Conclusion: While we continue to have a bullish view of oil based its quantitative set up, as a proxy to benefit from a weak U.S. dollar, on geopolitical risk premiums, and due to strong emerging market demand patterns, we would also be remiss not to highlight anemic U.S. demand on the negative side of the equation.
Position: Long oil via the etf OIL
We are starting to see Egyptian and Tunisian type popular tensions spread to some key oil producing states, which should provide a key support under the commodity. Specifically, both Iran and Libya have seen an increase in protests. This is relevant because, based on the most recent data, Iran is the second largest producer of crude oil in OPEC, at 3.7MM barrels of oil per day, and Libya is a sizeable producer as well at 1.6MM barrels of oil per day.
At this point, it is difficult to determine what direction the popular unrest in these major oil producing countries will take, but obviously a potential disruption of production in either of these nations is much more critical to global supply then either Tunisia or Egypt (less than 600K barrels of production per day). Egypt relevance is more related to its control of the Suez Canal, which controls more than 8% of the world’s sea trade – of which a large component is oil headed for Europe.
As a proxy for the status of the situation in the Middle East, we’ve been following the price of Brent oil, which is produced in the North Sea. As the actual or perceived threat of a supply or transportation disruption in the Middle East occurs, Brent should be bid to a premium versus its global counterparts. Currently the spread on front month futures in the U.S. is as almost as wide as it has ever been, with Brent trading at ~$102 per barrel and West Texas Intermediate trading at ~$85 per barrel, for a spread of $17.
In addition to the Middle Eastern dynamics, apparent weak demand for consumer fuels in the United States, namely gasoline, is one force that is driving the almost record divergence between WTI and Brent. As our Energy Sector Head Lou Gagliardi continues to highlight in his research, Cushing, Oklahoma is flush with supply. Cushing is the primary hub for transporting oil in the United States, and at any time stores up to 10% of North American supply. Cushing inventories are currently as high as they’ve been since 2004, and have risen 10 of the past 13 weeks.
In fact, according to data from Department of Energy, gasoline inventories in aggregate in the United States, as of the month of January, are 3.4% above the high of the normal range. In addition, distillates are 4.8% above the high end of their normal range. These inventory builds are not surprising given that retail gas prices have risen to almost $3.14 per gallon, which is comparable to the highs of October 2008.
Naturally, with rising prices comes a degradation of demand, which we are starting to see in inventory builds and actual purchases of gasoline. According to Master Card, which tracks weekly purchases of gasoline, gasoline demand was down sequentially week-over-week almost 3%, though still up 2.6% year-over-year. The real wild card for demand is of course the summer driving season and the price of gasoline at that point in the season.
To that point, according to the Department of Energy:
“There is also significant uncertainty surrounding the forecast, with the current market prices of futures and options contracts for gasoline suggesting a 35 percent probability that the national monthly average retail price for regular gasoline could exceed $3.50 per gallon during summer 2011 and about a 10 percent probability that it could exceed $4.00 per gallon.”
Clearly, given the trajectory we are on, there is some possibility that gasoline reaches a much more elevated level this summer, in which case we should expect to see a continuation of demand degradation and inventory building. This is not to say there aren’t many benefits to owning oil, but we need to be aware that the current supply factors of the world’s largest consumer of oil, the United States, are bearish.
Daryl G. Jones