©Copyright 2008 AirlineForecasts, LLC All Rights Reserved
 |  |  |  |  |
$139 Oil is Not Driven By Speculators
Vaughn Cordle, CFA / June 8, 2008
In my view the spike in oil prices has more to do with rational hedging and investing, not so much about speculation. This logic is based
on a new and growing understanding that there is a significant and worldwide supply and demand imbalance.
-- Rational investors are going long on oil primarily to hedge against higher inflation and the falling dollar. The euro has strengthened
against the dollar, and there plenty of evidence that a slowing US economy will continue to worsen over the next year or so. A weakening
US economy, combined with below-inflation FED Funds Rate, will not result in a strengthening dollar. $138 oil is only $87.90 when priced
in Euros and the odds are that interest rates in Europe - already twice that of the US - will increase as inflation
trends are too high.
-- Market sentiment about the proper price of oil has been shifting as more folks learn that there is a growing gap between worldwide oil
production and the demand for oil. There are real "demand" reasons behind why the bulls are making the case for $150 to $200 oil prices.
Even if demand falls in the US—300,000 to 500,000 million barrels per day (mb/d) within a year—other parts of the world will take up the
slack.
-- The bear-case argument—not as compelling as the bull-case, in my view—is that the correct price of oil should be between $95-$105
given "current" supply and expected demand in the short and intermediate term.
-- The oil futures market is currently in backwardation; prices for future oil delivery are lower than spot prices because the market believes
there will be shortages or disruptions in supply. Given the high odds of an actual supply disruption combined with tight supplies relative to
demand, the "market" believes that these higher prices are justified.
-- The dollar has fallen 46 percent from its mid-2001 peak against the euro and 21 percent since 2004. If the US currency had maintained
its 2001 value, oil would have traded at about $80 by early 2008, more than $20 below its actual price at the time. In other words, the
depreciating dollar accounted for 33 percent of the $60 increase in oil prices that occurred from 2003 to 2007. So, it can be argued that as
much as $50 [36%] of the current $138 oil price is a function of exchange rate movements, which is a driven by the precipitous
depreciation of the dollar. The expectation is that the US economy will continue to weaken as higher inflation erodes the purchasing
power of the dollar.
-- The foreign exchange value of the dollar has to substantially decline to make a serious dent in the record US current account deficit of
over $700 billion, which is about 5 percent of US GDP. Imports exceed exports by 50%. Asian currencies that have not yet appreciated
significantly against the dollar, especially the Chinese renminbi, will need to rise sharply. Asian and other central banks must cease
intervening in the exchange markets and accumulating massive amounts of dollar reserves to permit the market to begin the needed
exchange rate corrections.
-- Many wrongly believe that big manipulative investors or naive "speculators" account for the bulk of the price spike in crude. Geopolitical
and supply disruption risks are real and increasing. Any hint of a disruption in supply will result in a spike in oil prices because oil
markets have grown tighter as supply growth cannot keep up with demand growth. The fact that the spike in oil looks like a "bubble"
doesn't necessarily mean that it is a bubble. It could be argued that the market has simply reset the equilibrium price of oil based on new
information about supply and demand.
-- If the risk of disruption increases, investors, hedgers and yes, speculators, will naturally run up the spot price of oil. Futures prices
typically slope upward from the spot price, and this is the normal "contango" shape of the forward curve.
-- Most forecasts anticipate some softening of oil prices over the next few years - $90 to $105 is the consensus view - suggesting that oil
production will gain some ground on demand. Both the bull and the bear case are compelling, and so far, the bulls are winning.
-- OPEC's excess capacity has fallen from almost 5.6 mb/d in 2002 to an estimated 1.9 mb/d this year. And, that excess capacity is in
heavy crude oils that can only be processed in specialized refineries. In fact, those facilities are running full-out so the added supplies
aren't relieving the tight market. Evidence also suggests that OPEC is restraining its output.
-- We [AirlineForecasts] estimate that a 20 percent reduction in total US airline [passenger-only] capacity will result in a 79 million barrel
(220,000 mb/d) reduction in annual oil consumption. This, on top of the 300,000 mb/d the EIA now estimates for 2008. This decreased
demand because of the higher oil prices has already been addressed in many of the bull cases we have examined. The bears have yet to
catch up with the market and sentiment drivers behind the spike in oil.
-- History provides evidence that US consumption should decline by 10 to 20 percent over the next decade given the quadrupling of oil
prices over the last 5 years. Europe may experience a similar decline. However, given the projected demand growth from China, India, the
Middle East and other rapidly expanding economies, the reduction in US and European consumption will not be sufficient to relieve the
pressure on oil prices.
Bottom line: Rational investors and hedgers are betting that oil prices have to adjust much higher in a world where demand is outstripping
production supply. The purchasing power of the dollar has fallen significantly over the last few years because of the large trade imbalance
and weak US economy. Momentary policies that that pump up the money supply result in too many dollars in system. Rational investors
need to hedge against inflation and oil prices are being bid up by countries that compete with the US for precious commodities that are
increasingly in short supply.
Reasons for the spike in oil and jet fuel prices
Vaughn Cordle, CFA / June 8, 2008
In my view the spike in oil prices has more to do with rational hedging and investing, not so much about speculation. This logic is based
on a new and growing understanding that there is a significant and worldwide supply and demand imbalance.
-- Rational investors are going long on oil primarily to hedge against higher inflation and the falling dollar. The euro has strengthened
against the dollar, and there plenty of evidence that a slowing US economy will continue to worsen over the next year or so. A weakening
US economy, combined with below-inflation FED Funds Rate, will not result in a strengthening dollar. $138 oil is only $87.90 when priced
in Euros and the odds are that interest rates in Europe - already twice that of the US - will increase as inflation
trends are too high.
