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Are Oil Prices Set to Rise?

Despite the economic crisis, oil prices may continue to creep up



FLICKR/XCBIKER

NEW YORK – Investors are laying the groundwork for another bull run on the energy and commodities markets, in spite of signs suggesting the overall economy is still deteriorating.

Analysts and economists are saying with some confidence that oil prices have bottomed out. And Wall Street is taking notice that spot and futures prices for West Texas Intermediate crude have risen by nearly 40 percent since hitting $33 in December. At press time, benchmark WTI was trading at close to $54 a barrel on the New York Mercantile Exchange (NYMEX).

The best data show U.S. demand for oil is still weak. On Tuesday, the American Petroleum Institute reported a 4.6-million-barrel buildup in U.S. crude stockpiles, pushing prices lower. Demand in China is off by at least 15 percent year-over-year, and other bearish economic indicators will likely keep prices volatile in the short term.

But oil market watchers say the Organization of Petroleum Exporting Countries, or OPEC, has conclusively dropped production faster than demand has fallen. The cartel, which controls roughly 40 percent of global oil production, has cut output by about 8.5 percent over the same period last year, while global demand is down by a little over 2 percent, according to the U.S. Energy Information Administration.

Citigroup energy analyst Tim Evans, who has been tracking oil and gas markets since the mid 1990s, says some economists erroneously predicted that most OPEC members would cheat on their commitments and pump above their quotas after oil prices plummeted from a record $147 a barrel last July to the mid-$30 range by the end of 2008.

Preliminary February numbers "suggest the market balance between supply and demand is tighter than it was a year ago when we were trading $110 a barrel," Evans said. "Over the longer cycle, I don't like to bet against OPEC."

The impact of the down economy has been felt more on the supply side than on demand, as reflected in OPEC's response, but especially in the sharp fall-off of new exploration and production activity in non-OPEC states, experts say.

Once economies start growing again – Moody's Investors Service expects the turnaround to start in early 2010 – supply won't be able to come on line fast enough to meet demand. That mismatch suggests energy prices are poised to begin spiking again.

Analysts believe OPEC could boost production later this year, but only if prices rise above $70 or $75 a barrel, a level deemed appropriate by OPEC states whose national budgets depend on fossil fuel exports. NYMEX traders sense crude prices returning to $60 a barrel in short order, notwithstanding the possibility of wild swings as the market responds to overall economic trends.

This is sparking early enthusiasm for oil, natural gas, industrial metals, and in some cases, even food. Lately the business press has been rife with fresh reports of hedge fund managers and other investors still holding money staking new positions in commodities. Such outside investors were a key factor in driving up demand for energy investments during the record bull run of 2007 and early 2008.

And just as energy prices are bottoming out, major financial institutions are predicting that the stock market is close to ending its wild price swings as investors respond to the federal government's unprecedented moves to breathe new life into the economy. A rebound in equities will push oil higher, NYMEX traders say.

"We're in reverse gravity right now," said oil and gas trader Jeff Grossman of BRG Brokerage. "Anyone who had to sell has already sold, the stock market is lifting its head, and remember where we've come from. You're talking about a market that is just past one-third what it was eight months ago."

Big questions remain

Still, some experts caution that it is too early to get bullish about commodities.

"I'm not convinced that we've seen the bottoms of the equities markets, and I'm a little bit worried that some of the enthusiasm is premature right now," said Jeffrey Christian, head of the New York commodities consultancy and investment firm CPM Group.

Energy products "have staged pretty healthy rallies, like 10 percent of their price over the last two or three weeks, but they all have still relatively weak fundamentals, and the same is true in the base metals," Christian said. "I'm not convinced that we're out of the woods."

While many investors are eyeing the potential upside of a near- to long-term supply-demand disparity, Christian is mindful of the still-struggling manufacturing sector – in particular, the U.S. auto industry. General Motors Corp. will soon report back to the government on the progress of its restructuring efforts, and many analysts believe the giant automaker will ask for more taxpayer money to help it weather the storm.

But with U.S. fiscal outlays already skyrocketing and negotiations on a new federal budget intensifying, Christian says Washington could balk at any requests by GM executives for fresh capital. A sharp liquidation of GM assets or a corporatewide bankruptcy would send stock markets and mercantile exchanges roiling again.

"Let's say that the U.S. government doesn't blink next Tuesday," Christian said. "You could see this nascent rally over the last two weeks evaporate rather quickly."

But most market players, including CPM Group, are confident that energy and industrial metals prices will bounce back strongly and quickly once the world economy starts to recover.

Metals and energy suppliers had already struggled at keeping pace with demand growth from 2002 to 2008. Those dynamics should return, causing many to confidently predict a return to $100 a barrel oil or even higher over the next two to five years.

Impact of government spending

The biggest unknown factor: What impact – if any – will energy markets feel from trillions of dollars being pumped into the economy by Congress and the Federal Reserve?

The markets are beginning to grow very weary over the strength of the dollar, and inflation concerns are growing as deficit projections skyrocket and the Fed prints more and more money in an attempt to get credit flowing again. In the past few years, investors have used commodities, especially oil, as a hedge against dollar depreciation and inflation.

But many economists say past precedent suggests that all this spending will probably have little or no effect on energy prices.

Historically, the correlation between commodity prices and inflation has been extremely low. Raw materials markets are traditionally volatile and have often plummeted from highs as soon as consumer prices have risen to catch them.

And the Federal Reserve has shown time and time again that it is capable of tightening the money supply quickly just as an economic recovery begins. On at least seven occasions, from the early 1980s to the 2001 recession, the Fed has managed to suck the money it had put into the economy back out through issuing bonds.

Gus Faucher, director of macroeconomics at Moody's Economy.com, predicts the Fed will do the same in 2010, successfully avoiding a commodity-driven inflationary cycle.

"I think the Fed learned from the experience that we had during the housing boom ... so when they do move to raise interest rates, they will do so aggressively," Faucher told investors and reporters Tuesday.

But the value of the dollar seems certain to sink lower.

In a note to clients issued this week, analysts at Barclays Capital argue that massive debt spending will see investors who had rushed to Treasuries and the dollar in a flight for safety rushing out just as quickly as the economy begins to perk up.

Unless the global economy fails to return to something approaching normal conditions, resistance on the part of the Fed to higher interest rates will likely cause the dollar to sink to new lows, possibly even beating last year's record devaluation, Barclays predicts. A weaker dollar will put upward pressure on oil prices.

Reprinted from Greenwire with permission from Environment & Energy Publishing, LLC. www.eenews.net, 202-628-6500

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