Oil Prices Due for a Short-Term Setback, Although Long-Term Outlook Remains Bullish

[Editor's Note: This oil preview is the latest installment of a new Money Morning series that will make economic projections for key U.S. sectors for the last half of 2009. As part of that series, look for forecasts for housing, energy, U.S. stocks and the emerging markets.]

By Jason Simpkins
Managing Editor
Money Morning

While the long-term outlook for oil prices remains bullish, don’t be surprised to see a near-term correction.

After tumbling to a low of $33.98 a barrel on Feb. 12, crude oil more than doubled in price, soaring to $69.82 on the New York Mercantile Exchange (Nasdaq: CME) – before tumbling nearly 4% on Thursday on a worse-than-expected jobs report.

Indeed, Money Morning predicted precisely that kind of a run-up for crude oil, first in January and then again on April 16.

As a basis for those previous analyses of the oil market, we cited the declining value of the U.S. dollar, falling production, and the possibility that demand for oil would soar as the global economy emerges from the worst financial crisis since World War II. And those factors continue to suggest that the price of oil will rise over the long-term.

However, while we still believe the long-term outlook for oil prices is bullish, it’s important to note that the recent oil price rally is not supported by supply/demand fundamentals. It is the result of a shift in market sentiment and a corresponding reversal in U.S. stocks, not a material change in the global economy.

And because the five-month rally has proceeded at an exceptionally quick pace, it’s made prices more volatile. That means prices could experience a significant correction in the short-term.

So here’s what you need to know as we approach a major inflection point for one of the world’s most volatile commodities.

What to Make of Oil’s Recent Rally

Prior to Thursday’s stumble, oil prices had soared about 106% since sliding below $34 a barrel in February. The main reason for this jump has been the so-called “green shoots” of economic recovery led investors to believe oil was oversold and that the global economy will return to growth much sooner than originally predicted.

This is highlighted by the fact that the U.S. stock market has experienced an almost simultaneous recovery. The Dow Jones Industrial Average is up about 5% from February, and 30% from mid-March. Meanwhile, the Standard & Poor’s 500 Index has climbed about 11% since Feb. 12 and is up more than 30% from its March lows.

Historically, equities have been a leading indicator of economic growth and commodities have been a coincident indicator," Hussein Allidina, head of commodities research at Morgan Stanley (NYSE: MS), told CNNMoney.com. "Right now, you're seeing commodities and equities move up together as money comes back in at the same time."

However, there are other factors at work, including the declining value of the U.S. dollar and a shift in the futures market.

Because oil is priced in dollars, any decline in value of the U.S. currency drives crude oil prices higher.   During last year’s huge run-up in oil prices, the U.S. dollar fell to a record low of $1.59 against the euro, though it subsequently rebounded. Since oil began its current rally on Feb. 12, the dollar has fallen about 10%, declining to about $1.40 against the euro.

Additionally, many speculators reversed their positions on oil from short to long, and that can also pull prices higher.

“Prospects for equity markets and the global economy, backed up by exchange rate fluctuations, expectations about future oil market tightness, and, by inference, a shift of money into or out of futures markets can all influence short-term prices,” the International Energy Agency (IEA) said in its June Oil Market Report. “Indeed, it is tempting to conclude that the shift in [New York Mercantile Exchange] WTI noncommercial positions from a net 11,000 short in early May to 40,000 net long a month later is sufficient explanation for the surge in prices” of more than 20% during May and into early June.

On top of that, some $3.8 billion has flowed into oil-and-gas exchange traded funds (ETFs) this year, compared with $1.4 billion in the first half of 2008, Goran Trapp, head of global oil trading at Morgan Stanley, told BusinessWeek.

“Considering that supply seems ample and demand is weak, the fact that oil is going up looks kind of weird,” Adam Sieminski, chief energy economist at Deutsche Bank AG (NYSE: DB), told CNN. “But those factors are being overwhelmed by a huge sigh of relief that we're not going to have the Great Depression. A lot of money is coming out of mattresses."

