Get Ready For Higher Oil Prices

Jim Brown
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The sudden flurry of better than expected economic reports point to a U.S. economy that is accelerating out of the recession and that improvement will be felt in demand all around the globe.

Oil prices rallied +3% on Wednesday after another day of positive economic reports improved market sentiment in nearly all sectors. China reported manufacturing gains China is expected to use 9.6 million barrels per day of oil in 2011 according to the IEA but I expect it to be well over 11 mbpd by year end 2011. The IEA estimate is for a gain of +4%. With auto manufacturing and sales a solid growth business in China their demand for fuel is going to explode. Several of the major manufacturers like Mercedes Benz are expecting better than 100% growth in sales in China.

The country is frantically building thousands of miles of interstate highways and improving one-lane dirt farm roads to two lane concrete all across China.

China is at the end of a five-year mandated effort to reduce energy consumption to a certain arbitrary level. After this year is over they will go back to business as usual able to say to the world we achieved our goals. The world does not realize they achieved those goals by keeping fuel prices so low that refiners and service stations only sold the minimum amount of fuel because they were losing money on the deal. China mandated turning off power to streetlights in order to slow down traffic. They implemented rolling power blackouts to cut energy usage. So many companies bought diesel generators to supplement power for their operations that the diesel shortage forced long lines of up to 8 hours to fill up a car. Car owners were paying laborers to wait in the line for a fill up. They ordered hundreds of coal mines to close down until year end so there would be a shortage of coal for power and force lower power usage. In China if the premier orders a certain level of energy use then it has to happen by any means possible.

When this five-year program ends and all of these individual actions are no longer slowing down business production and personal travel the consumption of crude products is going to explode higher.

China's PMI Index rose to 55.2 from 54.7 in November. That is the fourth consecutive month that manufacturing increased in China despite the pressure from the government to slow inflation. In Europe, manufacturing grew at the fastest pace in four months in November led by Germany. The equivalent of the PMI for the 16-nation euro area rose to 55.3 from 54.6 in October. Another gauge of UK growth tallied by Markit Economics rose to 58 from 55.4 in October. That was the biggest increase in 16 years.

The chief economist of the IMF expects the global economy to expand by 4% to 5% this year and over 6% in 2011. All the Asian economies are growing in the 8% to 10% rate with some even higher than that.

All of this sudden improvement in growth signals is also an indicator of growing crude demand. Historically a percentage improvement in a countries GDP will produce a like increase in the demand for oil to fuel that GDP growth. That does not mean that a country with 5% GDP growth will increase oil consumption by 5% because there are other factors at work. An economically advanced economy like the U.S. may only see a 2% rise in oil demand because we have a greater energy efficiency factor than say a country like Vietnam, China or India. Our processes are more developed while processes in emerging markets are more diverse or even frantic and require more energy to accomplish the same amount of output.

Analysts differ on the rate of demand increase per country but using China as an example with a 10% GDP their oil demand is expected to grow by 4% to 5%. The U.S. is expected to grow by 4% to 4.5% in 2011 but oil demand growth is expected to be less than 2%.

However, applying these ratios to the entire world where the IMF economist expects 6% GDP growth in 2011 means oil demand growth could rise by 3% instead of the +1.4% the IEA predicted back in October.

Currently we consume about 86 mbpd and that is expected to rise to 87.5 mbpd in 2011. If you use the higher 3% growth rate demand would grow to 88.58 mbpd in 2011. That 2.5 mbpd increase would immediately erase the remaining production cuts by OPEC. They "officially" cut production by 4.5 mbpd in 2008 and they have not raised those quotas even though compliance is between 53% and 57%. That means of the 4.5 mbpd they "cut" only 2.47 mbpd is currently being held off the market. The other two million barrels are being produced and sold outside the official quota levels.

With only 2.47 mbpd still in "reserve" a +2.5 mbpd increase in demand in 2011 would erase that overage, "if it still exists." We don't know how much more oil is being consumed by the OPEC countries in their own country. Internal OPEC demand is the fastest growing demand factor in the world. It is growing even faster in total barrels than China's increased demand. This increase is not common knowledge since the oil is not exported and "accurate" numbers are not disseminated.

A 3% increase in crude demand in 2011 would put us back to the demand levels we had in 2008 when prices soared to $147. Only this time we are starting from a much higher price level.

They say there are only two things in life that are guaranteed. Those are death and taxes. Anybody with a mind would agree that there is a third thing and that is higher oil prices. You can't produce 87 mbpd of a finite commodity forever and you can't continue to expand consumption of a commodity that is limited in supply. The natural alternative is price rationing. As prices move higher demand slows and prices decline slightly. As consumers get used to the higher prices, demand begins to increase and prices rise again and the entire cycle repeats. Only it repeats from a higher level. This is where we are headed and I believe it will be here sooner than many think.

Goldman reiterated their call for triple digit oil prices in 2011 with continual increases thereafter. Barclays believes $100 is a starting point in 2011 and prices will really begin to accelerate in 2012, 2013 and 2014.

Are you ready for $8 gasoline, when you can get it? How will that change your life? Where do you want to live when your every waking thought is how much it will cost to drive from point A to point B. How much will it cost for your kids and grandkids to visit? How will you travel when plane tickets are $1000 each and capacity limited. Are you ready for peak oil?

Jim Brown

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