Transcript EMT & Associates, Inc

2011 Price Outlook For Oil Markets
New York Energy Forum
William H. Brown III
President
WHB Energy Research LLC
February 3, 2011
Outline of Presentation




Fundamentals:
World oil balance, 2011
Financials:
A review of 2010
Assessing non-commercial participation
CFTC data
The equity market
The dollar
Price components in another “recovery” year: 2011
Broad fundamental view
Non-commercial influence
Seasonality
Translate all factors into an “heroic” price forecast
WHB Biases:
Listener Beware

For equities, we tend to have a positive bias

For the commodities, we are indifferent with regard to price

We believe non-commercial activity has played a major role in crude oil price
determination since 2004

However, we view it as a fact of life and one component of the equation, and do not
believe that “speculation” is evil or that funds “have no right to hit a home run”

We have believed ever since the 1980s that commodities represent a legitimate
alternative asset class, but on both the long and short side


The fund influence on oil prices has played a major role in rebalancing
demand with supply in an industry that is not characterized by discrete,
annual, and predictable price increases
Legislation and/or rule making will have little or no effect on crude oil prices
Fundamentals
2011

World oil demand is forecast to rise by 2.0% in 2011, assuming real
GDP growth of 2.5%-3.0%

OECD oil demand is expected to gain by 1.0%

Non-OECD oil demand is forecast to rise by 3.1%, paced by China,
although the consensus tends to ignore Middle East demand growth

Refined product demand strength will once again be derived
primarily from middle distillates in both the OECD and non-OECD

Gasoline demand growth is expected to be moderate in the United
States, reflecting rising average fleet fuel efficiency, despite a
recovery in discretionary driving as consumer confidence improves
Fundamentals
2011

Non-OPEC supply is forecast to rise by 675 MB/D, with FSU accounting for
healthy share of total

OPEC “11” crude oil deliveries are expected to average 27.7 MMB/D

Saudi Arabia crude oil deliveries are forecast to average 8.7 MMB/D. Could
be higher due to domestic requirements

Iraq oil production expected to average 2.6+ MMB/D

Balances imply little net change in global stocks for the year, and thus the
market will remain adequately supplied and “competitive”. For example,
+1.6% U.S. refined product demand growth can be met by refinery crude
distillation capacity utilization of less than 90%
Financials
2011

Non-Commercial Participation
There was evidence of early-2011 allocation of capital to NYMEX crude oil, but
it was somewhat “disappointing”, as funds gravitated at the margin to Brent.
Most funds believe 2011 will be a “boom” year for commodities

The Buck Stops Anywhere
“Bears” repeating: the greenback has exhibited a periodically strong, inverse
correlation with crude oil over the last few years. The reason is that the trade
“worked” at certain times for hedge funds, and not due to any
sophisticated fundamental rationale that has any consistent historical basis

Don’t Forget Stocks
We will guess that funds will become a bit more enamored with equities versus
commodities by the time 2011 comes to a close. Commodities became en
vogue starting in 2004 based on attractive previous years’ returns, which
reflected sophisticated, fundamentally-driven CTAs who had no problem being
either long or short. Even if there is a bullish uptrend from here on, why not
participate more via “living breathing” entities that can maximize investor
value, and not just via an “inanimate” commodity?
Financials:
Non-Commercial Participation



CFTC data
This also bears repeating: the numbers are an
imperfect, but useful, tool to gauge the influence
Although the CFTC breaks down the weekly
Commitments of Traders Report into 4 categories, we
have found the two most “explanatory” to be Managed
Money and Swaps Dealer
Of the two, Managed Money helps the most
Financials
CFTC Data: Who Are They?

