A smart guy talks about oil:
morganstanley.com
China’s oil imports declined by 1.2% YoY in the first five months of 2005. US oil inventory increased by 6.4% in the first quarter of 2005. However, oil prices averaged 46% higher in these five months of the year and 50% higher in the first quarter, on a YoY basis. How to bridge the gap between rising prices and weakening demand? The answer, I believe, is that there are too many oil traders engaging in oil price speculation. They will likely keep prices up until an oil market collapse. That day is not too far away, I believe.
The global economic cycle looks to have peaked out, but the deceleration has been modest so far. This is why financial speculation can still bolster the oil price. I expect economic deceleration to deepen in the fourth quarter of this year, such that the oil bubble may then burst. The trigger could be a sharp drop in China’s crude imports.
The hype over ‘endless’ energy demand from China and India has triggered a massive boom in investment in this sector. As energy producers step up production from alternative energy sources (e.g., natural gas, tar sands, and coal gasification), oil prices could stay depressed for many years when the current economic cycle turns down. There appear to be many substitutes for oil at a cost equivalent to US$20/barrel. I think oil may experience a prolonged bear market in the next few years.
Oil Demand Is Weakening …
Economic overheating, primarily in China, has exaggerated energy demand in the past three years. BP estimates that total demand for energy grew by 4.3% in 2004, 3.3% in 2003, and 3.4% in 2002, compared with annual growth of 1.2% between 1991 and 2001 and 2.1% between 1981 and 1991. China accounted for 52% of this growth between 2001 and 2004. Global energy demand ex-China grew by 1.9% between 2001 and 2004, versus annual growth of 1.1% between 1991 and 2001 and 1.7% between 1981 and 1991.
The booming demand for oil tells a similar story. According to BP, global oil demand grew by 1.9% per annum between 2001 and 2004 compared with 1.4% between 1991 and 2001 and 1% between 1981 and 1991. China accounted for 37% of global demand growth between 2001 and 2004, compared with 26% between 1991 and 2001.
There is little doubt that the current energy boom has been driven by China. As regards the sustainability of global energy prices, the key question is whether China’s increased demand reflects a secular change or just cyclical overheating. I believe the latter to be the case. China’s oil demand grew by 15.8% in 2004, versus 7.7% in 2003, 6.9% in 2002, and 7.6% per annum between 1991 and 2001. Last year’s extraordinary growth was distorted by China’s electricity shortage. As China’s electricity generation capacity catches up with demand this year, demand for oil should decline (see Oil vs. Coal, January 17, 2005). Despite a 16.3% increase of industrial production in the first five months of 2005, China’s oil imports have declined this year.
I believe China’s oil imports are likely to decline in 2005 and may fall further in 2006, as China’s investment cycle turns down. The economic fundamentals for oil look very weak at present and into next year.
… and Substitutes Are Coming
The high oil prices have triggered an investment boom in oil exploration and the production of substitutes. Oil sands, LNG, coal liquification and gasification are competitive against oil at US$20-25/bbl. As fixed investment piles into such alternatives, the energy supply curve has been permanently shifted outward, in my view. The current investment boom and the production capacity to follow may keep a lid on oil prices for many years to come.
Demand is also responding to high prices. Fuel-efficient vehicles are in vogue again. China is shifting its auto policy in favor of fuel-efficient cars. Manufacturing enterprises around the world are trying to increase energy efficiency in production. The Chinese government has instituted tax policies to discourage inefficient energy use by businesses.
Oil Prices Could Collapse Soon
Despite weakening demand, oil prices have kept rising this year. Dubai recently hit a historical high. The high prices will further weaken the main consuming economies, which are already slowing down, and demand for oil should weaken further.
Why are oil prices rising despite weakening demand and rising inventory? The weak dollar used to be a justification. But the dollar has rallied substantially in recent months.
I believe that a large number of financial institutions have become dependent on commodity trading (mainly, oil) for profits. The financial system suffers from overcapitalization. The pressure for increasing profits is intense. Oil has become the most important new source of profits. As oil has worked for so long, the financial community is hanging on to this position. Of course, when demand from financial investors is high, oil prices can remain high on self-fulfilling expectation.
What is occurring now is probably the final frenzy, in my view. The closing of the Brent / Dubai gap to the historical average would appear to be another ‘sucking juice’ trade. Oil speculation last year was limited to light crude, such as West Texas or Brent. The gap between Brent and Dubai surged above US$12/barrel in late 2004, compared with an average of US$1.3/bbl between 1997 and 2001. The justification then was that there was a shortage of light crude. As soon as enough traders saw the wide gap, the ‘juice’ was going to be ‘squeezed out’, either by pushing down Brent or pushing up Dubai. Since the market tone remained bullish, the latter was the natural choice and this is what has happened.
As evidence of weakening demand and ample supply accumulates, the market may panic. The oil market has been the most speculative in this cycle. I believe it could correct in the most speculative fashion – it could collapse |