But while investors’ perceptions of the economic recovery – and, by extension, the oil market – have changed, the underlying supply and demand fundamentals have not. There is still a glut of oil on the market and not enough demand to soak it up.
Investors seemed to undergo a min-epiphany of that reality on Thursday, when disappointing jobless numbers raised concern “about the strength and timing of a recovery," James Williams, an economist at energy-research firm WTRG Economics, told MarketWatch.com.
August crude futures dropped $2.58 a barrel, or 3.7%, to settle at $66.73, the lowest closing level for a front-month contract since June 3, MarketWatch said.
That development supports the conclusions put forth in some recent research.

In its five-year forecast for the worldwide oil market, the IEA last week cut its five-year forecast for global crude demand and predicted that consumption won’t rebound to last year’s levels until 2012 – at the earliest.

“The deep economic recession that has spread worldwide in the past year has taken a severe toll on oil demand,” the IEA said in its Medium-Term Oil Market Report. “This marks a break after several years of strong oil demand growth.”

The IEA cut its oil demand estimates for every year through 2013 by about 3 million barrels per day (bpd). According to the agency, world oil demand would grow at an average annual rate of 0.6%, or 540,000 bpd, annually over the 2008 to 2014 period, reaching 89 million barrels a day by 2014.

Those estimates are based on the International Monetary Fund (IMF) forecast for global economic growth of about 5% a year between 2012 and 2014. In the IEA’s “lower GDP scenario,” in which the global economy expands by 3% a year, demand won’t reach 2008 levels until 2014.

With oil demand not expected to reach 2008 levels for another three years at least, the fact that oil prices are climbing more rapidly than they did in last year – when demand was high, supplies were tight, and the U.S. dollar was trading at significantly lower levels than it is today – is a red flag for many analysts.

There may be enough momentum to carry us up to just $72.50 [a barrel], but then I think the correction is going to be just that dramatic,” Guy Gleichmann, president of the United Strategic Investors Group, told The Wall Street Journal.

Additionally, a continued rise in oil prices could threaten the economic recovery by raising production costs and hurting consumers at the pumps.

Oil prices between $30 and $40 per barrel were like an “additional stimulus package,” Fatih Birol, the IEA’s chief economist, said last month. “But now this stimulus package is losing its strength and it will be definitely a problem for the global economy if prices continue to rise.”

Prices at above $70 a barrel “may well strangle the economic recovery,” Birol said.

If that’s true, oil prices, should they continue to rise, would only be setting themselves up for a bigger tumble when the economy slips back into recession later in the year.

Still Bullish Long-Term

While the short-term outlook for oil remains murky, if not bearish, the long-term outlook for crude is still strong, thanks to the weakness of the U.S. dollar and the probability that demand will eventually return.

In fact, the IEA estimates that oil demand will strengthen in India and Saudi Arabia this year, despite a 3% decline in global consumption.

And China, which has been using low commodities prices to stock up on resources, plans to increase strategic crude oil reserves by 160% to 270 million barrels during the next five years. Citing an unidentified official from China’s National Energy Administration, Nikkei English News said that Beijing would spend $4.39 billion (30 billion yuan) on stockpiling facilities with a capacity to hold 169 million barrels of crude oil.

“The wild card is really the Chinese,” said Money Morning Investment Director Keith Fitz-Gerald. “Don’t forget the Chinese are trying to diversify away from the dollar, and there are only two ‘non-currency currencies’ on the planet: gold and oil.”

And with the expansive monetary policy being employed by the U.S. Federal Reserve, the value of the dollar seems destined to retest the lows it reached in 2008.

The U.S. Federal Reserve has cut its benchmark lending rate to a range of 0.0% to 0.25%, and the central bank plans to purchase up to $300 billion in long-term U.S. Treasury securities and $750 billion of mortgage-backed securities as it pursues a policy of quantitative easing.

“Our forecast has been that oil will be at $100 in 2015 and it could happen faster if the economy recovers,” Deutsche Bank’s Sieminski told CNN.

Goldman Sachs Group Inc. (NYSE: GS) raised its 2009 oil price forecast to $85 a barrel from $65 and said prices would reach $95 a barrel in 2010. Other analysts agree.

J.P. Morgan Chase & Co. (NYSE: JPM) lifted its forecast for the average price of oil in 2009 to $55.63 a barrel from $49.38, though the investment bank noted "global demand and inventory levels look horrendous."

“We’re concerned about oil prices rising so rapidly in the near-term,” Hussein Allidina, head of commodities research at Morgan Stanley, told CNN. “But the bet in the long-term is one way, and that’s just up.”

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