Crude $49. Wow. Buy?

On the 11th of July 2008 the spot price of WTI Crude reached a high of $146.30. Yesterday it closed $ 49.62 in New York. That’s a drop of 66% in four months. Fears of a global economic collapse and massive selling by over leveraged players are the popular explanations. But isn’t $49 a steal and aren’t we still heading for “Peak Oil” ?

World Energy Outlook

Let’s start by having a look at the long-term prospects for energy. Last week the International Energy Agency published its “World Energy Outlook 2008″. As usual the IEA is drawing some interesting conclusions, of which I will highlight a few:

• World Oil Demand 2007 -2030
  • Global demand rises from 85 million barrels per day (mbpd) in 2007 to 106 mbpd in 2030;
  • All of the projected increase comes from non-OECD countries, most noticeably from India, China and The Middle East;
  • Three quarters of the projected increase comes from the transportation sector, despite a growing penetration of hybrid-electric cars;

• World Oil Supply 2007 -2030
  • Global supply is projected to rise from 82 mbpd in 2007 to 104 mbpd in 2030;
  • Conventional crude oil production increases by only 5 mbpd over that period because additional capacity of new oil fields is offset by declines in existing oil fields;
  • The bulk of the projected increase in production comes from Natural Gas Liquids (NGLs);
  • Most of the increase comes from OPEC countries, their collective share rising from 44% in 2007 to 51% in 2007;
  • Even if oil demand were to remain flat until 2030, 45 mbpd gross capacity - roughly four times the current capacity of Saudia Arabia- would need to be built by 2030 just to offset the effect of oilfield decline. Massive investment will needed to achieve this;
  • Around 7 mbpd of additional capacity, over and above the 23 mbpd that will come from the projects currently underway, needs to be brought on stream to avoid a fall in spare capacity towards 2015. In the light of the current financial crisis there are growing doubts that all of this capacity will be forthcoming.

Leading the IEA to amongst others conclude that: “while market imbalances could  temporarily cause prices to fall back, it is becoming increasingly apparent that the era of cheap oil is over”.

Historical Context

So how unusual is the 66% drop we’ve seen so far? Pretty unusual if you compare it with the crashes we’ve seen in oil since 2000. The chart below makes clear that we’ve seen several severe peak-to-valley drops in the spot price of WTI during the bull market since the past few years, ranging in size from -28 to -53%, but nowhere near the 66% we’re currently experiencing. Longer term key support seems located just below $40, corresponding to the former 1999 and 2002 highs.

We have to digg even deeper in the past to find something similar to the current situation. Using the Nymex crude oil futures contract this time (continuous, ratio-adjusted), we see two comparable plunges. One drop of 68% between 1990 and 1993 and another one of  73% between 1997 and 1998. Note that both plunges marked the beginning stage of a huge rally that followed.

So?

The fundamentals appear to be in tact and the market has just provided us with a price that looks attractive by historical standards. I’m strategically on the buy side here. Tactically I’d consider scaling into the trade though, as calling the exact bottom is obviously a mad man’s game in these violent circumstances.

Photo courtesy of divinemisscopa. Chart courtesy of Bloomberg.

—— This is an opinion on the state of financial markets and the opportunities it provides by quirijns.com. It is not investment advice and not a substitute for your own judgment. When taking on any investment, make sure to have a first aid kit at your disposal that is jammed with tranquilizers and sleeping pills, as you’ll need it. It also comes in handy for other possible disappointments in life. History is not a guide to the future, nor is anything else. Any sane person knows that there’s no sure thing except death and taxes. Fortunes are made and lost each day in this arena. If you can’t stand that heat, please stay out of the kitchen.