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What you may not know about oil' s climb above $100

BY MYRA P. SAEFONG, MarketWatch

SAN FRANCISCO -- The oil market has Egypt to thank for its jump above $100 a barrel, but the risk the political turmoil and violence in the nation poses to oil trade in the region isn' t the only reason crude prices are up over 10% this year.

Futures prices on the New York Mercantile Exchange closed at more than $100 on July 3 for the first time since May of last year, and there' s no doubt that Egypt was the catalyst. After all, violence there was mounting and late that day, the Egyptian military ousted President Mohammed Morsi.

But before the protests calling for Morsi to step down and before the military ousted him from office and appointed interim leaders, the oil market was already gathering momentum.

The "recent strength in oil prices has more to do with the tightness of global supply and demand," said John Hummel, president and chief investment officer of investment firm AIS Group.

Global oil production since 2005 has edged up about 0.5% per year, according to Hummel. Global exports have declined because of domestic consumption growth in exporting countries.

Demand for oil, however, is slated to expand. The International Energy Agency forecasts global oil demand to grow by 1.2 MMbopd in 2014 to 92 MMbopd.

"It is only the sluggish economic conditions globally that have kept prices from pushing substantially higher," he said. "Geopolitical events only exacerbate underlying fundamentals."

That doesn' t mean West Texas Intermediate crude prices would have jumped above $100 without Egypt. Some analysts estimate a $5 to $10 a per-barrel premium in oil prices attributable to risks tied to the nation' s turmoil.

"Egypt is a major ' chokepoint' in the Middle East region when it comes to factoring in potential economic disruptions," said Mark Stansberry, chairman of energy-management firm GTD Group.

And Egypt' s proximity to key oil producers and the fact that it has control over the Suez Canal is of key concern. Around 3 MMbopd are shipped through the canal and Sumed pipeline to the Mediterranean Sea.

"The unrest could possibly carry over into other countries in the region, where there is substantial oil production," said Stansberry, who argues for U.S. energy independence in a recent book, America Needs America' s Energy. "The unknown of oil-supply disruptions is a warranted concern for the short term."

That concern has probably added a nearly 10% risk premium to prices over the past week, according to a note Thursday from Robert Haworth, senior investment strategist at U.S. Bank Wealth Management.

And prices are likely to maintain the premium "until a transition of leadership can be managed," he said. "Further significant increases would likely require impairment of supplies or additional conflict across the Middle East."

In the case of disruptions to the oil pipeline, WTI crude prices may approach $115 a barrel, with Brent crude nearing $120, according to Jeffrey Sica, president and chief investment officer of Sica Wealth Management.

He is among those who believe that the Muslim Brotherhood, the political movement that supports Morsi, will view control of the Suez Canal and pipeline as a strategic target.

"The Muslim Brotherhood will not cede power without bloodshed," said Sica. "Whoever controls the Suez Canal and Sumed, controls Egypt."

But if there' s a smooth transition in Egypt, prices may lose their risk premium and fall back below $100 a barrel.

Even so, at just below $100, prices would still be around 17% above the 52-week low of $84.44 seen in early November of last year. That' s because aside from Middle East tensions, analysts attribute oil' s strength to other significant factors.

Those include "eye-opening draws" in U.S. crude-oil supplies over the past two weeks, said Tariq Zahir, managing member at Tyche Capital Advisors.

Supplies, according to the Energy Information Administration, saw a two-week decline totaling about 20 MMbbl. That hasn' t happened in decades, according to Zahir. "This caught traders off guard and helped sustain the recent strength we saw in spot prices."

There has also been a large contraction in the Brent crude vs. WTI crude spread recently that has contributed to WTI' s price gain.

The spread narrowed as prices for WTI gained more ground, with the recent return to service of domestic refining capacity, said Michael Peterson, managing director of energy research at MLV & Co. "U.S. crude processing volumes have reached levels not seen since 2007."

The price difference between the two crudes fell under $2 a barrel on Wednesday. That hasn' t happened since at least late 2010. A lot of people were on the wrong side of the spread trade, said Zahir.

The spread was at more than $20 in February. As the spread narrowed, some traders expected it to widen further so when the trade went against them and the price difference narrowed instead, losses mounted and traders wound up getting out of the position by buying WTI and selling Brent, Zahir explained.

Looking ahead, the spread may still narrow, but don' t expect "full convergence" anytime soon, said Richard Hastings, a macro strategist at Global Hunter Securities, who sees Brent at $105 to $110 and WTI at $100 to $105 near term.

"The strongest chance for a severe move towards convergence would probably involve a major Gulf of Mexico hurricane impacting a large area of platforms and refineries along the Gulf Coast," he said.

Still, if Egypt was such a big threat to oil trade in the region then why hasn' t Brent climbed as much or more than WTI crude prices?

If the world believed Egypt was a problem, Brent crude would have soared but it hasn' t, said Timothy Gramatovich, chief investment officer of Peritus Asset Management.

As of Wednesday, prices for WTI crude on Nymex had climbed 8.7% from the close on July 1, the day Egypt' s military gave Morsi a 48-hour deadline to resolve the political crisis. Brent crude had climbed 4% over the same time period. WTI prices, however, saw a sharp pullback Thursday to close at $104.91.

"This is a [U.S.] domestic issue," said Gramatovich. "The Egypt situation is being used as a scapegoat for the reality of the market." He expects shale oil, which has contributed to rising production in the U.S., to "fade rapidly over the coming years." Depletion rates are "astronomical" for fracked wells -- as much as 80% to 90% in the first year, he said.

"You need to keep punching holes to keep it flowing," he said, and "given that these wells are incredibly expensive to drill, the economics are very sketchy."

The EIA has said that production from shale-oil fields will contribute largely to growth in U.S. oil production. But it has also cautioned that estimates of the rapidly developing so-called tight-oil formations, such as shale, are uncertain.

Encouraging U.S economic data, including much larger growth in new jobs in June, also point to improved prospects for energy demand, has also provided an advantage for WTI prices.

Prices can go significantly higher should the global economy actually improve in the next few years, said Gramatovich.

"It is likely that $100 is starting to become the floor for oil, not the ceiling," he said. "The only reason prices aren' t even higher than they are today is because demand out of Europe and China is very subdued."

Dow Jones Newswires

07/12/2013

 

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