Excess Crude Production Capacity Falls
Developments in the Energy Sector
Several recent developments in the energy sector that investors may want to watch:
China Suspends Diesel Exports
Last weekend it was announced that China has suspended exports of diesel fuel indefinitely to help meet domestic energy demand ahead of the peak summer season. The measure could create energy shortages and spread higher prices – and possibly panic about the availability of energy supplies - across Asia.
The measure is designed to keep energy prices low domestically, similar to export bans implemented by several governments on agricultural commodities in 2007-08 – measures that sparked large increases in food prices over much of the globe. Russia also imposed a tax on fuel exports for similar reasons.
The Financial Times reports that China’s “The National Development and Reform Commission, China’s state planning agency, ordered state oil companies to stop exporting diesel to maintain social stability and promote economic development”. Further, they note that “China’s ban on diesel exports could prompt importers across the region to hoard energy commodities. ‘When you get export bans ... you get a stockpiling reaction among importers’” according to an analyst at Barclays Capital.
The Chicago Mercantile Exchange moved to hike margin requirements on oil futures contracts, which probably added to volatility as highly leveraged investors reduced their positions. A similar move with the silver futures contract resulted in a substantial decline in the price of the metal after a powerful six month rally in the price of that commodity.
While the action of the CME might depress oil prices short term and create volatile commodity markets, we expect the powerful global supply and demand trends in place to keep the price of oil near current levels, or higher, as the year progresses (see discussion below).
ETF Tracking Errors
One of the problems investors face if they want to invest in the crude oil market using exchange traded funds (ETF’s) is the divergence of the price of the underlying commodity and the performance of the ETF. These tracking errors can be enormous, as pointed out in a recent note in the Wall Street Journal:
The United States Oil Fund, ticker USO, remains one of Wall Street's most popular vehicles for betting on oil prices. The exchange-traded fund, which invests in oil futures, has had average assets of $2.2 billion since the start of 2009, according to Morningstar, meaning a payday for USO's managers of roughly $23 million given the 0.45% management fee. And yet, the USO and oil have inhabited different universes when it comes to performance. Front-month futures on West Texas Intermediate oil, USO's benchmark, have risen 123% since the start of 2009, while the ETF has risen a mere 19%.
The article included a chart that illustrates the extent of the tracking issue and how incredibly poorly investors have fared if they invested in the USO crude oil ETF compared to the price of crude oil:
The problem the oil ETF faces is that it must roll over the futures contract each month, replacing the existing contract with more expensive contracts (a situation known as ‘contango’). But the tracking error issue exists for many commodity based ETF’s, which is one (of many) reasons we prefer to invest in individual stocks in the energy sector.
While Warren Buffet may recommend tracking ETF’s for most investors (see discussion of Berkshire Hathaway shareholder meeting below), we agree with Buffett’s Co-Chairman Charlie Munger that we would rather have an actively managed portfolio with specific firms we have selected after conducting due diligence.
International Energy Agency Demand Forecast
The IEA last week lowered forecast for growth in global oil-product demand in 2011 to 1.3 million barrels a day citing persistent high prices and weaker projections for advanced economies. Disruptions in Japan also figure in. Global oil demand is expected to reach 89.2 million barrels a day in 2011, which is 190,000 barrels a day less than earlier projections—but still a record.
While high energy prices might be impacting gasoline sales in the U.S. keep in mind most of the incremental growth in demand is from elsewhere – and many countries are subsidizing prices to maintain political and social stability. Demand from developing economies including China is likely to remain unaffected as government subsidies cushioned the end-consumer from strong outright prices. Chinese demand rose by 0.89 million bpd in March according to data.
The Financial Times carried an excellent article last week about fuel subsidies and how they sheltered consumers from higher prices that might otherwise reduce demand. The IEA’s lowered forecast due to reduced demand in the U.S. and Europe overlooks the elephant in the room: China’s incredible growth in oil demand. The fact that fuel subsidies are increasing in the Middle East as countries try to avoid political disruption has resulted in robust demand growth in that area (chart courtesy Financial Times):
Keep in mind that the IEA consistently underestimated oil demand growth last year. They had to increase their demand estimates month after month starting last fall. We think the IEA, for a number of reasons, will once again have to increase demand estimates for 2011 later this summer or in the fall.
