Are Oil And Gas Prices Headed Higher?

According to AAA, the average nationwide gasoline price hit another all-time high a couple of weeks ago at $3.22/gallon, besting its previous record of $3.06/gallon on August 11, 2006. Some are calling for energy prices to continue to move up calling for $4/gallon gas. Well, allow me to add some fuel to the speculation fire (pun intended).

We just completed the spring “shoulder season” for energy commodities. There are two shoulder seasons each year, one in the fall and one in the spring. During these periods, the demand for energy commodities tends to dip as people drive less and less energy is required to heat or cool their homes, businesses, etc. With depressed demand typically comes increased inventory – but not this year. Let’s take a look at how energy inventories have behaved this year compared to the previous six years (1).

Average build in inventories from the end of September till the end of May for the previous 6 years: 4.9% or 31M BBLs.
The decline in inventories from the end of last September till the end of this May: -4.1% or 28M BBLs.

Therefore in a typical or average year, inventories should be approximately 9% or 59M BBLs higher than they are today.

Back in December I noticed that inventories were being depleted at a more substantial rate than in previous years. Initially, I originally thought that this was a hangover from the massive builds we saw last summer and early fall, but I decided to start studying it more closely and discovered a disturbing trend. For my research, I calculated the difference in draws/builds of inventories from the start of the fall shoulder season, through the winter until the end of the spring shoulder season. As you can see above, the average build from 2000 – 2006 was around 5% through this time period. This year however, we saw a draw of just over 4% – a 59M bbl difference.

So this begs the question, what is the underlying cause for the unusual decrease in supplies? Was there any short-term impetus or does this signal a breakdown in the fundamental supply and demand for energy inventories leading to higher prices? Unfortunately, the answer is No, there was not a short-term reason for inventories to be depleted!

Let’s quickly examine the usual suspects that result in a short-term draw of inventories.

Weather:

Energy inventories declined during most of the winter despite an unusually warm climate. With the exception of a bitterly cold February, the winter was exceptionally mild. Especially in December through January, there should have been a continuing build but instead there was a draw.

Furthermore, the weather last summer was not responsible for any sort of supply disruption (i.e. Hurricanes). Unfortunately, this year might be different situation. Accuweather’s Joe Bastardi is warning of the potential for significant storm activity in the Gulf coast. He is quoted as saying on the Accuweather website:

We’ll see storms on the prowl in the Gulf again. The entire region – including New Orleans and other areas that are still rebuilding after Katrina – is susceptible to landfalling storms. Of concern to consumers everywhere is that there is so much oil and natural gas drilling and refining occurring in the Gulf. This year’s stronger storms are likely to cause the kind of disruption that will be felt in wallets and pocketbooks.

Global Geo-politics:

On the geo-political front, no news is good news for energy prices (good news meaning declining prices for the consumer). Even though the War in Iraq is turning into a complete debacle; there hasn’t been any significant disruption in supplies stemming from turmoil in Africa or South America. I believe it’s a bit too idealistic to think that the relative lack of violent activity from these regions will continue. Any sort of flare up in Africa, Latin America or the Middle East could cause major supply disruptions. Ironically, higher prices may lead to increased volatility in the region as greed will provide the necessary incentive for militias and unscrupulous political leaders to “mix it up”.

Doug Casey, a well-known commodity analyst, wrote an interesting article on our growing dependence on African Oil and how the instability in the area could impact energy prices.
Conclusion:

When you combine the effects of a mild winter with a lack of supply disruptions overseas, we should have seen a solid build in energy inventories over the last eight months. But we didn’t and that should be alarming!

There is a litany of reasons that could explain why energy inventories were depleting when they should have been building. But without any short-term impetus (2) causing inventories to decline, the most plausible explanation is that the long-term fundamental case for rising energy prices is strengthening. Supply is simply not keeping up with demand – if supply is growing at all. According to T. Boone Pickens, perhaps the market’s most renowned energy analyst, the world is producing 85M bbls/day and the world is consuming 85M bbls/day. There is no room for demand growth or supply disruptions!

Furthermore, he along with well-known investors such as Jim Rogers and Matt Simmons believe that the “elephant” fields in the Middle East and Latin America are declining in production – a theory known as “Peak Oil”. (Matt Simmons has written a book called “Twilight in the Desert” that defends the “Peak Oil” theory). These regions have used various means of increasing short-term production to mask the longer-term fundamental issues with their capacity. Pickens is calling for $85/bbl oil by the end of this summer and given the sizable draw over the last eight months, it wouldn’t surprise me if he is right.

Fortunately, for the average investor, there are several means of profiting from the rise in energy prices without venturing into the tricky world of commodity derivatives. Oppenheimer Funds offers significant energy exposure though it’s Commodity Strategy Total Return Fund, ticker symbol QRAAX (A-share) or QRAYX (No-load, investor class share). Approximately 2/3’s of the fund is comprised of energy futures. If you want pure exposure to energy, BBL
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there are few ETF’s that you can use. IPath’s OIL and United States Oil’s USO are two offerings that are pure crude oil plays. If you would like a fund that has diversified exposure to energy futures, Proshares offers an ETF, ticker symbol DBE, that invests in Crude, Distillate, RBOB Unleaded Gas and Natural Gas futures. Each commodity comprises approximately 25% of the fund.

1) Calculation Data: I track inventory levels by adding the total inventories of Crude, Distillate and Total Motor Gasoline provided by the Energy Information Administration. Percentage changes in inventories was calculated by taking the difference in Weekly Supply Estimates from the June 1st reading and the September 29st and then dividing it by the September figure.

1455 blg

Are Oil And Gas Prices Headed Higher?

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