Barrons: Get Ready for $150 Oil!

The U.S. economy is never completely ready for higher oil prices, which is one reason they take a nasty economic toll when they arrive. But readiness can be enhanced by awareness of the likely outlook for petroleum prices–and the outlook today is relatively grim, although probably not disastrous.

Despite the recent 20% decline from April highs, new highs on crude, heating oil, diesel fuel, jet fuel and gasoline seem likely over the next 12 months. Following some further easing over the summer, the second leg of the long-term bull market in petroleum–the first occurred in 2007-08–probably will begin this fall.

As oil producers’ spare capacity gradually declines to worrisome levels, the average monthly price could reach a record $150 per barrel by next spring, with spikes to $165 or $170. With this, $4.50-a-gallon gasoline will become the norm. That will put a huge dent in consumer wallets, while ramping up the desirability of fuel-efficient cars.

The continued short-term easing of oil prices should benefit the economy over the summer, only to exact a much larger payback later. The projected oil shock of spring 2012 will hurt the economic expansion, but not kill it, pruning about 1.5 percentage points from quarterly growth in real gross domestic product.

While painful, this forecast isn’t quite as extreme as it might appear. Short-lived price spikes and troughs make for frenzied headlines in newspapers and on the Internet as well as for hysterical talking heads on radio and TV, but what matters for the economy are average prices over at least a few months. Barron’s estimates that the effective price of crude was about $110 in this year’s second quarter, which just ended. So a projected increase to $150 by the second quarter of next year assumes a rise of $40. Oil is likely to stay at $150 for several months, before the promise of greater supply brings a gradual easing.

The $110 price estimate comes from taking the midpoint between the market price on West Texas Intermediate oil traded on the New York Mercantile Exchange in New York and on Brent crude traded on the Intercontinental Exchange in London. While the recent unusual 10%-15% premium of Brent over WTI, which actually is of higher quality, has puzzled many analysts, those Barron’s polled agree that the lower price on WTI is potentially misleading.

According to Credit-Suisse energy analyst Joachim Azria, the U.S. is mainly paying the West Texas Intermediate price, but the cost of gasoline and diesel and jet fuel reflects the higher Brent price. James Hamilton, an economics professor at the University of San Diego, has studied the effect of oil shocks on the economy. He suggests using a midpoint between Brent and WTI to capture the effective price. That’s what we’ve done.

Still, even a $40 rise, to $150, by next spring differs by several country miles from the oil market’s own implied price outlook. Last week, futures contracts for June 2012 delivery of WTI crude were trading around $99, while Brent crude for June 2012 delivery was commanding just $112.

Steve Briese, publisher of the Bullish Review of Commodity Insiders newsletter and Website, says that commercial hedgers–who deal in the underlying commodity and thus have lots of professional experience in these matters — are “overwhelmingly bearish” and are putting their money where their convictions are. They currently have a record net short position on the Nymex futures and options market. Because history shows that the hedgers often have been right, Briese concludes that the “short profit potential is enormous.”

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While Barron’ssees some short-selling potential this summer, it’s not “enormous.” And with all due respect to the expertise of the commercial hedgers, even pros can be wrong. We think this is a great buying opportunity for bulls on petroleum.

Cornerstone Analytics oil analyst Michael Rothman, with more than 25 years’ experience calling the market, foresees an extended price plateau of $170. In support of his view, Rothman cites a comment made by Nobuo Tanaka, executive director of the International Energy Agency, the Paris-based organization that represents oil-consuming nations. Tanaka spoke on June 23, when the IEA helped cause a selloff in the petroleum market by announcing that 60 million barrels were being released from strategic reserves held by the U.S. and 27 other countries. (For more on the effects of this move, see Commodities Corner column.)

The markets seemed quite impressed by this infusion, even though it amounted to just a little over two-thirds of the nearly 90 million barrels the world consumes each day. At that rate of daily off-take, the total emergency stocks held world-wide, 1.6 billion barrels, come to only about 18 days of supply. Far more important is the ability of producing nations to meet needs, month after month.

The ostensible reason for releasing the 60 million barrels was to help replace the loss of production from war-torn Libya. But Tanaka, who not surprisingly said that he had been in “close consultation” with “major producing countries,” also linked the decision to concern about spare capacity within the Organization of Petroleum Exporting Countries, and especially from its largest producer, Saudi Arabia. While welcoming increased production from this source, he cautioned that it “will take time” to come on line.

Comments Rothman: “Read between the lines. This raises the specter that the Saudis might have a problem raising their output.”

The Barron’s projection assumes that the Saudis will ramp up output this month, and that prices will continue to ease as a result. Another oil bull, Morgan Stanley’s commodity research head Hussein Allidina, sees this only furthering the decline of OPEC’s spare capacity to “untenable levels,” and especially in the land that Allidina dubs the “kingdom of spare capacity” — Saudi Arabia.

While Allidina is more cautious than Rothman — his most bullish scenario projects a Brent average price of about $140 through next year — their broad concerns are similar. Author of a September 2009 report called “Crude-Oil Balances to Tighten Again by 2012,” Allidina foresaw the process by which unused capacity would eventually be reduced to puny levels, sparking higher prices.Shared From And Read More

Get Ready for $150 Oil – Barrons.com.