OIL HELD HOSTAGE

From Econoday:

Though most of us suspect that oil prices are bound to jump higher sooner or later, recession together with alternative fuels and fuel efficiency can’t be positives for the oil sector. Another negative is the collapse underway in the auto industry, especially the collapse in light trucks. The current setting is definitely a reminder of the 1970s, an even more dramatic time in the oil sector when the shocks of successive embargoes made for a major shift in oil consumption.

The graph below tracks oil supply since 1970. World supply, the red line, entered an unprecedented eight year trough beginning in 1980 and it may currently be entering another. Any crimp in current supply is not coming from a lack of proven global reserves, which the U.S. Energy Information Agency estimates to be 1.34 trillion barrels, double the level of 1980.

Supply in the U.S., the blue line in the above graph, has been in a long gradual downtrend, a contrast to consumption of petroleum products in the U.S. which had, until recently anyway, been in a gradual uptrend. The graph below tracks U.S. consumption since 1980.

The dip in the red line at the left side of the above graph shows the effects of deep recession and also the shift from giant gas guzzlers to small foreign brands. James Williams, energy economist at WTRG Economics, (WTRG.com), notes fuel switching by utilities and industrial users, switching that became permanent, was also a major factor at the time. The dip on the right side of the graph shows the still ongoing impact of this recession including the collapse in light trucks where sales rates have fallen in half from their 2005 peaks. Williams stresses that consumption this time around will be most affected by the depth of the recession and only to a lesser degree by substitution to alternative fuels which are still in their infancy.

The ongoing dip in oil demand is pulling down the energy sector where firms this earnings season are reporting order push outs and cancellations. Halliburton fed Monday’s steep sell-off in the market, saying conditions in the global energy market may not be bottoming. Baker Hughes‘ rig count data highlight the extent of the ongoing pullback in North America. The number of oil rigs has fallen in half, from a peak of 442 in early November to 205 at mid-month April. Rig count outside of North America, currently at 784, has held little changed.

Despite the cut in production, supply of crude oil keeps on swelling. Weekly data show U.S. inventories at multi-year highs and still climbing, this despite comparatively low gasoline prices, averaging just over $2 and well under $3.50 this time last year. Six months of OPEC output cuts have yet to have a dramatic impact on supply or on prices. OPEC meets again in late May and — at least as of now — there are few expectations for further cuts.

Oil prices are currently the hostage of the equities market where day-to-day shifts are interpreted as a leading sign for the global economy and global demand for oil. Oil fell $5 on Monday following bad news out of the banking sector and a drop in the stock market. Aside from Monday’s trouble, oil has been trading very steady and very quietly since March in a narrow range centered at just about $50.

But when oil prices are moving, especially when they move upward, they can have a dramatic impact on just about everyone’s lives. Price peaks in oil correspond more often than not with recession. Of course there are plenty of factors behind a recession and oil is just one of them. Arrows in the graph below highlight the five price peaks over the past 40 years that have corresponded with recession.

On the short view, the deep global recession has cut prices by a third. Monday’s big sell-off in oil shook up what had been a very quiet market. Oil prices did flirt with $30 early in the year but the effect of Saudi-backed OPEC cuts, even if only psychological, has made for flat trading conditions since. But increasing length in holdings at U.S. Oil, a major ETF, is raising talk that investment demand is long. Without investment demand, many say oil would now be closer to $40 than $50. Shares of oil companies also track oil prices and are a favorite of energy traders. The graph below compares WTI against shares of Exxon Mobil where profits, however enormous they were, would appear to be on the way down.

Cullen Roche

Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.

He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.