For my Energy and Capital article this week, I evaluate the EIA’s new oil outlook report, and conclude that there are at least five reasons why oil should go higher from here, unless we have very severe demand destruction in the developing world.

Five Reasons Why Oil Must Go Higher

Evaluating EIA’s New Oil Outlook Report

By Chris Nelder
Wednesday, December 10th, 2008

When CNN Radio called me yesterday for my take on the new EIA report, I knew I was going to have to tell them, once again, a story nobody wants to hear.

The agency’s new outlook expects the global financial crisis to put the brakes on the world economy, slowing the economic growth rate to just 0.5 percent and damping demand for oil and other commodities. The World Bank issued a similar warning the same day.

I don’t disagree with the EIA’s revised demand outlook for oil. For 2008 and 2009, they project a decline of a half-million barrels per day from 2007 levels, to roughly 85 million barrels per day (mbpd). The decline would owe largely to a 1.2 mbpd reduction in US demand, which would be partially balanced out by still-increasing demand from China other developing countries.

What I disagree with is its projection on prices. Where the agency sees “additional declines in crude oil and other energy prices,” I don’t believe prices can go much lower, particularly where oil is concerned. Its new 2009 forecast for crude is $51/bbl, down from $63.50 in its previous forecast.

I have several good reasons for my skepticism.

First, there is the history of EIA forecasting. Last year the agency published a retrospective of its own annual energy outlook reports, and found that since 1997 it had consistently underestimated future oil prices. To be fair, the IEA is little better, having projected a cost of $21/bbl as recently as 2002, rising to $29/bbl by 2030! Neither agency has any sort of predictive track record to crow about.

Second, OPEC is widely expected to cut its official production targets by at least 1 mbpd at their meeting next week. The group has signaled that it wants to keep oil in the $70-75 range, and if Saudi Arabia can exercise discipline on the group (Iran and Venezuela, among others, are suspected of exceeding their production quotas) it will likely succeed.

Third, there is the simple fact that oil production costs are now well above the going price of oil. At $42 a barrel today, it simply doesn’t pay to keep pumping oil from the more recently developed fields. In addition, the producers of the Persian Gulf have massive federal budget dependencies on oil, and would run serious current account deficits at current prices.

According to a recent study by Brad Setser for the Council on Foreign Relations using data from the IMF and other sources, Saudi Arabia, Kuwait, Algeria and Libya all need $50-60, and Russia needs $70, to break even on production and meet their budgetary needs. (These numbers are averages across many different kinds of reservoirs with different cost structures, but do reflect the real forward production cost.)

With the world’s oldest, largest, and cheapest fields either already in decline or soon to be, we are now depending completely on difficult, unconventional oil projects like deepwater, tar sands, and oil shales to manage any increase at all in supply. My research suggests that oil needs to be at least $65/bbl to sustain investment in these incredibly capital-intensive projects.

The real bar is probably even higher. Credible experts maintain that oil will have to remain above $100/bbl for a good length of time before oil companies are willing to invest in the much more expensive and risky projects that will deliver the oil we need over the next several decades.

As I have argued in my recent columns, oil in the $40s now almost certainly means we are setting ourselves up for an “air pocket” in supply, which we will hit within the next few years when the global economy recovers. (See “The Truth Behind Low Oil Prices” and “Oil Prices: Why the Past is Not Prologue.”)

The oil prices we see now, therefore, are truly an aberration. The Street has overreacted to the declining economic growth forecasts, and sold oil too low. I don’t see a severe and lasting demand destruction yet; I see a temporary slump, a gentle cooling of an overheated global market. I expect the global economy to find its legs again by 2010, at which point the spare oil production capacity will once again shrink to nothing.

Fourth, we are now seeing a few more aberrations, like the steep contango in 12-month forward crude futures, which is greater now than it has been in a decade. Contracts for crude delivery next December are currently trading at $57.50 a barrel, a premium of more than 32% over the $43.40 a barrel for crude delivery later this month. That rubber band seems stretched to the breaking point.

This has caused another aberration. Tanker rates are going up not because more oil is being shipped, but because the tankers are being used to store oil that’s now too cheap to sell. One could buy oil today, store it for a year, and sell it for an 11% profit after expenses. As the worldwide inventory of tankers is limited, that’s not a situation that can hold for very long.

But nothing assures me I am right more than seeing the reaction today of Phil Flynn, the guy who called me a “peak freak” on Fox Business. “We’ve lowered the bar for gasoline demand so much that it’s going to take years for it to recover to the type of demand numbers that we had in the past,” he said.

I love to trade opposite Flynn’s advice, and this statement is no exception. We haven’t seen tens of millions of gas guzzlers sent to the scrap heap and replaced by more efficient vehicles; we’ve simply seen them garaged for a while. Now that it costs under $40 to fill up a typical tank, I have no doubt that they’ll be back on the streets soon.

We should always bear in mind that oil is priced at the margins. The last, most expensive barrel essentially sets the price of the whole lot. When there is spare production capacity, as there is now, oil prices will eventually be set by the production cost, which we’re already below. When that spare production capacity collapses to nothing again, as it did when oil prices peaked in June, no one can say how high prices might go.

The EIA and the IEA certainly never imagined that oil would reach $147/bbl this year, and I wouldn’t give a plugged nickel for either agency’s estimates of future prices.

Long Term Oil Prices: Outlook Murky

To CNN’s credit, the bit of my interview that they aired got the most important point across: Eventually, oil prices are going to rebound, and when they do, watch out.

If I am correct, and the global economy recovers in 2010 at the same time that global oil production peaks, we will see oil prices shoot for new record highs. For the long term investor, and by that I mean two years or so, I think oil at current prices is a drop-dead bargain.

However, despite the above arguments for higher oil prices, my crystal ball is still saying “outlook murky.” Oil could continue to overshoot to the downside until supply truly dries up. If oil falls below the $40 level for more than a few days, I think it could go lower, albeit for a short while. So I am keeping an eagle eye on the near- and long-term crude futures, and may temporarily hedge my long oil position (United States Oil Fund LP ETF, NYSE:USO) with a short side position (ProShares UltraShort Oil & Gas ETF, NYSE: DUG)

On a final note, I had the privilege of speaking to the students and faculty of the University of California Nuclear Engineering Department and the Lawrence Berkeley Lab on Monday, which was also simulcast to the University of Tokyo. My presentation was largely a condensation of my book, Profit from the Peak. If you are interested in my big-picture view on energy, you can watch the presentation here: http://www.nuc.berkeley.edu/Chris-Nelder-Video (The sound is rough at the beginning, but once I start the presentation it clears up.)

Until next time,

Chris