ENERGY SECTOR FACES UNCERTAIN FUTURE
Falling Demand
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
January 19, 2007

Plunging oil prices are bringing major players in the market to the brink of having to make significant decisions. Their conclusions are likely to ripple through the marketplace for the next several months.

Prices for gasoline might have reached high enough levels to have dampened demand for crude oil in 2006, perhaps as early as the middle of the year, setting up the potential for lower prices says the International Energy Agency.

If the IEA is correct, and conditions have not changed, then the current decline in crude oil might be the first leg in a protracted decline for the price of oil.

If the analysis is correct, then the world's financial system is about to face a significant redistribution of buying power, as money shifts back into the hands of oil consumers and away from producers, both OPEC and non-OPEC, setting the clock back to 1998.

The implications are huge, from the financial, environmental, and political viewpoints.

As the 2008 presidential election nears, the Democrats would love to have high oil prices as a lever against the Republicans, tying high oil prices to the war in Iraq, and offering allegations of ties in the White House to big oil. But if prices remain low, the opportunity is lost, and a new issue will have to be raised. More than likely this seems to be health care.

At least two areas of the U.S. have ridden the high price of oil to a new wave of prosperity, as the farm belt has increased corn production and has become the ethanol belt, building distilling plants and creating a new industry. At the same time, cities such as Houston and Forth Worth have enjoyed real estate booms based on high oil prices in the former, and the exploitation of the Barnett Shale, a huge natural gas deposit for the latter.

That means that real estate prices and general employment conditions in these oil boom areas could be affected in significant ways over the next few months.

In Canada, tar sands have led to huge growth in Alberta, at the cost of what some are describing as significant environmental damage, and rising emissions of greenhouse gases.

And in parts of Indonesia and Asia, deforestation and illegal logging have risen dramatically as developers increase farm land to produce feedstock for biofuels.

If the biofuel and tar sand boom ends or is significantly reduced, long term environmental damage will eventually have its consequences.

Politically, three countries have ridden the price of oil to new prominence in the world: Russia, Venezuela, and Iran.

Russia has used its vast natural gas and oil resources to remove foreign energy companies as major players in its energy industry, as well as having flexed its muscles against Europe and its former republics by shutting down natural gas flow to various customers over the last 14 months.

Venezuela has turned high oil prices into a platform for socialism and wealth redistribution. And Iran has used the opportunity to position itself as a resurgent regional player in Middle East politics.

Yet, much of the success enjoyed by cities such as Houston, regions such as the farm belt, and countries such as Iran, have been built on the assumption that oil prices would remain at historically high prices, a notion fueled by the Peak Oil theory, and a consensus among analysts that due to production bottlenecks, the situation would not change for the foreseeable future.

But, if oil demand is dropping, and biofuel production is on the rise, it could be that both sides are likely to lose, at least based on the principle that oversupply will lead to falling prices.

So here are the two key points to ponder:

1. OPEC and Non-OPEC producers have continued to produce at very high levels, despite recent agreements to cut production. If the cartel wasn't cheating, then it would be hard to explain the continued buildup of supplies in the U.S. based on the weekly estimates supplied by the Energy Information Agency, with the latest figures showing much larger builds than expected, especially for crude.

2. According to a bevy of reports, biofuel plant production is on a near meteoric rise, with the Wall Street Journal reporting: "Forecasts by the IEA suggest biofuels output could rise to the equivalent of more than five million barrels of crude oil a day by 2011, close to triple output of such fuels in 2005."

Chart Courtesy of StockCharts.com

ADM has lost nearly 35% of its value since topping out in May of 2006, a full three months before oil topped out in August.

The break in ADM coincides with a top in both its revenues and earnings for the June 2006 quarter, while the company's outlook looks less than stellar, at least for growth, due to the expectations of a smaller than expected corn crop, according to the U.S. Department of Agriculture's most recent crop estimate.

Charts don't lie. And if we take ADM's action at face value, as the market sees it, the bust in ethanol has been under way for months.

Conclusion

The energy sector is at a crossroads. A case can be made for the fact that prices reached levels high enough to change consumer behavior. Smaller cars, changes in driving habits, and milder weather have likely contributed to decreasing demand.

At the same time, production of both traditional and alternative fuels has been growing.

This combination might have created a mini-glut of supply, while demand has stalled.

From our point, this is a plausible scenario, which the market has clearly priced in, and may continue to price in, at least in the short term.

The fly in the ointment is the geopolitical aspect. Iran, Russia, and Venezuela have a lot to lose, on multiple levels, if the price of oil continues to fall. It is clearly in their best interest for something to happen to bring back the geopolitical premium to the marketplace.

That may or may not any practical bearing on the price, at least not in the short term. But, it is something to keep in mind, given the fact that desperate people tend to do desperate things.

© 2007 Joe Duarte, M.D.
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