China’s Electricity Shortages Will Drive Oil Demand
The Financial Times also noted this weekend that Beijing is forecasting severe electricity shortages in some areas this summer because of limited coal supplies and reduced hydroelectric power because of droughts in central and eastern China. China exported about 100,000 barrels a day of diesel over the past year but became a net importer in late 2010 as power shortages forced enterprises to rely on portable generators.
The IEA estimates the diesel shortage could prompt China to turn to imports again, boosting expected global demand growth of 1.3 million barrels a day noted above by an additional 200,000 b/d to 300,000 b/d. David Fyfe, analyst at IEA, noted that we could see “a significant demand increase in China if small businesses and homes need to crank up their power generators.”
Wang Xiangwei published an article entitled ‘Power shortage is back - only this time it's worse’ in the South China Morning Post last week:
Mainlanders can be forgiven for having the awful feeling of deja vu as the national media is again ablaze with reports and analysis pieces detailing how the power shortage is sweeping across many provinces. . . . In many parts of Zhejiang, power rationing has been introduced not only to factories but also, increasingly, to residential compounds and office towers. Indeed, the power shortage has become almost an annual ritual in recent years, but this year it is getting much worse. The shortage started last month, well ahead of the normal peak consumption season in summer, and is threatening to bring much more serious disruptions. State media has warned that much of the mainland is bracing for the worst power shortage since 2004. . . . As usual, the officials attributed the causes to a jump in electricity consumption, insufficient coal stocks at power plants, and lower water levels for hydropower generation.
Reuters points out that China’s National Energy Administration forecasts electricity consumption would grow about 11 percent year-on-year in the first half of 2011, with full-year consumption estimated growing at 10 -12 percent.
The China Electricity Council, a power industry association, has estimated a nationwide shortfall of 3 percent of China's total generating capacity, an amount similar to that used by Sweden or Argentina. Some claim the actual shortfall could be much higher, exceeding the shortfall seen in the ‘power gap’ in 2004. The power shortfall is likely to substantially increase diesel demand. Reuters continues: “Last year, many power users such as factories and businesses switched to stand-alone diesel generators, leading to a spike in diesel demand.”
As long as China is growing their economy at 8+% and India at 6+%, and Middle East countries heavily subsidize fuel use, global oil demand will continue to rocket ahead. Which is one reason why Goldman Sachs, Barclays Capital, Platts, and Morgan Stanley and a number of other firms project much higher oil prices by year end and into next year. The ability of exporting countries to meet record global demand with the installed production facilities and current excess capacity is suspect – especially as Libyan high quality light sweet crude remains shut in and unrest continues to fester in producing regions.
Long Term Forecast
The IEA also recognizes the longer term demand and supply issues in the crude oil markets, as was pointed out in the New York Times:
…IEA chief economist Dr. Fatih Birol says the world’s crude oil production peaked back in 2006 and the price of oil will continue to rise. “The existing fields are declining so sharply that in order to stay where we are in terms of production levels in the next 25 years, we have to find and develop four new Saudi Arabias,” he said. For reference, Saudi Arabia has claimed (as it has for the past 25 years) to be sitting on 267 billion barrels of oil.
Dr. Birol is quick to point out that oil reserves are out there. Yet, the ability to access some of these oil reserves is not. Compounding this issue is the fact that from a business standpoint it is not in the best interest of oil producers to flood the market with their product. There is also the rising tide of demand from China for oil, and India is gaining ground as well. More demand plus less supply will lead to higher prices. . . .
We agree with the consensus opinion that we remain in a bullish trend, and think this is an opportune time to add to energy positions – especially in companies that are smaller and not well followed that have a ‘catalyst’ in place that could ramp up reserves or production. We expect the IEA will have to substantially increase their crude oil demand estimates later this year, with China’s electricity shortages and imports of diesel for portable generators one of the catalysts of higher than expected demand.