Managed Money
A registered commodity trading advisor (CTA), a commodity pool operator
(CPO), or an unregistered fund identified by the CFTC (e.g. hedge fund)

Swap Dealer
An entity that deals primarily in swaps for a commodity and uses the
futures market to manage or hedge the risk associated with those swaps
transactions. The swap dealer’s counterparties may be speculative traders,
like hedge funds, or traditional commercial clients that are managing risk
arising from their dealings in the physical commodity
Financials:
CFTC Data: Explanatory or Not?
Correlations: A Look by Year
Swap Dealer
2007
2008
2009
2010
0.19
0.38
0.25
0.62
Money Manager
0.42
0.41
0.72
0.75
Financials:
CFTC Data: Explanatory or Not?
Once again we would make the point that “Managed Money” has a strong
explanatory power regarding NYMEX crude oil, but generally during
discrete periods within a given year.
2010 Correlation
Prompt NYMEX Crude Oil Contract vs. CFTC "Managed Money"
300,000
95.00
250,000
90.00
200,000
85.00
150,000
80.00
100,000
Partial uncoupling
post the November 3
"news"
50,000
75.00
70.00
0
65.00
Period of QE II discounting between
Ben's Jackson Hole speech and
November 3 FOMC statement
CFTCNMM
PCL
12/20/2010
12/6/2010
11/22/2010
11/8/2010
10/25/2010
10/11/2010
9/27/2010
9/13/2010
8/30/2010
8/16/2010
8/2/2010
7/19/2010
7/5/2010
6/21/2010
6/7/2010
5/24/2010
5/10/2010
4/26/2010
4/12/2010
3/29/2010
3/15/2010
3/1/2010
2/15/2010
2/1/2010
60.00
1/18/2010
-50,000
1/4/2010

Prompt NYMEX Crude Oil
vs.
Managed Money:
Correlation or Causality?


Reasonably high correlation, on average, suggests that either
Managed Money is reacting to fundamental developments (read
demand) or is helping to cause prices to rise or fall
To believe that Managed Money is reacting to fundamentals,
however, perhaps presupposes a real- time and near-perfect
knowledge of fundamental developments in the physical market
Prompt NYMEX Crude Oil
vs.
Managed Money:
Nonetheless, It Isn’t Always Just A Pure Response To Liquidity and
Inflation Expectations
U.S. Commercial Days Supply of Crude Oil vs. Prompt NYMEX CL
95.00
27.00
QE II discounting led to counterintuitive
behavior of rising prices and rising days
supply
90.00
26.00
85.00
25.00
80.00
24.00
75.00
23.00
70.00
22.00
Once QE II had been discounted, however,
market reverted to intuitive behavior of rising
prices and declining days supply
PCL
USCLDS
12/20/2010
12/6/2010
11/22/2010
11/8/2010
10/25/2010
10/11/2010
9/27/2010
9/13/2010
8/30/2010
8/16/2010
8/2/2010
7/19/2010
7/5/2010
6/21/2010
6/7/2010
5/24/2010
5/10/2010
4/26/2010
4/12/2010
3/29/2010
3/15/2010
3/1/2010
2/15/2010
20.00
2/1/2010
60.00
1/18/2010
21.00
1/4/2010
65.00
Financials:
The Equity Market

Correlation, S&P 500 vs. NYMEX CL:
2004
2005
2006
2007
2008
2009
2010
0.00
0.25
0.40
0.15
0.66
0.76
0.76
Financials:
The Equity Market
The correlation is close enough for government work, given the comparison of a 4:00
equity market close with a 2:30 NYMEX settlement
2010 Correlation
Prompt NYMEX Crude Oil Contract vs. S&P 500
PCL
SP500
20-Dec
6-Dec
22-Nov
8-Nov
25-Oct
11-Oct
27-Sep
13-Sep
30-Aug
16-Aug
2-Aug
19-Jul
5-Jul
1000.00
21-Jun
65.00
7-Jun
1050.00
24-May
70.00
10-May
1100.00
26-Apr
75.00
12-Apr
1150.00
29-Mar
80.00
15-Mar
1200.00
1-Mar
85.00
15-Feb
1250.00
1-Feb
90.00
18-Jan
1300.00
4-Jan
95.00
Financials:
The Equity Market
Let’s Look at Month-by-Month Capital Allocation Patterns in 2010
Cumulative Gain/Loss,
First Three Trading Days of the Month
Prompt NYMEX CL
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Net
Investment:
Broad
Economic
Optimism
$3.82
$4.09
$1.21
$3.08
-$6.18
$0.64
-$3.65
$3.52
$2.68
$2.85
$3.26
$5.08
Net “Disinvestment”: Euro Crisis
and “Double Dip” Fever
Net Investment: Ben’s QE II
Discourse and Renewed
Economic Optimism
For 2010 as a whole, the “average peak” in the first three trading days of the month was $81.25 per barrel. The
average for remaining trading days of each month was $79.51 per barrel. Therefore, on average the difference
was an early-month peak that was higher than the subsequent average by $1.74 per barrel, suggesting that
early-month asset allocation played a role. A similar pattern often occurred in the equity market.
Financials:
“Economic Growth Price Formula”


