell in the first half of 2008. So the idea that it will grow for the full year suggests that the EIA and IEA are making some truly heroic assumptions for non-OPEC projects coming online in the back half of this year. Given historical patterns, I find this a dubious rationale to look for falling oil prices.

And the EIA and IEA are once again projecting some big jumps in OPEC and non-OPEC supply for 2009. This, too, looks optimistic at best.

Finally, I’m utterly puzzled by the idea that there’s a global glut of crude oil. This concept isn’t only unsupported by hard data but actually flies in the face of recent reports. According to this week’s inventory report from the EIA, US gasoline inventories are near the “lower boundary of the average range” for this time of year. Meanwhile, crude oil inventories are in the “lower half of the average range.” Despite weak demand, there’s no sign of a build in US crude oil inventories.

The same basic inventory picture is also evident across the OECD. With Saudi Arabia cutting into its spare capacity to boost production and developed world demand for oil weakening, oil inventories in the developed world should be rising. Declining OECD inventories suggests one of two facts: global oil demand is rising faster than expected or non-OPEC supply isn’t meeting expectations. I suspect the latter point.

All told, I don’t believe the bearish case for oil prices is supported by the data. Before I change my mind on oil prices I would need to see one of the following factors: non-OPEC production growth that meets or exceeds the IEA’s optimistic forecasts, a demonstrable decline in non-OECD oil demand or a real build in global oil and refined products inventories.

Speaking Engagements

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat if the federal government.

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