Supplying the Energy Demand

The obvious questions: How low can oil go, and when can we expect a turn? Although it’s next to impossible to call a turn exactly, the fundamentals for oil and gas don’t support current depressed prices. In particular, natural gas looks poised for a rebound as we enter the peak of the winter heating season.

Here’s my take on the current outlook for oil prices. I’ll offer a more detailed outlook on natural gas in a series of upcoming posts on the financial blog, At These Levels.

The primary fundamental driver of the crude oil market right now is simple: global oil demand.

The US economy is in recession and so are some of Europe’s largest member states. I suspect that the US recession will be longer and more severe than either the 2001 retrenchment or the recession of the early 1990s. Check out the chart below for a closer look.

Source: National Bureau of Economic Research, Bloomberg

This chart shows the year-over-year change in the US index of leading economic indicators (LEI) going back to the early ’80s. The LEI is nothing more than an index that summarizes the performance of 10 key economic indicators, including building permits, stock prices, interest rate spreads and manufacturing orders.

When it comes to economic analysis, sometimes it helps to keep it simple. When the year-over-year change in LEI falls below zero, the US is likely slipping into recession. As you can see, the LEI called the recessions in 2001, the early ’90s and the early ’80s.

The official definition of a recession is NOT two consecutive quarters of negative Gross Domestic Product (GDP) growth--as some contend. Rather, the Business Cycle Dating Committee of the National Bureau of Economic Research looks at a wide variety of indicators to fix the official start and end dates for US recessions.

As my friend and colleague Ben Shepherd pointed out in a post yesterday on At These Levels, the head of this committee said on Friday that we’re definitely in a recession. The National Bureau of Economic Research (NBER) now appears to be trying to determine the official start date of that contraction. If there was any doubt in your mind about the recession, there shouldn’t be now.

My guess: NBER will ultimately peg the start date of the recession in late 2007 or very early in 2008. This is roughly the time when the LEI first turned negative.

That means that the contraction has already been underway for roughly one year. The last two recessions in the US were short, totaling 8 months each. My guess is that this recession will be more severe, perhaps lasting 16 to 18 months – this would put it on a par with the recession in 1973/74 and 1981/1982. If that proves correct, the US should begin to see recovery in the latter half of 2009.

To make a long story short, this economic slump is having a profound effect on US oil demand. According to the Energy Information Administration’s (EIA) most recent Short-Term Energy Outlook, developed world oil demand is projected to decline by 2.2 million barrels per day between 2007 and 2009 with most of that decline coming from the US.

This will be offset by a 2.3 million-barrels-per-day day jump in developing world oil demand. But with oil demand growth of just 100,000 barrels per day in 2008 and 2009 combined, this will represent the slowest rate of demand increase globally since 1993. The most recent EIA outlook showed a big downward revision in expected oil demand from the developed world. 

The downward revisions in 2008 and 2009 oil consumption are a direct consequence of the severe credit crunch that gripped the market in September and October. Check out the chart below.

This chart shows the so-called TED Spread. This spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR). The three-month US Treasury yield is essentially a risk-free interest rate. LIBOR is the rate that banks charge to lend each other money. The more elevated the TED spread, the more pervasive the sense of fear in credit markets.

You can clearly see the massive spike in the TED spread in September and October. In fact, this period saw record highs for this key spread indicating extreme credit market distress.

Concerted government action has helped eased the crunch. By injecting capital directly into the banking system, governments seem to have eased concerns about massive bankruptcies in the financial space. The TED spread has declined to it slowest levels since before Lehman Brothers declared bankruptcy.

But some of the damage was already done. This is clearly visible in government statistics such as auto sales. New vehicle sales in the US slumped to the lowest level since the early ’90s recently as consumers simply couldn’t get access to credit. See the chart below.

In short: The initial decline in oil prices from the $150 per barrel region to around $90 to $100 per barrel was warranted in light of slowing global demand. The correction to recent levels was due, in large part, to the credit panic that kicked off this autumn.

The market is now focused on demand, but supply will become the bigger issue as we move through 2009. This morning, the International Energy Agency (IEA) released its annual World Energy Outlook. It’s an 800-page document, so I haven’t had time to digest it completely.

But one of the key points of the report is that global oil supply is troubled. Specifically, the IEA projects that the world will need to spend more than $26 trillion dollars between now and 2030 to meet rapidly growing demand for oil from the developing world. Although 2008 and 2009 may mark a temporary lull in demand, the long-term consumption growth story is very much intact for countries such as China and India.

That amounts to more than $1 trillion annually on energy infrastructure, exploration and development. Without that level of spending, supplies will fall short of demand, and prices could shoot sharply higher.

Current depressed oil prices are insufficient to attract spending on the order of $1 trillion annually. In fact, we’re already seeing evidence of a retrenchment in spending in certain regions of the world. For example, Brazil will likely have to delay the production of its massive deepwater fields because the Brazilian drilling contractors it was planning to employ just can’t raise enough capital to build crucial equipment.

And many smaller and mid-size producers in the North Sea and parts of Africa are traded on London’s Alternative Investment Market (AIM). Many of these firms were funding their drilling in large part with debt capital. That major source of funding has dried up, and they’re pulling in their capital spending plans. Ultimately, this will lead to falling global oil supplies.

If I’m correct in my estimate that the US recession will end in the latter half of 2009, global oil demand should reaccelerate into 2010. That demand will be tough to meet with global oil supplies falling. This leaves open the very real possibility of a super-spike in oil prices to $150 to $200 per barrel as early as 2010. The longer prices and spending remain depressed, the higher oil prices will ultimately run.

As oil service giant Schlumberger stated in its conference call last month, even if demand for oil remains flat, falling capital spending will rebalance the oil markets within 18 months.

Demand woes currently dominate the crude oil market. Since both the S&P 500 and crude are attempting to discount the severity of the US recession,   oil prices will likely continue to be correlated to the path of the S&P 500. I’m looking for a year-end rally in both stocks and oil based on continue normalization in global credit markets.

I prefer owning energy-levered stocks to the commodities themselves. The reason is that the broader energy indexes are currently trading at their cheapest valuation since the ’98 lows. Back then, oil was trading under $20 per barrel and natural gas was under $2/MMBtu. This is a total overshoot to the downside of actual fundamentals. Investors are, quite simply, getting the bargain of the decade. By the end of 2009, I believe we’ll once again be discussing new highs for key energy indexes such as the Philadelphia Oil Services Index.

For those reluctant to ride out the gyrations in many energy stocks, consider the three high-yielding income ideas I highlighted in the most recent issues of both TEL and my paid newsletter The Energy Strategist. You can quite easily pick up yields in the 10 to 15 percent range in the current environment, and there’s very little risk of a cut in dividends--even if commodity prices remain depressed for a while longer.

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