The Energy-Price Tsunami of 2005
By Andy Weissman
Street Insight Contributor
6/17/2005 7:03 AM EDT
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Prices for oil, natural gas, electricity and coal have once again started to spiral upward. While it may not be initially apparent to portfolio managers who don't specialize in energy, the potential risks to the broader market are far greater than they have been at any other time during the past two years.
When previous energy price run-ups have occurred, supplies have been tight. Fundamentally, however, there still has been enough fuel and feedstock available for the U.S. and global economies to continue to grow at a reasonably healthy clip. As a result, energy prices have increased -- but typically only by 20% or 30% in any two- or three-month period. This has given the U.S. and global economies time to adjust to higher prices.
This time, however, is fundamentally different -- different in ways that may shake the U.S. and world economy to its core. Major events that change the direction of the entire market for extended time periods occur relatively rarely, of course. But I believe we're on the verge of such an event.
Nominal Supply, Substantial Demand
Over the past seven weeks, since President Bush met with Saudi Crown Prince Abdullah in Crawford, Texas, it has become crystal clear that global oil supplies are barely going to increase over the last six-and-a-half months of 2005. At most, we'll be lucky if supplies increase by a few hundred thousand barrels per day. At the same time, demand is continuing to grow at an annualized rate of at least 1.8 million to 2.0 million barrels per year. The resulting supply gap isn't likely to be small. Instead, by the end of the year, using the Department of Energy's own figures, it's likely to be at least 700,000 barrels per day, if not greater.
No one knows for sure how steep of a price increase will be required to balance supply and demand given this massive shortfall in supply. Energy markets, however, are exquisitely sensitive to even small imbalances between supply and demand. Given the magnitude of this impending imbalance, a rapid increase to prices of $80 per barrel before the end of this year would not be the least bit surprising; even steeper increases can't by any means be ruled out.
At the same time, natural gas prices also are likely to soar this summer, and could well ignite even before oil prices jump to the next level. Higher oil prices also are likely to have a frightening impact on the U.S. balance of payments deficit, which potentially could suddenly increase by as much as $350 million to $500 million per day. This in turn could send the value of the U.S. dollar plummeting back downward.
Over the next 30 to 90 days, therefore, there may be no greater set of risk factors facing many portfolio managers, in almost every sector and over a broad range of investment strategies.
The problem, more specifically, is this:
The U.S. Energy Information Administration's most recent estimates of supply and demand indicate that, even at prices in the mid-$50-per-barrel range, global demand for oil is likely to increase by at least 2.0 million barrels per day between the fourth quarter of 2004 and the fourth quarter of 2005. Much of this increase already has occurred during the first five-and-a-half months of this year. To meet this demand, EIA's analysis indicates a 2.0 million barrel per day increase in supplies is needed between the fourth quarter of 2004 and the fourth quarter of this year.
Net of expected year-over-year declines in production from the North Sea, however, the total expected increase in supply from all of the producing countries of the world (other than Russia and the members of OPEC) over this 12-month period is only 1.0 million barrels per day -- i.e., half the level EIA calculates is necessary to meet growing world demand.
To avoid a rapid and potentially dangerous erosion of U.S. and global inventory levels, therefore, it is imperative that OPEC increase its production by at least 700,000 barrels per day over fourth-quarter 2004 levels and Russia increase production by at least 300,000 barrels per day over fourth-quarter 2004 levels. There is no other potential source of supply available if these levels are not achieved.
Over the past seven weeks, however, it has become clear that neither OPEC nor Russia is likely to be able to increase production significantly between now and the end of this year. It has been well known for some time that, within OPEC, only Saudi Arabia claims to have any remaining spare capacity. In early May, however, shortly after President Bush met with Crown Prince Abdullah, it became crystal clear that this remaining capacity, to the extent it exists, is of no use in meeting current global needs.
Both U.S. Energy Secretary Bodman and Saudi Oil Minister Ali al-Naimi publicly acknowledged -- and have since reiterated -- that there is no refining capacity available that can process this oil. In the words of the Saudi Oil Minister, existing refineries "can't handle it." As a result, Saudi Arabia has been forced to take it off of the world market. As Secretary Bodman has now repeatedly stated, this capacity is, therefore, not "usable" in the current world market.
No other OPEC member claims to have any other spare capacity available. Nor is any OPEC member expecting to bring on any major new project between now and the end of the year (with the possible exception of 100,000 barrels per day of Algerian capacity that conceivably could come on line in December, but is more likely to come on in the first quarter of next year). For all practical purposes, therefore, OPEC appears to be maxed out.
This leaves the cartel at least 400,000 barrels per day short of the production levels EIA has determined are necessary to avoid a meltdown of global inventories later this year. Meanwhile, Russian officials acknowledged in a June 3 interview in The Wall Street Journal that there's little or no likelihood that we'll see any increase in Russian production this year, leaving them 300,000 short of EIA's estimate of what is necessary.
Therefore, global production is realistically likely to fall at least 700,000 barrels per day short of required levels by the fourth quarter. Cumulatively, between now and the end of the year, the total shortfall in supply is likely to exceed 100 million barrels worldwide, at a minimum.
This will dwarf the supply crunch that occurred during the 1973-74 embargo, when a cutback in deliveries of only a fraction of this magnitude was sufficient to cause a fourfold increase in oil prices. Further, there is a significant risk that the supply gap could be even greater than the 100-million-barrel total suggests.
This is because virtually every producer in the world has been producing flat-out for over a year now. Past experience suggests that, when this occurs, sudden declines in production in all likelihood are inevitable in at least some fields. If this occurs, there is no other source of supply available to make up the difference.
Protecting Against Energy Tidal Wave
How then can we protect against the energy tidal wave that almost certainly is coming sometime later this year -- possibly even within the next 30 days?
There are obvious steps that might be considered, like shorting the broader indices or the dollar. This also, however, has its obvious risks and may or may not be consistent with the strategy of a particular fund. My own view is that at least part of the answer, for most funds, should be to find an appropriate vehicle to increase your upside exposure to energy -- i.e., depending upon your appetite, energy commodities, energy-related equities or both.
Some traditional energy analysts may see the sector as already fully valued. These often are the same folks, however, who were convinced that oil prices were going to decline in 2005. My own view is that the analysts who take this view simply don't understand the fundamentals. While energy prices will remain highly volatile near term, by the end of this year, current prices are likely to look like "fire sale" levels. |
