BULLISH
ENERGY SECTOR SINKING THE WORLD'S ECONOMY
by Joseph Dancy,
LSGI Advisors, Inc.
Adjunct
Professor, SMU School of Law
August 15, 2004
Crude oil futures closed the month over $43 a barrel – the highest closing price since crude oil futures began trading on the Nymex exchange 21 years ago. Many analysts have been predicting that crude oil prices will slip back below the $30 a barrel range this year, but we continue to maintain worldwide demand and supply issues make this price target a longshot at best.
* Crude Oil
In July it was reported that U.S. crude oil demand increased 3.4% in the second quarter of 2004 from year earlier levels, the largest reported increase in three years. And refinery output is running flat out – at nearly 97% of capacity according to recent reports, yet it has been difficult to grow inventories of gasoline in light of strong demand. Only gasoline imports have prevented shortages.
And statistics released last month showed a striking decline in U.S. crude oil production from earlier this year—a decline in production of 5% or so (300,000 barrels per day (b/d)). The U.S. pumped 5.4 million barrels per day of oil in early July compared to 5.7 million bpd in early February according to the Energy Information Administration. The United States uses all of its domestic crude production and relies on imports of crude oil and products for the remainder of the approximately 20 million barrels of oil it burns daily.
While
refineries are operating at nearly flat out levels, some have begun to
question whether the stocks of heating oil can be replenished by next
winter in the Northeastern states. Most experts think that we have
plenty of time to fill inventories by adjusting refinery runs and
imports, but heating oil prices have been very firm for this time of
year.
Not a lot of excess refining capacity will come on line domestically either - there hasn't been a new refinery built in the U.S. in 28 years. More than 200 smaller facilities have closed. In 1981 the country had 324 operating refineries; today there are 149.
Worldwide political issues have also raised fears regarding crude oil supplies. Yukos, the Russian oil giant, produces around 1.7 million barrels of oil per day – around 2% of world supply. Due to a tax dispute with the Russian government concerns have arisen that this production may be shut in. While Yukos has temporarily been assured it can maintain current production levels, ongoing expenses and required maintenance are likely to be ignored, and the Russian government might take further actions to secure payment which could be detrimental to production levels.
In Iraq, pipelines continue to be the focus of numerous attacks aimed at disrupting exports. In July a total of 15 serious incidents or interruptions were reported – about one every other day. Most were repaired quickly according to official reports, but substantial uncertainties still exist regarding exports from this country. The infrastructure and the expertise, to say nothing of a stable business environment, needed to maintain current Iraqi production levels remains lacking in our opinion.
In Venezuela, recall elections are to be held within the next two weeks. Both sides have reportedly been arming themselves to insure the election is not ‘stolen’ by improper balloting. Regardless of the outcome of the recall election experts are concerned that dissatisfied parties might cause disruptions that will impact the export of crude oil or refined products to the U.S. Venezuela is the world’s fifth largest oil exporter.
Worldwide demand for crude oil remains strong. Concerns about a sudden reversal of China’s economy, and a drop in oil demand from Asia, were overblown. Reports indicate demand for oil in China rose by around 30% in the first six months of 2004 compared to year earlier levels as its economic growth continued at an impressive rate. Other Asian countries also reported demand increases.
* Natural Gas
Several interesting reports on the natural gas sector were released last month. One of the studies showed Canadian exports of natural gas to the U.S. continue to decline, with little growth expected over the next year. This is significant due to the fact that Canada supplies around 10% of U.S. natural gas demand.
Another study released by Lehman Brothers showed that even with all the recent U.S. drilling activity U.S. natural gas production continues to decline—by an estimated 1.8% in 2004, and 2.6% in 2005. In 2003 the Lehman analyst estimated that natural gas production fell 6.5% (an incredibly large figure). Raymond James & Associates released a study indicating U.S. gas production in the first quarter declined 4.2% over year earlier levels. Both the Lehman Brothers and Raymond James & Associates studies reach the same conclusion – natural gas supplies in the U.S. are falling at a surprisingly fast rate.
Second
quarter GDP growth in the U.S. was positive growing at a rate of around
3%, and GDP data correlates very closely with gains or declines in
electrical generation. Data compiled by the Edison Electric Institute
continues to show impressive generating gains year over year – and a
large portion of the incremental demand going will be met by natural gas
fired generating units.
Electrical demand also hit record levels in California last month—and these records are expected to fall in August. The record demand has stirred fears of blackouts, similar to what occurred on the East coast last August.
As the economy continues to grow and additions to North American natural gas supplies continue to fall, natural gas prices should remain strong.
* Coal & Hydroelectric
Last month several domestic coal companies announced that they could not get the rail capacity to ship their product to market, and issued warnings that earnings may not meet expectations due to transportation bottlenecks. The railroad companies claim they have been swamped with additional demand from the economic recovery, and shipment volumes of all goods are up sharply.
Some of the rail firms are adding crews, engines (apparently the two largest locomotive makers have production sold out for the next year), and are talking about adding track—a long term but very expensive solution. Coal prices remain firm, and new long term contracts are being signed at these higher prices by customers – a sign they see higher energy prices for some time to come.
Water levels at several of the major hydroelectric dams out West are at levels well below normal, and the issue of electrical generation schedules from these facilities is getting a bit more attention. Besides electricity, the water needed for a number of communities and agricultural areas will be a major issue should the dry weather conditions continue – conditions some have compared to the dust bowl of the 1930s.
* The Economy & Energy Sector – “This Time is Different”
With prices of crude oil, coal, and natural gas prices all nearing record levels there is no question they will impact the economy. The U.S. sends over $400 million per day overseas for oil imports – most of which goes to countries such as Saudi Arabia or Venezuela so does little to enhance worldwide economic growth.
The U.S. gross domestic product for the second quarter grew by 3% - a disappointment for economists who were calling for a much faster growth rate, but explainable due to the drag caused by higher energy prices. Many of these experts point out that most modern economies are not as dependent on energy as they have been in the past. But the fact is there is a strong positive correlation between economic growth and increased energy use.
In the past higher energy prices have slowed the economy or caused recessions, but lower energy prices generally revived the economy. The difference this time is we have explosive growth in energy demand from China and the rest of the world, and many of our major producing energy assets are quite dated and the growth in supply has begun to level off. As a result we could see higher energy prices for a much longer period than we have historically.
Higher prices will mean slower economic growth in the U.S., stagnant worldwide economic growth, and most likely weakness in the worldwide stock markets as non-energy firms have difficulty generating the growth and earnings expected by analysts. Eventually, higher energy prices will generate more supply, make alternatives attractive, and will cut demand, but in our opinion these options will take some time to play out.
© 2004 Joseph Dancy
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Oil & Gas Law,
SMU School of Law
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LSGI Market Letter
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