$100 Oil Before Year End?

Jim Brown
 
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With the dollar in a suicide dive and economic activity increasing the odds of higher oil prices continue to increase. JP Morgan and Merrill believe $100 may be just around the corner.

JP Morgan and Merrill Lynch both set their sights on triple digit oil prices in 2011 after the Fed announced its latest round of quantitative easing on Wednesday. The more money in the system the more it costs for hard commodities. This is simple economics 101. When dollars go down in value it takes more dollars to buy the same ounce of gold or barrel of oil. Those commodities did not change in value overnight. It was the dollar that changed. The dollar has declined in value by 15% since its recent high back in June.

Oil prices have gained +8.1% for the year without the benefit of increased demand. Now that demand is beginning to accelerate the price of oil should follow. To put that in perspective the price of gold has rallied +24%. Demand for gold is relatively stable where the underlying economics for oil had restrained the price. Inventories of refined products had risen to a 20-year high. Now those inventories are starting to be withdrawn and investors are expecting crude prices to catch up with the gains in gold prices.

Crude has the added lure of the coming production peak in oil over the next several years. That will be like winning the lottery for investors who are planning ahead today.

You may remember the $65-$75 band of prices that OPEC and especially Saudi Arabia was "comfortable" with over the last several years. This week the Saudi Oil minister Al-Naimi spoke of being comfortable with the $70-$90 price range for the first time. This gradual increase in expectations is very subtle but the key point is that OPEC will not be raising quotas until the upper end of that band has been exceeded. By expanding the band in normal conversations they are trying to immunize consumers and analysts about the coming price spike. If you say $90 enough it eventually loses its shock value.

On October 13th the IEA predicted oil demand would rise +2.1 million barrels per day to 86.9 mbpd in 2010 and another 1.3 mbpd in 2011 to 88.2 mbpd. They also said spare capacity declined by one-million barrels per day in 2010. That is "official" spare capacity. That is the amount OPEC claims it has but there is no confirmation. When it comes time to actually see them produce it we could be in for a big surprise.

Hedge funds and large speculators increased bets on crude by 9.3% for the week ended Oct 26th pushing longs to the highest level in more than six months.

A Merrill Lynch analyst said the big risk for the Fed is that oil prices get out of control. He expects $90 by year end and then $100 next year. If the pricing scenario begins to spiral out of control as investors snap up all available contracts then prices could race ahead to $125-$130 and cause another recession.

It was commonly thought in the past that $85 oil would be an economy killer. Quite a few analysts and economists believe the rapid spike over $85 that ran to $147 in 2008 was the true cause of the recession. People could not afford to make house payments and drive to work and they started falling behind in their debts because of the increased cost of fuel. There have been numerous papers written on this subject with tons of valid data to support their case.

Now, with oil already at $85 again, the economy killer price is being quoted as $100. With oil approaching triple digits the cost of gasoline and diesel will begin to rise with gasoline moving back over $3 and diesel over $4. That becomes a serious drain on the economy but will it be enough drain this time to overcome the impact of $2 trillion in quantitative easing? Time will tell.

Signs of increasing demand include a supertanker shortage in the Persian Gulf. For the first time in over a year there are more cargoes available for loading than there are available tankers. It is not a big increase but still an increase. There was a 20% surplus of tankers just a few weeks ago.

I believe this a sign OPEC has stepped up its cheating on production quotas. Obviously somebody has to be pumping more oil if the normal tanker transportation cycle has suddenly run short of tankers. When a VLCC tanker takes on a load they spend 30-45 days transporting that load, unloading and making the trip back for a refill. They don't offload and then sit around waiting for a new gig. It is a round trip over and over again for most. There are some tankers in the spot market that make special runs and go to different places based on the load and volume. Bottom line, there was not a sudden loss of tankers over the last month. There were no collisions and sinkings. More than likely there is a sudden surge in production.

Sinopec (SNP) said it will increase refining capacity by 10% in an effort to overcome the sudden shortage of diesel in China. Sinopec refined a record 577,100 tons of crude per day in October and they are raising output to 583,000 tons per day. The challenge is a power shortage in China as manufacturing activity increases and the government tries to control demands on power. This shortage forces companies to use their own diesel generators and that requires additional large quantities of fuel.

Sinopec has canceled maintenance on its refineries and postponed upgrades in order to run at full capacity to keep up with demand. Sinopec has ordered increased imports of diesel by 200,000 tons to ease shortages until production can be increased. Sinopec refineries have been running at 100% capacity for the last four months and that capacity increased by 8.3% in October.

Signs like these suggest global crude demand is increasing and possibly increasing faster than the IEA has predicted. These demand stories should keep speculators in long positions as prices move higher.

Jim Brown

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