Commodities | Nov 15 2011
– Oil and US equities now strongly correlated
– Iran an emerging oil market issue
– Suggests higher prices given tight fundamentals
– US production growth may become more consistent
By Chris Shaw
According to US Energy Information Administration (EIA) figures, crude oil and the S&P500 Index have had a close positive correlation in 12 of the past 13 quarters. This follows not one single quarter of similar positive correlation in the previous 35 quarters.
For US Global Investors, the current correlation suggests equity prices have the potential to move higher if oil prices continue along their currently positive trajectory. As US Global Investors CEO and chief investment officer Frank Holmes notes, West Texas Intermediate Prices have risen by about 28% since early October.
Holmes sees scope for further oil price upside, in part due to current supply and demand fundamentals in the market. On the demand side, Holmes notes the turmoil in Europe and a slowing in the Chinese economy has had little impact.
EIA figures support this, as by the end of 2012 the group is forecasting world crude oil and liquid fuel consumption of nearly 90 million barrels per day. Expectations are for global demand to move beyond 110 million barrels per day by 2025.
Holmes suggests the emerging market transportation sector is a major driver of this increase, with International Energy Agency (IEA) figures suggesting the total number of passenger cars in the world will almost double to 1.7 billion by 2035.
On the supply side constraints continue to impact, with US crude oil inventories now at the lowest seasonal level for seven years, observes BA Merrill Lynch. Geopolitical unrest is also an ongoing issue, with Iran now a major contributor to such unrest on suspicions of nuclear proliferation.
Barclays Capital has also picked up on this, noting the International Atomic Energy Agency has released a report indicating an increase in concerns about possible undisclosed Iranian nuclear activities. The report has come at a time when US-Iranian relations are already strained, as the White House is expected to push for tougher economic sanctions against Iran.
The reports of Iranian nuclear activity have some in the market speculating on a possible Israeli strike, though Barclays takes the view a regional war involving Iran is a low risk at present.
The issue for the oil market would be the potential for any closure of the Strait of Hormuz, as this is the sole waterway leading out of the Arabian Gulf. Barclays expects the US military would be able to keep this Strait open, but there would still be a question as to whether Iran could impede shipping enough to impact on supply from the region.
Barclays suggests any market fears of such a disruption to traffic could boost market sentiment and so support oil prices, especially given current fundamentals are tight. Holmes agrees, seeing potential for the market to be concerned about any possible loss of shipments through the Strait, which accounts for 18 million barrels per day.
A possible Iran conflict adds to market fears, as Holmes notes around 40% of global oil supply is currently under autocratic rule. Libya is not yet unified following the death of Gaddafi, sanctions and violence continue in Syria and almost half of Yemen's output has been offline since March.
As Holmes points out, the IEA view is trends in both demand and supply are maintaining pressure on prices. Holmes suggests average prices will remain high, forecasting a price of US$120 per barrel in 2010 dollars in 2035. That equates to a price of more than US$210 per barrel in nominal terms.
In the US market, Reuters market analyst John Kemp notes production has increased by more than 10% or 500,000 barrels per day since 2008. Most of the increase can be attributed to some very productive wells in the Gulf of Mexico and a number of additional wells in North Dakota.
Kemp expects increased drilling and a price driven shift from oil to gas exploration will likely ensure crude output continues to increase over the next few years. The Gulf super wells will be a major driver, as Kemp points out total output from regular wells has fallen from 1.6 billion barrels in 1995 to 1.1 billion in 2009.
Output from stripper wells that produce less than 10m barrels of oil per day has remained relatively constant over that time at around 200 million barrels per year, while super well production has been far more volatile. Super well production at present is in the order of 176 million barrels per year but typically changes by as much as 30 million barrels per year.
Looking forward, Kemp suggests US production increases could become more steady than is the case when super wells are involved. The increased drilling and production in North Dakota stemming from increased use of horizontal wells may well be extended to other regions, something Kemp expects would deliver steadier growth in US output.
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