Record Breaking Contango Suggests Higher Oil Prices for 2011

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ConocoPhillips (NYSE: COP) is paying $41,000 a day to keep a storage tanker capable of holding 3 million barrels of oil floating in the Gulf of Mexico, according to international ship- and offshore broking firm RS Platou. And the TI Europe is just one of hundreds of oil tankers sitting idle in waters around the world, as energy companies and investment banks await higher prices for crude.

Oil prices have fallen precipitously since the spring, as optimism about "green shoots" of economic growth gave way to fears of a double-dip recession. Prices have fallen more than 12% to $75.81 a barrel, from a high of $86.54 a barrel in April.

Indeed, with the U.S. economy stuck in the mire, the global outlook for oil demand has diminished – at least in the near-term. Longer-term, however, traders expect prices to surge higher next year as growth solidifies. That's why contracts for crude set to be delivered six months from now are worth more than crude at its current prices – an anomaly known as "contango."

Thus, speculators such as ConocoPhilips are willing to pay a premium to keep large quantities of oil idle at sea in the hopes of selling the cargo next year for a higher price.

The price advantage to buy and hold crude more than doubled to $5.76 a barrel last month from $2.60 at the end of July. The spread peaked in January 2009, when oil for delivery in six months cost $18.40 a barrel more than immediate crude contracts, helping to propel the longest period of contango on record.

As of Sept. 3, the prompt oil contract had been cheaper than the next month for 651 days – a period that stretches back to November 2008. The previous record spanned 640 days from October 2005 to July 2007. Oil prices surged 17% in that time.

Falling tanker rates and low-cost financing also have contributed to the contango by making it less costly to store oil for long periods of time. The cost of storing a barrel of oil offshore has dropped 24% this year, according to the world's second-largest shipbroker Simpson Spence and Young.

Contango doesn't guarantee higher prices, but it shows that analysts believe strongly that economic growth will accelerate enough in 2011 and take oil demand higher. And they may be right.

Global Growth to Goose Demand

U.S. economic growth, while languishing right now is expected to accelerate next year. And economies in Europe, Asia, and even South America are already on the path to sustainable growth. So while oil supplies are sufficient now, a drawdown in inventories is imminent.

The International Energy Agency (IEA) said today in its monthly Oil Market Report that global crude demand will average 87.9 million barrels a day next year. The agency revised the 2010 estimate 50,000 barrels a day higher to 86.6 million.

Demand will be led by China, which has some $2 trillion in foreign exchange reserves, a fast-growing consumer class, and scorching economic growth to match. Chinese consumption will contribute about a third of world growth in 2011, the IEA said.

China's economy expanded by 11.9% in the first three months of the year and by 10.3% in the second quarter. And the only reason growth decelerated is because the central government deliberately curbed lending to prevent the economy from overheating. Now that it's accomplished its goal, Beijing is again loosening its lending controls and promoting growth.

China's banks extended $80.5 billion (545.2 billion yuan) in new loans in August, up from $77.7 billion (523.8 billion yuan) in July, central bank data issued Saturday show.

That suggests the government is quietly loosening controls on bank lending and speeding up approvals for infrastructure projects. As a result, industrial production in August was up 13.9% from a year earlier, accelerating from 13.4% growth in July. The figure was well above market expectations, and reversed the gradual slowdown from the 20.7% pace at the beginning of the year.

Reflecting accelerating industrial activity, China's implied oil demand rose 7.4% in August from a year earlier, more than twice as fast as in July.

"The earlier fears that the government's tightening measures will cut fuel demand didn't really materialize," a fuel marketing executive with top oil and gas firm PetroChina told Reuters. "We are still seeing strong demand from projects like roads, railways and others."

China's crude imports rose 13% last month from a year earlier, and consumption has risen following the startup of two new refineries, totaling a capacity of 260,000 barrels per day. August refinery output was up 7.2% from a year earlier to 34.73 million metric tons, or 8.18 million barrels per day (bpd), data from the National Statistical Bureau showed on Monday.

"The data out of China was quite supportive," said Jonathan Barratt, managing director at Commodity Broking Services. "The whole world is looking for a means to create confidence. As result of that being created you'll see more oil demand, or an expectation for more consumption of oil."

Economies are picking up elsewhere in Asia, as well. South Korea's gross domestic product (GDP) was up 7.2% year-over-year in the second quarter, after surging 8.2% in the first three months of the year.

Singapore's economy is expected to grow 11.6% in the third quarter from a year earlier, slowing from an 18.8% second-quarter expansion, a central bank survey recently showed. The economy will grow 14.9% in 2010, according to the median forecast of 20 economists in a central bank survey, up from an estimate of 9% published three months ago.

