Crude oil price can be US $150 / barrel by 2012: 1. We expect crude oil price to average US $83 / barrel in Q4 2010 with an average price volatility of 20% with a slight skew of 10% towards downside. This implies an upper bound of US $ 91 / barrel and a lower bound of US $73 / barrel. We expect the crude oil trading to be highly volatile although with a decreasing trend which may continue for remaining part of the year. 2. We also expect the crude oil price to average US$ 86 / barrel in 2011. Crude oil price will remain flattish till mid 2011 because of combined impact of a slow growth, lower US gasoline usage & substitution of crude oil price by Natural gas / other sources of energy and efficiency gains both in cars and processing. 3. In H2 2011, the price of crude oil may average around US $ 85-88 / barrel by improvement in economic data, draw down on inventories, and investment flows hedging impending inflation as capacity constraints ease but with an increased volatility in Q4 2010 with a skew on upside. 4. By the end of 2011 crude oil implied volatility will increase as the Market may put a price premium on normalized price level. 5. Despite using the consensus (modest) GDP growth, an increase in energy efficiency of GDP as crude oil consumption per GDP $ declines, crude oil as percentage of energy consumption declines for US & EU, remains constant for Japan & China (crude oil remains at 12% of energy consumption) (remains a coal based economy), may result in increase of crude oil demand to 94 million barrels per day with supply lagging the demand by 2 million barrels per day by 2017. 6. At around US $140 / barrel spike in crude oil, the price may be capped by supply substitution and demand destruction. A strategic long position is recommended in crude oil prices and related equities. click to enlarge
Nine reasons for being on the long side for crude oil: 1. Global risk appetite will increase, resulting into an increased money inflow into the crude oil market. 2. Lower volatility may help crude oil prices to consolidate in US $ +80 / barrel per range in early part of 2011. 3. World industrial production will increase, with an increase in distillate prices, refining margins and refinery utilization and a decrease in crude oil price inventories. 4. Number of miles driven in USA (FHA) is recovering (Refer to Q3 2010 crude oil price projection) (Both the factors 2 & 3 will help reduce the crude oil inventories), which should bode well for US gasoline demand (single largest demand segment at 9 million barrels per day) 5. Increased infrastructure spending in the Middle East will increase the demand stress (unless there are serious efforts to go alternative) 6. Crude oil spare production capacity will decline below 1.5 million barrels per day by the end of 2010 and below 0.75 million barrels per day by the end of 2011 (with slag picked up by natural gas & other sources of energy) 7. Crude oil is undervalued compared to most of precious and industrial metals by a long shot 8. China buying spree (as crude oil will forms an increasing portion of energy used) 9. Structural weakness in US $ will help US $ price crude oil price. Investment Implications of demand of 94 million barrels per day: 1) Prices of corn, ethanol and most grains may test their 2008 highs. 2) Prices of bulk commodities will also peak because of an increase in cost of extraction and shipment. 3) Price of natural gas and coal may rise (estimated
natural gas price may be US $ +6 / MMBTU. (Positive for Qatar) 4) Average freight rate may shoot up to +US $180,000 / barrel. 5) Energy & commodity equities may outperform the market. 6) May cause commodity currencies like CAD & AUD 7) Inflation will peak 8) GDP growth will be stunted 9) There will be massive financial flows in GCC countries which may put severe stresses on capacities 10) It should result in negative real interest rates as inflation will outstrip the credit growth and thus asset bubbles (Dubai real estate?) 11) Standard of living in low GDP / capita countries will decline dramatically with oil consumption following (long term consumption themes?) which can serve as a crude oil price inflection point (although most of marginal demand may be reasonably inelastic to the crude oil price. Projection Risks: 1) a regime change in the natural gas (discovery of shale natural gas in US) market may put a lid on upwards momentum 2) an increase in crude oil price may stunt any nascent recovery 3) Although both gold and oil are affected by similar factors, the effect could be different 4) OPEC may increase its crude oil production beyond allocated quotas (adding 0.5 1 million barrels to the current supply), stressing inventories 5) US increases its crude oil production further. Valuation Models: Fundamental Based Crude Oil Price Valuation: Goldilocks Price for GDP Growth: 1) Goldilocks crude oil price is the GDP neutral price and may not hurt the nascent economic recovery. Taking consensus global GDP growth estimates and crude oil consumption which is needed to support this growth, we have estimated that the crude oil price of US $86 / barrel does not cause a severe demand & supply reaction in an atmosphere of a slow economic recovery. 2) We are of the view that the US economy now could absorb that crude oil price and still post some GDP growth. 3) Crude oil price is fundamentally driven by demand & supply equation, spare production capacity, inventory overhang and price flexibility of substitution by natural gas and other sources of energy (coal, nuclear etc). Our conceptual framework is based on energy sensitivity of nominal GDP, which we define as marginal GDP current US $ produced by consumption of a marginal barrel of crude oil. 4) Higher crude oil price may result in substitution of crude oil by other sources of energy like natural gas, coal & nuclear energy. Simply rising NG and Coal consumption offset what was at the minimum optimization of oil consumption to the transport sector if not an outright decline. Conservative estimates of EU / US / Japan & China GDP / crude oil consumption (i.e. increasing) and higher crude oil substitution flexibility to crude oil price may result in estimated crude oil price consumption to reach 94 million barrels per day by 2017.