With the increasing strength of the relationship between NYMEX
crude oil prices and the S&P 500, funds are assuming that oil prices
will vary with economic growth as represented by the equity market
While economic growth is clearly fundamental in nature, we have
observed that funds, when making crude oil buying or selling
decisions, lean toward the following equation:
Economy = Oil Demand = Oil Prices

That is, funds tend to look only at oil demand and not the
entire fundamental balance as embodied by the net global
inventory position
Financials:
The Dollar

Correlation, Dollar/Euro vs. NYMEX CL:
2004
2005
2006
2007
2008
2009
2010
2010, Apr-Nov.
0.04
0.43
0.02
0.93
0.73
0.87
0.22
0.60
Weak for last year as a
whole
It had its moments, however
Financials:
The Dollar
2010 Correlation
Prompt NYMEX Crude Oil vs. Dollar/Euro Rate
95.00
1.5000
Things started "tighening up" prior to
the Greece crisis and collapse of the
euro
Decouple
Decouple
1.4500
90.00
Things remained fairly tight leading up
to Ben's Jackson Hole speech
1.4000
85.00
1.3500
80.00
1.3000
1.2500
75.00
1.2000
Period of QE II
Discounting
70.00
1.1500
PCL
DVEURO
20-Dec
6-Dec
22-Nov
8-Nov
25-Oct
11-Oct
27-Sep
13-Sep
30-Aug
16-Aug
2-Aug
19-Jul
5-Jul
21-Jun
7-Jun
24-May
10-May
26-Apr
12-Apr
29-Mar
15-Mar
1-Mar
15-Feb
1-Feb
18-Jan
1.1000
4-Jan
65.00
Price Components in Another “Recovery” Year:
Seasonality, Redux


With very few exceptions, crude oil prices tend to rise in the second quarter from
a first quarter trough
Factors include:
In Q1, lower refiner demand for crude in Atlantic Basin, U.S. stocks recover
In Q1, market discounts end of winter
Consensus invariably “mis-correlates” the first to second quarter downturn in
global refined product demand with crude oil prices
In Q2, refiner crude oil demand recovers
In Q2, North Sea production begins to fall seasonally
In Q2, funds buy gasoline, always believing the U.S. gasoline season will be
strong

The exceptions to this pattern tend to lie with global macro developments that
more than offset the seasonal first-to-second quarter price recovery. In the case
of 2010, the seasonal pattern was well defined until the Greece crisis in early May.
Summertime “double–dip” fever also led to lower prices than those prevailing in
the first quarter, also an exception
Price Components in Another “Recovery” Year:
Seasonality, Redux
Monthly Crude Oil Price Seasonality Since 2004:
Year=1.00
January
February
March
April
May
June
July
August
September
October
November
December
2004
2005
2006
2007
2008
2009
2010
20042010
0.83
0.84
0.88
0.89
0.97
0.91
1.00
1.08
1.12
1.27
1.15
1.04
0.83
0.85
0.97
0.94
0.88
1.00
1.04
1.15
1.15
1.10
1.03
1.05
0.99
0.93
0.95
1.06
1.07
1.07
1.12
1.10
0.96
0.89
0.90
0.94
0.75
0.83
0.84
0.88
0.88
0.94
1.03
1.00
1.10
1.19
1.31
1.27
0.93
0.95
1.05
1.13
1.25
1.34
1.34
1.17
0.98
0.78
0.58
0.42
0.67
0.63
0.78
0.81
0.97
1.13
1.03
1.14
1.12
1.22
1.26
1.20
0.98
0.97
1.03
1.06
0.93
0.95
0.97
0.96
0.95
1.03
1.06
1.12
0.85
0.86
0.93
0.97
0.99
1.05
1.08
1.09
1.06
1.07
1.04
1.00
Price Components in Another “Recovery” Year
2011:
Summarizing the Components
2011 NYMEX crude oil prices will once again be determined by a combination
of fundamental and financial variables:

