Oil prices will get higher, possibly much higher

At the start of October 2011 West Test Intermediate crude (WTI) was trading at $76.25. By 1 March 2012 the price of oil had reached a peak of $110.55, a rise of nearly 45%. Since then the price has dropped to around $105, however thanks to tight supply, rising global demand, and increasing geopolitical risk the price of this vital commodity looks set to remain high. There is even a chance that over the next few months seasonally high demand will push the price of crude to its previous high of $114.83, or even beyond.

The Fundamentals

World oil demand in 2011 stood at 89 mbpd (million barrels per day), while supply was only 88.4 mbpd. There was therefore a daily shortfall of around 600k bpd, and as a result global oil inventories are now at the lowest levels seen in years.

At Cushing in Oklahoma, the delivery point for Nymex oil futures, stockpiles are at the lowest level in more than two years. Meanwhile stockpiles in Europe are near their lowest level in fifteen years.

Rising demand

In a new report published on 14 March the IEA (International Energy Agency) forecasts that demand for oil in 2012 will increase by 800k bpd. In a separate report the OPEC group predict that demand in 2012 will rise by 900k bpd, while the U.S. Energy Information Administration (EIA) forecasts that demand this year will increase by of 1.3 mbpd.

Tight supply

The prospect of higher demand raises the question: Where will the increased supply come from to meet that demand? The answer according to many analysts is that excess global capacity will come online and make up the shortfall. However this might not be possible.

According to the EIA excess spare capacity has fallen to 2.5 mbpd, down from 3.7 mbpd this time last year. However in a recent interview energy market analyst Joseph Dancy, of LSGI Advisors Inc., stated that he has seen spare capacity numbers as low as 1 to 2.5 mbpd.

This fall in spare capacity is manly due to reduced production from several key producing counties, such as South Sudan where production is down 300k bpd, Yemen where it is down 250k bpd, Libya it is down 600k bpd, and the North Sea where production is down by around 200k bpd.

Add to this the fact that from 1 July oil supplies from Iran will fall by 1 mbpd and it’s possible that there will be little or no spare capacity capable of meeting the expected new demand.

In response to concerns about a possible oil supply crunch Saudi Arabia has vowed to increase its production by 25% if necessary. This would increase their daily output to around 12.5 mbpd, something the kingdom believes is possible within just a few months.

It’s possible however, that Saudi Arabia will not be in a position to dramatically step up its production. According to the cables released by WikiLeaks in February last year, the kingdom’s crude oil reserves may have been overstated by as much as 300 billion barrels – nearly 40%, meaning that they may not be able to pump enough oil to keep a lid on prices.

There are already indications that the oil supply situation may be a serious one. A story on Bloomberg 29 March reports that governments in the US and Europe are moving closer to an agreement to release oil from strategic petroleum reserves in order to “stem gains in crude that have driven prices to the highest levels in three years.”

The Bloomberg story reports that Olivier Jakob, managing director at Petromatrix GmbH, a Switzerland-based researcher, said: “Oil prices are rising, which is a threat to the economic recovery, so pressure is growing on governments. The Saudis aren’t acting, so the only thing left is to release stocks.”

The Long Term Outlook

The IEA forecasts that global oil demand will rise from 89 mbpd in 2011 to 99 mbpd in 2035, while the production of conventional crude oil (that is oil that is liquid at surface temperatures and is extracted from conventional wells) will drop from around 73 mbpd to 68 mbpd.

The difference of 31 mbpd will need to be made up from unconventional sources of oil such as oil sands, natural gas liquids and biofuels. However, if these replacement fuels fail to come online in sufficient time, oil prices in years to come could rise a great deal further.

The Technical’s

Both short-term and long-term the fundamentals appear to favour higher oil prices. Those looking to benefit need to time their entry and this is where the technical’s can play a role.

An 18 Month Chart Of West Test Intermediate Crude

Chart courtesy of stockcharts.com. Brent oil valued in Euros set an all-time high in February above €93 a barrel, beating the 2008 pre-financial crisis high.

Having briefly touched $110.55 a barrel on 1 March the price of oil has entered a period of sideways consolidation and is now trading in a range between $108.70 and $103.78. If crude were to breakout of this range to the downside, it may find support at $101.21, the 61.8% retracement of the $95.44 low to the $110.55 high. A break through this level could lead to a bigger selloff with the next major support level being the 2 February low of $95.44.

A pullback to either of these support levels would likely represent a good entry point for those going long the commodity.

After a period of consolidation I expect oil to make a run at its previous high of $114.83 – a level last reached in the spring of 2011.

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