Muted outlook for oil prices

As prices start moving sharply upwards at the pumps, it’s inevitable clients will be asking about oil as an investment. But the outlook for oil prices is not as strong as the recent run-up would suggest, according to number of analysts.

The price of a barrel of oil has accompanied the stock market rally going from the low US$33 to around US$60. No doubt investors remember the heady days of 2008, with oil at more than $140 a barrel. It’s not hard to see oil prices having a lot of upside potential — we’ve been there. But the recent run-up is not a sprint to new highs; rather oil prices seem to be taking into account that the worst demand destruction that accompanied the global recession has slowed.

Over the near term, a rise in oil prices well beyond what they stand at now is not expected, according to a new Banc of America Securities-Merrill Lynch research report. If oil prices were to start flirting with $100 a barrel price again, then the global economic recovery would probably start to falter. In other words, cheap energy prices along with low interest rates are the most important current drivers of growth.

“In a way, the recent sharp liquidity increases by OECD and Emerging Market central banks are contributing to fuel a strong rebound in emerging market equity and commodity prices. However, a very fast increase in oil prices in the coming months could also put the embryonic economic recovery at risk,” according to Francisco Blanch, the firm’s head of Global Commodities Research. “How high could oil go near-term? In OECD economies, our economists believe that $70-to-$80/bbl oil could start to pose a risk to the recovery, while the risks to emerging market growth would come in at $90-100/bbl.”

When the global recession took hold and demand dropped very low, producers in the OPEC nations responded in kind by decreasing supply. As it stands, the world’s oil producing nations still have more than 6 million barrels of excess capacity should demand start returning to the marketplace.

“OPEC has plenty of spare crude production capacity and refining is no longer the bottleneck that it was. The recent output disruption in Nigeria — where production is reportedly down to 1.2 million b/d at present from an average of 1.8 million b/d in the last six months — is contributing to push oil prices higher in the near-term,” Blanch says. “But spare OPEC capacity still stands at 6 million b/d, and we believe key members would step in to increase output should WTI crude oil prices breach the $80/bbl mark in the coming months.”

According to Peter Buchanan, a senior economist with CIBC World Markets Inc., demand in the most important oil consuming nation in the world, the United States, remains quite low.

Buchanan notes there is a lot of emphasis on the emerging market recovery right now, which some commentators say is a fundamental driver of oil price growth. But countries like China and India still only represent a tenth of the world’s oil market. They do have potential to add significant strain, though, when demand in the industrialized world comes back online. And this strain will only grow as they continue to increase their need for energy.

“If you look at the U.S., the most recent demand numbers are still relatively soft and inventories remain quite high. Overall oil demand is down over the last four weeks in the United States between 7% to 8% year-over-year. Quite clearly that is impacted by the economy,” Buchanan says. “As far as target for oil prices — we’ll probably be revising them up — but right now we’re looking at $53 a barrel for this year, and $64 a barrel for next year. Those may be on the low side, but I don’t think you’re going to see oil go materially above $70, because you’ll see a lot more countries in OPEC quietly increasing their output if it does.”

Investors do need to consider that excess capacity will do little to offset the long-term implications of this downturn, which has created a halt in much-needed oil exploration. When the economy has actually reached a recovery, then you have oil back at capacity, plus there will be excess burden of the emerging market economies, which are greatly increasing their proportional share of demand.

“I think certainly demand in the U.S. is going to rise with the economy. You may see demand turn positive later this year, which would be a big comeback from the 7 to 8% decline,” Buchanan says. “Chinese auto sales are already quite strong, and the latest forecasts having them surpass the U.S. in terms of unit sales on a yearly basis.”

A report released Monday by BMO Economics warns the world may eventually be facing an environment of increased global demand for oil amongst substantially reduced supply.

“Even with recent price increases and recession-induced declines in costs, oil prices are not high enough to spur the development and production of new, longer-term resources in oil sands and deepwater fields. In the Canadian oil sands, where the all-in, longer-term cost, including a normal rate of return, exceeds $70 a barrel to develop and produce new resources, investment is slated to drop sharply this year,” the BMO report says.

In the meantime, though, there is a substantial oversupply, the BMO report notes.

“In the United States, crude inventories are still setting new five-year highs by a wide margin, although recently they fell on lower imports. While steep production cuts by OPEC will likely erode the inventory overhang over the next year, supplies are currently high enough to put a hold on a further rally in crude prices,” the report says. “However, as excess inventories are reduced, another up-leg in the rally will likely get underway later in the year as signs of global economic recovery cumulate and winter approaches. We project WTI to average $52/barrel in 2009 and $65 in 2010.”

(05/26/09)