Fundamental factors:
-Growth in world oil demand
-Growth in non-OPEC supply
-Geopolitical influences on supply
-Global days supply of crude oil and product inventories influenced by:
-Excess refining capacity
-Excess producing capacity, primarily Arabian Gulf sour grades

Financial factors:
-Need/desire by financial institutions to diversify invested assets. However, by the
end of 2011 we believe there is a good chance funds will begin to rethink their longterm commitment to a long-only oil strategy, particularly v. equities
-Global equity market strength/weakness
-Value of the dollar, although only periodically a factor since this argument is starting
to get “old”
-Interest rate expectations
Price Components in Another “Recovery” Year
2011:
Adding It All Up



Fundamental factors are “straightforward”, but there is still a critical need to
appreciate the importance of the financial factors and the “non-commercial” price
influence
This is particularly critical for producers (hedge timing) and equity portfolio
managers. The non-commercial influence implies a greater volatility and velocity of
crude oil price movement than if prices were determined solely by fundamentals
Ever since 2004, the non-commercial influence on crude oil prices has been
increasing, and has had a major impact, even during the global recession. We have
tried various approaches to quantify the impact for the last four years. In our view,
those who argued that fundamentals were primarily, if not exclusively, responsible for
the price run up because there was little consistent, public, and quantitative
“proof” of the non-commercial influence were guilty of the logical fallacy:
Argumentum ad ignorantiam
i.e. asserting that a proposition is necessarily false because it has not been proven true
Price Components in Another “Recovery” Year
2011:
Adding It All Up





2010 Post Mortem:
This time last year with WTI trading at $79.65 per barrel we
expected the prompt NYMEX crude oil contract to average $86.15
per barrel in 2010
The actual average came in 7.7% lower than we thought a year ago
Our fundamental balance was close to the mark, with demand and
non-OPEC supply both a bit higher than first forecast
Our expected second quarter seasonal price recovery was on track
until the Greece crisis unfolded. Prices were “derailed” during
summer from “double-dip fears” which, as we anticipated, never
materialized
Let’s try it again, shall we?
Price Components in Another “Recovery” Year
2011:
Laying It On The Line
“Pure” Fundamental
Outlook
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
$59.55
$59.70
$64.40
$66.80
$68.60
$72.10
$73.90
$74.60
$72.60
$73.60
$71.65
$69.30
Yr
$68.90
“Pure” Fundamental Plus
“Robust” Financial Outlook
$90.30
$86.40
$88.25
$91.80
$94.40
$99.50
$102.20
$103.15
$100.25
$101.75
$98.85
$95.40 Fund Length
$96.00
Liquidation as
Concerns Begin to
Mount Over 2012
Anticipated
“Blend”
$89.48
$88.00
$88.25
$91.80
$94.40
$96.50
$97.20
$101.15
$90.25
$86.75
$73.85
$73.30
$89.25
“Normal”
Seasonality
With Some
Geopolitical
“Overlay”
Peak Comes
Somewhat
Short of
“Financial
Ideal”
Price Components in Another “Recovery” Year
2011:
Conclusions




The overall fundamental global balance should remain competitive in 2010
with excess producing and refining capacity suggesting much lower prices
than $80.00 per barrel
However, early 2011 market behavior and anecdotal evidence suggests
funds and other non-commercials are intent upon allocating more capital to
oil this year, given bullish economic expectations
Thus, a higher price “bar” has been established from which prices will rise
seasonally as we move through the next couple quarters
Price elasticity of demand still “exists”, however, suggesting that crude oil
price strength in 2011 will extend only through summer. In the fourth
quarter, concerns over the impact of higher oil prices on 2012 economic
activity will lead to fund net length liquidation back toward, but not to,
underlying fundamental value. Funds will limit their net length
liquidation in order to retain some exposure to the possibility of
generating “excess” portfolio returns