-- Market sentiment about the proper price of oil has been shifting as more folks learn that there is a growing gap between worldwide oil
production and the demand for oil. There are real "demand" reasons behind why the bulls are making the case for $150 to $200 oil prices.
Even if demand falls in the US—300,000 to 500,000 million barrels per day (mb/d) within a year—other parts of the world will take up the
slack.
-- The bear-case argument—not as compelling as the bull-case, in my view—is that the correct price of oil should be between $95-$105
given "current" supply and expected demand in the short and intermediate term.
-- The oil futures market is currently in backwardation; prices for future oil delivery are lower than spot prices because the market believes
there will be shortages or disruptions in supply. Given the high odds of an actual supply disruption combined with tight supplies relative to
demand, the "market" believes that these higher prices are justified.
-- The dollar has fallen 46 percent from its mid-2001 peak against the euro and 21 percent since 2004. If the US currency had maintained
its 2001 value, oil would have traded at about $80 by early 2008, more than $20 below its actual price at the time. In other words, the
depreciating dollar accounted for 33 percent of the $60 increase in oil prices that occurred from 2003 to 2007. So, it can be argued that as
much as $50 [36%] of the current $138 oil price is a function of exchange rate movements, which is a driven by the precipitous
depreciation of the dollar. The expectation is that the US economy will continue to weaken as higher inflation erodes the purchasing
power of the dollar.
-- The foreign exchange value of the dollar has to substantially decline to make a serious dent in the record US current account deficit of
over $700 billion, which is about 5 percent of US GDP. Imports exceed exports by 50%. Asian currencies that have not yet appreciated
significantly against the dollar, especially the Chinese renminbi, will need to rise sharply. Asian and other central banks must cease
intervening in the exchange markets and accumulating massive amounts of dollar reserves to permit the market to begin the needed
exchange rate corrections.
-- Many wrongly believe that big manipulative investors or naive "speculators" account for the bulk of the price spike in crude. Geopolitical
and supply disruption risks are real and increasing. Any hint of a disruption in supply will result in a spike in oil prices because oil
markets have grown tighter as supply growth cannot keep up with demand growth. The fact that the spike in oil looks like a "bubble"
doesn't necessarily mean that it is a bubble. It could be argued that the market has simply reset the equilibrium price of oil based on new
information about supply and demand.
-- If the risk of disruption increases, investors, hedgers and yes, speculators, will naturally run up the spot price of oil. Futures prices
typically slope upward from the spot price, and this is the normal "contango" shape of the forward curve.
-- Most forecasts anticipate some softening of oil prices over the next few years - $90 to $105 is the consensus view - suggesting that oil
production will gain some ground on demand. Both the bull and the bear case are compelling, and so far, the bulls are winning.
-- OPEC's excess capacity has fallen from almost 5.6 mb/d in 2002 to an estimated 1.9 mb/d this year. And, that excess capacity is in
heavy crude oils that can only be processed in specialized refineries. In fact, those facilities are running full-out so the added supplies
aren't relieving the tight market. Evidence also suggests that OPEC is restraining its output.
-- We [AirlineForecasts] estimate that a 20 percent reduction in total US airline [passenger-only] capacity will result in a 79 million barrel
(220,000 mb/d) reduction in annual oil consumption. This, on top of the 300,000 mb/d the EIA now estimates for 2008. This decreased
demand because of the higher oil prices has already been addressed in many of the bull cases we have examined. The bears have yet to
catch up with the market and sentiment drivers behind the spike in oil.
-- History provides evidence that US consumption should decline by 10 to 20 percent over the next decade given the quadrupling of oil
prices over the last 5 years. Europe may experience a similar decline. However, given the projected demand growth from China, India, the
Middle East and other rapidly expanding economies, the reduction in US and European consumption will not be sufficient to relieve the
pressure on oil prices.
Bottom line: Rational investors and hedgers are betting that oil prices have to adjust much higher in a world where demand is outstripping
production supply. The purchasing power of the dollar has fallen significantly over the last few years because of the large trade imbalance
and weak US economy. Momentary policies that that pump up the money supply result in too many dollars in system. Rational investors
need to hedge against inflation and oil prices are being bid up by countries that compete with the US for precious commodities that are
increasingly in short supply.
Reasons for the spike in oil and jet fuel prices
• Future supplies tighter than previously thought
• Aging oil fields and diminished investment
• Supply of oil will not keep up with demand
• OPEC's spare capacity could shrink to minimum levels by 2012
• Goldman Sachs' recent prediction that oil could top $140 by this summer and $200 within 2 years
• Cambridge Energy concluded that the depletion rate of the world's 811 largest fields is around 4.5 percent annually
• IEA's suggestion that the world could face a shortfall of as much as 12.5 mb/d by 2015 unless there is a sharp falloff in demand
• EIA's prediction that daily output of conventional crude oil, now about 73 mb/d, will plateau at 84 mb/d
- Nonconventional fuels will be required to uptick significantly to produce 100 mb/d by 2030.
- The worldwide consumption was forecast to be around 87 mb/d in 2008
• The significant depreciation of the dollar against foreign currencies and investors' use of commodities as a hedge against
inflation
• Emerging market and Middle East demand and prosperity growth are driving worldwide demand for oil faster than originally
anticipated
• China's diesel demand and stockpiling for August Olympics as well as the recent earthquake.
• Latin/South America and European demand for diesel