Spare Production Capacity:
1) Crude oil price reaction to the spare production capacity below 1 million barrels per day can be dramatic (July 2008). During 2004-2008, crude oil prices grew from around $40/Bbl to more than $140/Bbl as a result of physically tight supplies and speculators. What is interesting is that total OPEC crude oil supply increased by approximately 0.72 Mb/d (using IEA s criteria of a production that may be sustained for 90 days) (June 2008 compared to June 2005). It required a doubling of the price to bring this increase in supply into existence. This suggests that OPEC had little spare crude oil capacity during the summer months of 2008. Despite this increase in supply, data shows that OPEC net exports were lower in 2008 than in 2005. Total supplies from Angola, Iraq & Ecuador have recently reached the same level as during the summer of 2008, and recently this has been driven by growth in Angolan supplies. The only spare production left could be in Saudi Arabia (2.5 mbpd) 2) The IEA Oil Market Report for August 2010 estimates OPEC's crude oil spare capacities at around 6,0 Mb/d, while the EIA Short Term Energy Outlook for August, 2010 provides a corresponding estimate of 5.1 Mb/d for 2010. Oil prices and OPEC spare capacities are closely linked, and therefore monitored closely by companies planning to invest in new supplies that presently are at the margin--for example, some oil sands developments. Most analysts seem to agree that OPEC presently has spare marketable crude oil capacity, and that this spare capacity could be used to maintain an oil price in the present comfort zone of $75-85/bbl. The amount of the spare capacity would thus define how long investments in new supplies at the margin are deferred. 3) According to our calculations, OPEC's probable marketable crude oil capacities as of June 2010 were approximately 2 2.5 Mb/d (and not 6 million barrel per day as suggested by EIA) and that a majority of this spare capacity is most likely in Kuwait, Saudi Arabia and the UAE. Based on this analysis, it is probable that demand for OPEC supplies could grow by approximately 2 Mb/d between 2010 and the end of 2011. Putting the estimated current OPEC spare capacity of 2 Mb/d together with the expected increase in demand for OPEC oil supplies of 2 Mb/d suggests that during 2011, OPEC's spare capacity may be completely eroded - a very serious situation. Risk Discount / Premium Approach: Another approach which had been argued by JP Morgan is a Risk Discount and Risk Premium approach. This risk discount / premium are tacked on top of normalized crude oil price which has been estimated by JP Morgan as US $ 75 80 / barrel. We estimate the risk neutral price of US $ 84-86 / barrel. Both the discounts and premium are signalled by implied CBOE implied volatility, which increases in the case of increase in risk. Estimated risk premium in June 2008 was estimated at around US$50 / barrel and risk discount of around US $ 50 / barrel in December 2008 (Chart 6). It is estimated that the current crude oil price implies neither a risk premium nor a risk discount. Current consolidation of crude oil price in this range is accompanied by a drop in CBOE volatility. We expect COBE volatility to start rising by the end of Q1 2011 which may result in a gradual aggregation of risk premium at the top of the fundamentally neutral crude oil price of US $ 84-86 / barrel.
Relative Valuations: Crude oil is currently cheaper compared to other commodities based on mean reverting levels and price ratios. Current crude oil price multiples to gold, silver, platinum, copper, aluminum, steel, SPX and the US $ index is 1.5 to 2 standard deviations below mean reverting levels / adjusted historical averages. This breakdown in correlations will return closer to the levels seen when markets are not stressed. If we assume that correlations would head back to normal at some point in time and if true correlations were to come back to the market we are likely to see either crude oil prices rise to the level predicted by our relative valuation model or prices of these commodities, especially Gold, silver & platinum, will fall (assuming crude oil is fairly priced). However, we believe that precious metal prices may be sticky in the short term because of safe heaven demand away from fiat currencies, which in turn mean that our relative crude oil price of US $ 90 / barrel is a possibility (Table 1). On the other hand, a united interest in the pace of the economic recovery had driven the correlation between Standard & Poor s 500 index and crude futures to a peak of 76% in late August. Recently, however, record high US petroleum inventories have put a damper on crude prices, while the stock market has rallied off a wave of mergers, increased dividends, and stock buybacks. The correlation between the equity market and crude prices fell to 47% at the close of trading Sept. 23. This correlation may rise to 65% in 2011, which implies a crude oil price of US $ 85 90 / barrel (Table 1). Inventories: We expect a draw down in crude oil and gasoline inventories like what happened in the last DOE report (September 30, 2010). This was also backed by an FHA reported increase in the number of US vehicle miles, which were up. Although inventories are still higher than the 5 year average, we expect a gradual draw down in the coming six months. The trajectory of prices will be highly dependent on demand for the coming six months because of overhang. This implies a more flattish view of crude oil prices. Basing crude oil projection solely on inventories should result in an estimated crude oil price of around US $ 75 / barrel.