Too Far, Too Fast: The Trouble with $100 Oil
Today’s commentary is by Eric Roseman, The Sovereign Society’s Investment Director and editor of Commodity Trend Alert.
Dear A-Letter Reader,
It’s hard to believe the world’s largest economy is stuck in a recession while energy prices remain near all-time highs.
Something's got to give – and I’m betting it’s going to be energy. In fact, I’d say that by the end of the year, crude oil and the rest of the energy complex will suffer a long overdue correction. That’s because I see global demand slowing amid a decline in consumption and growing inventories.
Today at 10:30 AM, the U.S. Energy Department released the weekly crude oil inventories. According to the most recent numbers, oil inventories rose again this week, although somewhat less than expected.
While you can't place too much emphasis on a single data point, the inventory trend has been no friend to energy bulls in recent months. That's because gasoline inventories reached the highest in level in 15-years recently, until a small drawdown last week. This is hard evidence of falling energy demand in the United States.
And I’ve got some smart money who agrees with me…
One of the legends in the oil industry is also making big bets against oil this year. That’s after this legend rode the oil bull for the last six years all the way to the bank.
What Goes Up Must Eventually Come Down
Soaring Oil as U.S. Growth Slows?
For the first time in the post-WWII period, the price of spot crude is actually rising at the same time the world’s largest economy is contracting.
From an all-time high of US$111.80 per barrel on March 17, 2008, West Texas intermediate crude oil has declined to US$100 this week. Still, prices are up over 60% over the last 12 months. Meanwhile, other distillate fuels have also surged since March 2007. Gasoline, natural gas, heating oil, diesel, jet fuel – you name it, the entire complex has literally gone through the roof!
But energy is still a dangerous speculation at these lofty levels because of the growing recession in the United States. There will be a contraction in overall demand combined with a slowdown in most major and even emerging market economies. Plus, soaring oil prices have also reduced net demand as prices finally hit the upper end of what the market can absorb.
U.S. Demand Declining since 2006
True, the world needs oil. However, even a hot commodity like oil is forcing companies, individuals and governments alike to look beyond Black Gold. Instead, they’re boosting alternative fuels like coal, wind, solar, nuclear fuel and ethanol to supplement high prices.
Alternative fuels remain very cheap relative to oil and gas. Consumption is also growing, especially for cheap coal and increasingly, nuclear energy where uranium prices have plunged more than 25% year-over-year.
According to the EIA or the Energy Information Agency, U.S. total demand for crude oil in 2007 actually changed from the 2006 levels at 20.6 million barrels per day. And consumption is slowing in 2008 as the economy suffers from the tribulations of a housing bear market, a credit crunch and broad-based consumer slowdown.
China Can’t Support High Oil Prices Alone
It’s true that total global energy demand continues to exceed supplies by approximately 1 million barrels per day. The world is demanding 86 million barrels for every 85 million barrels of net supply.
It’s hard to imagine that China, which continues to rapidly boost consumption, can offset declining U.S. petroleum demand without triggering a major correction in oil prices this year. The United States economy might not be the powerful force it was 20 years ago, but it still remains a formidable consumer of almost every raw material, including oil.
Investors and especially speculators wrongly assume that oil demand is elastic, or that high prices will command a buyer. That’s simply not the case and proof is the growing transition from energy-based fuel consumption to alternative fuels this decade amid Peak Oil.
A high price for any commodity will ultimately encourage research and eventually, consumption into a cheaper alternative. This largely explains why we’ve seen a boom in nuclear energy, coal, wind and solar energy this decade. Consumers simply won’t pay a high price indefinitely.
Texas Oil Maverick Turns Bearish
Inventories are rising for most refined products this spring. These high inventories are setting the stage for a major price decline. Speculators are finally pulling the trigger on one of the most lucrative commodity trades since 2002.
Recognizing the shift in consumption and rising inventories, Texas oil maverick, T. Boone Pickens, has turned bearish on oil in 2008. His hedge funds, which have earned a fortune for investors are now shorting oil.
Pickens’ funds were down 14% the first two months of this year, but are making a major comeback with their oil holdings. His funds just scored direct hits when crude slid from US$111 a barrel last week. Pickens believes large speculators are heavily long crude oil and in the absence of demand-side fundamentals are priming themselves for a major spill.
Mr. Pickens, by the way, is not alone betting against oil in 2008.
Long-Term Bull, Short-Term Bear
My Commodity Trend Alert (CTA) service has been recommending a reverse-index exchange traded oil fund since last fall.
I expect oil and gas stocks to break down. This trend is actually already underway because many energy stocks have disconnected from the oil price recently. That’s a bearish sign. Even with oil trading around US$100 a barrel, we’re sporting a small profit on this trade since late 2007!
Longer term, oil prices are likely to head much higher. Global economic growth will accelerate long-term, and China and other emerging powers will devour more energy and refined products derived from oil.
Also, the world is not replacing its annual production compared to 35 years ago. That means we are consuming more oil than we can replace every year.
But no bull market is uninterrupted. Commodities suffer violent corrections, particularly following blistering gains.
Oil prices will decline this year, probably to the US$75 or US$65 per barrel range. The actual price depends on the severity of the U.S. economic recession and whether foreign economies catch a similar cold, or at the very least, downshift from a strong growth trend since 2003.
ERIC ROSEMAN, Investment Director
P.S. As I mentioned, long-term there will be stunning opportunities in energy – particularly in crude. But in the short-term, I’m preparing my subscribers for a nice pullback. Try out my Commodity Trend Alert service today to find out how to play both sides of this energy story – the long and the short.
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