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Tuesday, August 19, 2008

From contango back to backwardation...

Summary: Oil may continue to trade in a range bound fashion, but don't expect it to drop too much further, in the medium to long-term fundamentals are nothing but bullish.
To the average American, the US economy is clearly in recession. This is because, in most people’s eyes, a recession is what a recession does: it snuffs out jobs as companies cut output to accommodate a weakening in demand, thus reducing real income. However, the data on GDP have yet to meet what many call the “technical” definition of recession--two consecutive quarters of .negative growth, an oxymoron that only economists could love. In fact, the National Bureau of Economic Research (NBER) the arbiter of business cycles in the United States does not use this definition. In its words: “a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The four monthly indicators on this list that the NBER specifically tracks are consistent with the common view that a recession started late last year. The conclusions today are the same as they were then, strengthened a bit by revisions that have steepened the declines in the interim. In particular:

1. The US economy probably hit a cyclical peak last November.

2. The recession has been exceedingly mild, at least so far.

Although the rise in unemployment that most people take as telltale of recession has been anything but mild, all four indicators have held up better than the median for the cycles since 1953. All but real sales have also fallen less quickly than in 2001, when the US economy experienced the mildest recession on record as measured by GDP the only one that shows no year-to-year decline in real GDP. Given this backdrop, it should not be surprising that the lack of a significant drop in real GDP has held up the NBER’s recession call. Even after last month’s annual revision, which produced a tiny 0.2% annualized drop in the fourth quarter, some members of the NBER committee charged with this august responsibility seem hesitant, pointing out that real GDP subsequently rose during the first half of 2008. Conceptually, Gross Domestic Income (GDI) and GDP are equivalent, as sales of goods produced in the United States (GDP) generate income for someone (GDI). Observed differences are statistical in nature. According to a Fed staff study, real GDI often gives a more reliable signal than GDP around turning points.

That being said, we can’t help but wonder if lower energy prices will lead to economic salvation. However, as is usually the case that form of syllogistic reasoning is flawed. Although lower energy prices will assist the consumer it only takes care of one of our “four horsemen of the recession” (the others being: housing malaise, credit freeze, and the indebtedness of the U.S. and its citizens).

Now I shall shift the focus more onto this “correction” in energy. The tug of war between fundamentals tightness and concerns over demand weakness continues to dictate oil price movements, with the latter in the spotlight over the past few weeks. The explosion in the BTC pipeline and the recent hostilities between Russia and Georgia have not only materially disrupted a significant portion of Azeri exports, but have also underscored the vulnerability of oil supplies from the region, which accounts for a good part of the expected year-end supply growth. However, oil prices have continued to sell off to below US$115/bbl regardless.

Although concerns over demand weakness have outweighed fundamentals tightness in the past few weeks, recent data releases confirm that constrained supply and supportive non-OECD demand continue to more than offset weak OECD demand. Declining supplies in mature producing regions and strong non-OECD demand more than countered the 1.1% price-induced decline in OECD demand in 2Q08, leaving total OECD inventories flat in 2Q08 against a seasonal 900 kb/d build, remaining below 10-year average levels for the end of July. The 9.5% annual increase in Chinese demand in July exemplifies that non-OECD countries continue to absorb oil supplies and keep fundamentals tight even in an increasing price environment. Further, last week’s US Department of Energy (DOE) statistics have confirmed a decline in refined product inventories prompted by refinery run cuts, against a backdrop of continued low crude inventories.

While near-term fundamentals remain tight, since the beginning of the year and specifically over the past few weeks’ expectations regarding long-term fundamentals have been center stage. Long-dated oil prices have been driving the rally since the end of last year, accelerating dramatically in May and June, and are now leading the downwards correction. While the 20% sell-off over the past four weeks has been a record decline for long-dated oil prices, it comes on the heels of a record acceleration that had brought backend prices above the trend in price changes that had characterized the market since the end of last year and in the 2004-2005 structural rally. In particular, five-year forward prices had soared to over US$140/bbl at the beginning of July. Despite tight near-term fundamentals, bearish sentiments over future demand destruction have driven the back-end sell-off. Indeed, remarkably, the recent sell-off has been accompanied by signs of strengthening physical fundamentals as prompt WTI timespreads have strengthened over the past few weeks moving into a front-month backwardation. Further, while the price acceleration in May and June weighed on 2Q08 US demand and more modestly on European demand, overall the impact on global demand has likely been modest as is suggested by the unseasonably flat OECD inventories in 2Q08.

The long-term drivers in the market remain intact –trend supply growth has declined and cannot continue to accommodate stable trend demand growth on the back of supportive global economic growth fuelled by emerging markets. Therefore, on a long-term basis, higher prices are necessary to promote a structural demand adjustment and to continue to incentivize investments in production capacity enhancements. While weakening economic conditions in G3 countries coupled with the recent acceleration in oil prices have restrained demand, especially in the US and more modestly in Europe, the necessary structural adjustment required to bring demand in line with production capacity will likely take many years of high prices to promote a meaningful increase in energy efficiency.

While concerns over demand weakness continue to permeate market sentiment, recent data releases confirm that supportive non-OECD demand and restrained supply have more than offset OECD demand weakness, leaving total OECD inventories unseasonably flat in 2Q08 against a seasonal 900 kb/d build. Further, preliminary industry data for July indicates a 28 million barrels increase in total OECD stocks in July, which while slightly higher than the 19 million barrel seasonal build for July, continues to leave inventories below 10-year average levels.

The lack of inventory builds in 2Q08 despite softer price-induced OECD demand and the 400 kb/d increase in Saudi production in May and June underscores extremely tight crude balances suggesting that non-OECD demand has continued to be exceptionally strong and, possibly, that supply growth could be lower than currently estimated. It should be noted that given the 90% yoy surge in oil prices in 2Q08, the 1.1% yoy decline in total OECD demand over the same period has not been surprisingly strong but, if anything, has been lower than would be suggested by standard demand elasticity estimates, likely on the back of supportive power-related demand in Japan. Further, while US oil demand has born the brunt of the oil price surge, given its higher price sensitivity, weaker economic environment and distressed credit conditions, the decline in total US oil demand has not been stronger than in previous economic slowdowns.

More importantly, US gasoline demand growth continues to show a strong correlation with price changes instead of with price levels, underscoring that as oil price inflation moderates in the second half of the year, some pressure on demand will likely be alleviated.

The necessary expansion in oil production capacity remains constrained by escalating resource protectionism at the same time that alternative fuels are proving to have limited scalability. As these constraints are slowing trend oil supply growth against a backdrop of higher world GDP growth, long-dated oil prices need to increase steadily to slow oil demand growth in line with supply on a long-term basis. While the need to curtail demand growth on a long-term basis will likely keep long-dated prices above marginal cost of production, industry costs are re-accelerating at the same pace as they did in the 2005/2006 period.

This indicates that the floor below which long-dated prices are unlikely to fall for a sustained period of time is rising. In particular the historical relationship between industry cost indicators such as the US Oil and Gas Field Equipment and Machinery PPI and long-dated oil prices suggests that the cost-based floor to long-dated oil prices was US$105/bbl in June and is likely continuing to increase.

In other words, don’t bet the farm on oil falling too much further.

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