Short term shocks drive energy sector

It’s common sense that no rally continues forever, but it may be getting harder to persuade investors that this remains true of the energy sector. It seems every time the market gets a cooling signal, another flares up — whether it’s in the form of fresh Middle-East conflict or falling inventories.

The latest blow to supply came over the weekend, when the world’s second largest oil company, British Petroleum, suddenly shut down its pipeline from America’s largest oilfield, Prudhoe Bay, to the lower 48 states. The problem? Apparently those pipelines require more maintenance than BP had dedicated to them and corrosion had caused a leak.

To make matters worse, inventory data released on Wednesday showed that U.S. gasoline supplies had fallen far more than expected for the week ending August 4. Analysts had expected to see a decline of between 400,000 and 800,000 barrels, but reserves plummeted by 3.2 million barrels. Meanwhile, crude oil inventories were a little stronger than expected, but news of the gasoline decline sparked a renewed rally on the NYMEX.

“Either real or potential supply disruptions are a dominant factor in the marketplace,” says Garey Aitken, vice-president of equity research and co-manager of the Bissett Canadian Equity Fund.

“We see what’s happened in North American oil and gasoline prices as a result of several hundred thousand barrels a day going off line — just imagine if we lost several millions barrels a day from a Middle-East country,” he says. “It would completely change the playing field.”

Saudi Arabia and Mexico have pledged to make up the shortfall with increased shipments to the U.S. Aitken questions the substance of such a promise, though.

“Oil is at record prices in the mid-$70s. I would think if anyone had spare capacity, we would have seen it,” he speculates. “Why would they have held back in such a tight market? One field goes down and these people magically have excess capacity to come to the rescue? I’m really skeptical about that.”

Whatever spare capacity these producers can scrape together is not likely the light sweet crude that refiners prefer, but is more likely to be heavy sour crude, which is more expensive to refine.

While short-term shocks may fuel speculation, Aitken says the market is increasingly concerned about the long-term ability of the industry to increase supply.

Aitken thinks the BP pipeline situation should be viewed as an isolated incident and not an indicator of an overall state of crisis in the industry. The expense of shutting down and rebuilding far outweighs that of a proper maintenance regimen. In the case of BP, the shutdown could be partially offset by increased use of tanker vessels to deliver crude to the U.S. west coast.

“This is just another example of how fundamental issues, in this case on the supply front, can have a big impact on the global market where spare capacity is just so limited,” he says. “If we’re looking at several hundred thousand barrels a day in a market this tight, it really does have a big impact, even if it is only to persist for a few months.”

With some global consumption estimates as high as 1,000 barrels per second, any new oil discoveries would have to be extremely large to have an impact on pricing. Crude could retrench if there were a lull in the Middle-East conflict, but lasting stability in the region appears no more likely now than any time in the past 60 years.

Far more likely would be a slump in demand as a catalyst for price contraction, either as a result of recession or more aggressive use of alternatives among the largest consumer nations. While the U.S. economy has been showing signs of fatigue, the Federal Reserve is now already taking steps to avert a recession, taking a break from its credit-tightening cycle earlier this week.

While Aitken is reluctant to call an end to the energy rally, he says his fund has trimmed its positions and is now under-weighting the sector, with an allocation of about 25%.

“If people have held energy, they probably want to reassess how much of that they want in the portfolio,” he advises. “The most dangerous thing would be to make a dramatic commitment to the sector right now. That is where you have the potential to really get hurt.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(08/09/06)

Steven Lamb