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Long-term oil

 
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arthur
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PostPosted: Thu Dec 08, 2005 6:06 pm    Post subject: Long-term oil Reply with quote

Asia/Pacific: Weak Oil Demand to Last

Andy Xie (Hong Kong)

Oil demand could remain weak for years

High oil prices in 2005, caused by financial speculation and unjustified by demand weakness, have triggered major changes in consumer behavior that could depress demand for years to come. China’s government is introducing energy-saving policies that could halve the growth rate of its oil demand. The auto industry is shifting to fuel-efficient cars that would also depress demand.

Oil substitutes will mushroom

The high oil prices have triggered numerous investment projects to develop oil substitutes. Such projects could not be reversed when oil prices come down. Coal production, for example, would continue to grow rapidly despite economic deceleration.

Oil demand could disappoint in 2006

The market is forecasting significant acceleration in oil demand in 2006 from the 1.2 mb/d increase in 2005. However, the global economy is cooling to 4.1% in 2006 from 4.6% in 2005, we estimate, and China is shifting from shortage to surplus in electricity production and, hence, no need for running diesel generators.

Summary and Investment Conclusion

High oil prices this year are due mostly to financial speculation, I believe. The 10% rally in oil prices at the sight of the winter storm over the past two weeks is a dead cat response. The high prices that demand could not justify have damaged demand. Some of the consumer responses are permanent, which would keep demand low for years to come. Oil prices could surprise on the downside in 2006 and may drop below $40/bbl, I believe.

The market has exaggerated China’s long-term demand, in my view. China’s strong demand for oil during 2002–04 was due to economic overheating and global trade boom. Half of China’s industrial production is exported. Industrial production accounts for about two-thirds of China’s oil consumption. The Chinese government plans to decrease energy consumption per unit of GDP by 20% over the next five years. China’s oil demand may grow by only 4–5% per annum in this decade, half of what the market expects.

High oil prices have led to reduced demand for SUVs around the world. As automobile companies respond to change their production mix and to focus on fuel efficiency for SUVs to recover demand, the oil demand for driving would grow much slower than before.

Financial Speculation Has Driven Oil in 2005

According to the IEA, global crude demand is up by 1.2 mb/d in 2005 compared to 2.94 mb/d in 2004. Despite the decline in the past two months, crude prices are up 46% for Dubai Fateh, 42% for Brent Blend Dated, and 37% for West Texas Intermediate Cushing.

There are two types of arguments in favor of higher prices. First, many have been advocating the technical argument of limited spare capacity. The theory is that small spare capacity makes oil supply vulnerable to shocks and, hence, sellers are more willing to hold back supply, driving up prices. Second, expectations that the industrialization of China and India would exhaust global oil reserves increased the expected value of oil and, hence, less willingness to sell.

The bull case is based on the rising perceived value to sell due to short-term and long-term factors. This sort of view has the advantage that it could not be quantified. But, the issue is why it happened this year rather than before. The biggest short-term effect to oil supply was the Iraq War in 2003. Oil suppliers have known about the China and India demand story for a long time and they did not show a marked decrease in their willingness to sell.

The difference is the increased participation of financial investors rather than the change in the willingness to sell by major exporters, I believe. The global liquidity boom is the real driver for the surging oil prices, I believe.

ChinaWill Go on an Oil Diet

High oil prices are leading to behavioral changes among consumers that could depress oil demand for years to come. First, high oil prices are altering China’s national policy. The core of the next five-year plan is to decrease energy consumption per unit of GDP by 20%. This would not have happened if oil prices had remained flat.

When the Chinese government puts down a quantifiable target, it has enough power to make it happen. Increasing vehicle fuel efficiency, introducing fuel taxes, and closing down inefficient factories are some of the policy tools that the government has.

The cyclical factors will also depress China’s demand for two to three years. First, about two-thirds of China’s crude consumption is for industrial production, of which about half is exported. China’s exports have more than doubled in three years due to factory relocation and global demand boom. Both forces have peaked out. China’s exports would slow by half to 15% in 2006 and even more so in 2007.

Second, the expectation of China’s auto sales is vastly exaggerated. About half the cars, or 23% of vehicle sales are bought by households. The rest are for businesses. Hence, vehicle demand is part of the industrial demand and will be affected by the export and fixed investment cycles.

Third, China is moving from shortage to surplus in electricity production due to massive capacity buildup and cyclical slowdown in demand. Export factories are phasing out the use of diesel generators for electricity. The net imports of refined products are down by 17% this year. With more substitution effect to come, it would be another effect to depress demand.

I believe China’s oil demand would average 4–5% annual growth compared to 10% between 2001 and 2004, and 7.5% between 1994 and 2004. The oil bulls expect China’s strong oil demand from the past three years to continue. Most think-tanks are less bullish, but still expect around 8%. China’s demand could surprise on the downside for years to come.

The Winter Bounce Won’t Last

The winter storms have revived the oil market. Brent crude has appreciated by $3/bbl since December 1, after dropping $12/bbl from the high on September 1. I believe that the bounce is temporary. The news flow in 2006 will be overwhelmingly negative for oil.

First, the supply capacity is rising rapidly. The IEA is forecasting that the supply capacity would rise by 2.6 mb/d. This would far exceed the most optimistic forecast for demand. High prices are motivating oil producers to squeeze more out of existing wells. For example, China’s crude production is up 4% in the first 10 months of 2005, compared to 1.6% annual growth rate between 1994 and 2004.

Second, the substitution effect could be more powerful than expected. China’s coal production, for example, is up 15.1% in the first 10 months of 2005, compared to 2.6% annual growth rate between 1994 and 2004.

Third, the demand could be much weaker than expected. The IEA forecast calls for a 1.6 mb/d increase in demand in 2006. Most forecasts look for acceleration in demand from 1.2 mb/d increase. But, we expect the global economy to slow to 4.1% in 2006 from 4.6% in 2005. Why should oil demand accelerate?

The reason is that most believe that China’s oil demand is normal in 2005 and next year would see some sort of normalization. I think that the market will be disappointed.
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