Most firms still forecast higher prices. JPMorgan Chase & Co raised its oil price forecasts because exporting countries are not increasing supplies to meet rising demand, boosting its 2011 Brent crude forecast to $120 a barrel from $110. It also raised its estimate for West Texas Intermediate crude to $109.50 from $99. Forecasts for 2012 prices were raised to $120 and $114, respectively.
JPMorgan forecasts supply to fall short of demand by 600,000 barrels a day during the third quarter, and next quarter there's a risk oil might move toward record levels near $150 set in 2008. China’s crude-oil inventories have been “drawn heavily” in the past six months according to their analysis.
Goldman Sachs was also bullish, stating that oil prices could surpass its recent highs by 2012 as global oil supplies continue to tighten. The firm reaffirmed its long-term bullish view of oil after the crash in prices, stating this was a medium-term correction followed by a renewed pricing ascent.
“It is important to emphasize that even as oil prices are pulling back from their recent highs, we expect them to return to or surpass the recent highs by next year . . . We continue to believe that the oil supply-demand fundamentals will tighten further over the course of this year, and likely reach critically tight levels by early next year should Libyan oil supplies remain off the market” according to the Goldman report.
Last, Morgan Stanley had this to say in a research note:
We cannot attribute last week’s price declines to fundamentals, which for many commodities, particularly oil and corn, are still constructive. To be clear, prices could fall, initially even on favorable data, as price gains could be met with additional selling. Evidence of this was clear on Friday as the market initially found support on a better-than-expected US non-farm payrolls report in the US. A still positive macro growth environment, leads us to believe that the declines exhibited last week provide a good entry point for both investors and consumers. We continue to prefer corn, crude oil, gold, aluminum, copper and nickel to natural gas, zinc, the meats and the softs…
Energy: Oil and Product Inventories to Tighten
The sharp decline in crude prices seen late last week was not warranted by current and expected fundamentals, in our view. Importantly, supply disruptions are still present and despite higher prices, global oil demand remains robust. Economic growth, albeit more sluggish than envisioned, is still seen averaging well-above 3% boding well for oil demand growth in both 2011 and 2012 and ultimately portending to further inventory draws in the months to come.
The market has honed in on weakening OECD demand, and in particularly weak US gasoline demand, as evidence that the rally in crude, which started on improving fundamentals in 3Q10, is overdone and has run its course. Despite pockets of OECD weakness, robust non-OECD demand continues to lift global demand — as it did starting in 2006.
Fuel Export Limitations
As gasoline and diesel prices rise, and food inflation surges, discontent grows in emerging countries and elsewhere. In the last week both Russia and China announced steps to restrict the export of fuels in an attempt to moderate prices. The ‘flash crash’ of crude oil prices has pushed this item back to page 16 of the news, and it could have significant implications for global energy trading patterns. Last year this export limitation was implemented by a number of countries in the grain markets after the severe Russian and Ukraine drought.
The export limits essentially subsidize internal consumption by promoting lower prices than would otherwise be the case, while the reduction in supply increases prices in other markets. If this trend is adopted elsewhere the impact on the energy markets could be quite disruptive for consumers – but would focus investor attention on the energy sector.
Our bottom line: (1) the International Energy Agency’s estimate that global crude oil demand will increase 1.3 million barrels per day in 2011 while (2) 1.5 million barrels per day of light sweet crude oil exports from Libya and Yemen remain off line and (3) both China and Russia effectively prohibited exports of diesel due to domestic shortages last week as they (4) attempt to control inflation and promote social stability we can’t help but conclude that crude oil prices will be pushed higher in the second half of the year.
Add into the mix the huge electricity shortage in China developing due to generating shortfalls from coal and hydro plants, and the fact that diesel generators are used by China’s commercial and industrial entities when power is rationed, we think the IEA’s estimate of an increase of 1.3 million barrels per day will need to be increased this summer and fall—probably by a substantial amount. Coal prices and exports from the U.S. will also rise to levels not seen in years.
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