Thailand's economy grew by 10.6% in the first half of the year, with second quarter GDP soaring 9.1%. The Thai economy has been largely boosted by the country's robust export growth, which surged 42% in the first six months of the year, according to Ampon Kitti-ampon, the secretary-general of National Economic and Social Development Board (NESDB). The country's GDP for the whole 2010 is projected to expand by as much as 7.5%.

And then there's India, which like China, subsidizes fuel costs and expects double-digit economic growth this year. The Indian government expects the economy to expand by 8.5% in 2010, and the International Monetary Fund (IMF) predicts 8.8% growth for the subcontinent.

India's annual oil products demand is expected to rise by 5.7% in the current fiscal year, the highest since 2007/08. Consumption of refined products in India is estimated to rise to 146.08 million metric tons this year.

JPMorgan Chase & Co. (NYSE: JPM) said last month that Indian gasoline demand is up 15% from year-ago levels as vehicle sales soar.

"It would be wrong to paint a universally bleak economic picture," the bank said.

That's because in addition to these fast-growing Asian economies, Europe is benefiting from Germany's vibrant export sector, and in the Western hemisphere, Canada, Brazil, and Chile are demonstrating strong and sustainable economic growth.

That bodes well for the United States, which has a fair shot at getting back on track in time to drive oil higher prices in 2011.

"Rapid world growth will eventually rekindle the economic fires here, producing a growth that is more balanced than the bubbles of 1995-2008," says Money Morning Contributing Editor Martin Hutchinson. "It should rectify the U.S. balance-of-payments problem, so that even modest fiscal discipline will produce a quickening of U.S. growth rates, and a full economic recovery."

"On balance, U.S. investors should be optimistic for 2011 and beyond," he added.

A Late Year Comeback for the U.S.?

Indeed, the U.S. economy is facing its fair share of problems, but there are some bright spots.

Industrial production rose 0.2% in August after a downwardly revised increase of 0.6% in July, while manufacturing output rose 0.2% in August following a 0.7% advance the month prior.

"Manufacturing is recovering at a brisk pace and the August industrial production report confirms relatively widespread growth among industries – 14 of the 20 major manufacturing industries posted growth last month," said Daniel J. Meckstroth, Chief Economist for the Manufacturers Alliance/MAPI.

The industrial sector is benefiting from strong export growth, Meckstroth said, and a resurgence in repair, replacement, and cost cutting has motivated machinery and equipment spending and replacement demand for big ticket consumer items like appliances and motor vehicles.

New life in manufacturing will boost oil consumption in the United States and help draw down bloated reserves. U.S. crude oil stockpiles fell by 2.5 million barrels to 357.4 million barrels – their lowest level in a month – for the week ended Sept. 10, according to the Department of Energy.

Stockpiles of crude at Cushing, Oklahoma, where New York-traded West Texas Intermediate oil is delivered, fell by 218,000 barrels to 35.5 million in the week ended Sept. 3, the lowest level since April, according to the Energy Information Administration.

"The prospect of falling inventories provides a certain amount of cheer," Michael Lynch, president of Strategic Energy & Economic Research told Bloomberg News. "It wasn't long ago when inventories were threatening to reach recent highs."

Part of the reason for the decline is that imports are sliding as refineries close for routine maintenance. Refineries switch crude blends this time of year as gasoline demand falls and demand for heating oil rises. But another reason for the drop is that a pipeline leak has disrupted supply lines from Canada.

Enbridge Energy Partners LP's Line 6A was closed because of a leak in Illinois and the company isn't able to predict when it will be reactivated.

"The Enbridge problems will be significant in next week's report," Andy Lipow, president of Lipow Oil Associates LLC in Houston told Bloomberg. "This will be bullish for WTI because the refineries in Illinois and the Ohio valley are left with two choices. They can either take delivery of Cushing supply or get supply from the Gulf Coast."

And while supply disruptions and season shifts could help buttress prices in the short-term, demand will likely increase next year.

"Demand is going to look a lot better in 2011," said Adam Sieminski, chief energy economist at Deutsche Bank AG (NYSE: DB). "By then the overall numbers on things like industrial production, housing, investment, and probably even consumer sentiment will be better."

Sieminski predicts prices will reach $80 a barrel next year. He's joined by Goldman Sachs Group Inc. (NYSE: GS), which believes crude prices will rise into the $85 to $95 a barrel range by the end of this year.

"It looks like from a global prospective we are now in a period of drawdown," said Goldman Sachs analyst David Greely.

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