This column was originally published on RealMoney on June 23 at 12:57 p.m. EDT.
With oil powering toward $60 a barrel but falling just short, the energy commodity trading battlefield is heating up this summer.
Recently, a number of readers have asked for a battlefield roadmap, so they could have an idea of what to look for that might signal the direction of crude prices during the dog days of summer. That is a perfect query for a checklist of what to watch for in the crude markets, both positive and negative.
Here's my take on what is important for the direction of crude in the coming weeks:
Signs for the Bulls
The determinant of crude price is the age-old economic formula -- the equilibrium point at which the supply curve and demand curve intersect. The bulls argue that recent data suggest that both the supply curve and demand curve have shifted higher, meaning that at every level of demand and every level of supply, clearing prices are now higher. Here are some data points suggesting that may be true:
- OPEC's announcement that it would increase quotas by 500,000 barrels last week left everyone wanting more. Problem is, there may not be any more. In fact, OPEC's quota bump was less than the cartel's current production, suggesting that OPEC has no spare capacity. In addition, while OPEC may be able to push production modestly higher, the incremental barrel of oil coming from the cartel is likely to be heavy, sour crude, which has a much smaller market because of the refining difficulty. As a result, OPEC is the critical supply variable: If the cartel boosts its quota another 500,000 barrels, it won't matter if it can't deliver lighter oil. Data from PetroLogistics, London's Centre for Global Energy Studies and the cartel itself will provide hints of OPEC's supply outlook.
- Specific country risk is also bullish. While it is easy to get used to Iraqi pipeline disruptions, it's hard to ignore the risks in other producing nations, and many still exist. Most recently, the potential for a Norwegian labor strike showed just how tight and fragile the energy-supply situation is. For other hot spots, I continue to watch Nigeria, which almost always has unrest this time of year; Venezuela, where nobody knows what may happen with Chavez at the helm; and Russia and its quest for governmental recapture of energy assets. In addition, don't discount the possibility of further Middle East unrest. Syria remains a wild card that needs a careful eye.
- A final point on the supply side that is admittedly more difficult to track is to watch OPEC member nations' -- especially Saudi Arabia's -- appetite for drilling rigs. The Saudis have tendered more than two dozen rigs this year, many more than in any year in recent memory. Those tenders suggest the need to drill to boost production. In other words, the only way to keep production steady and have any hope of increasing the flow of crude is to rapidly accelerate drilling. More rigs could be a sign of supply concerns from producing nations.
- On the demand side, the primary key is China. Moreover, China's announcement on Wednesday that it will begin to fill its own Strategic Petroleum Reserve this year will support Chinese demand. The report indicated the country will be working toward 100 million barrels. Oil has and will continue to react to reports on Chinese growth estimates.
- Domestic demand is also important, as is noted from the attention now paid to weekly domestic crude and product inventories. Should supplies of crude and/or gasoline tighten in the coming months, a real price shock could occur in oil.
- Finally, watch refiners. The ability to turn crude into gasoline and heating oil has become key, as refining capacity is tight. Any unexpected refining outages will prove bullish for prices.
There is a road map for the bulls. Now for the other side of the ledger.
Those who are looking for a steep oil price correction wrap their argument around current inventory levels, which are slightly above historic norms.
For example, crude stockpiles are 7% above last year's levels and 8% above seasonal norms. So even with talk of a tight gasoline market, gasoline inventories are 5% above 2004 levels and 3% above normal. However, distillate inventories, which include heating oil, are about flat with last year and 1% below normal.
Here are some other issues to watch that might provide bearish signals for crude:
- Strength in the dollar. Remember, worldwide crude is priced in dollars and bears argue a large portion of the move in crude has been related to weakness in the dollar. Continued strength in the greenback should help keep oil prices in check.
- The U.S. Strategic Petroleum Reserve is nearly "full." As of yesterday, there were 696 million barrels of oil in the reserve program, the highest level on record. Current capacity, according to the Department of Energy, is 727 million barrels and many argue the facility will be "full" no later than year-end. That would provide more oil for the "active" domestic market and send at least a signal that would be bearish for crude prices.
- On the demand side, watch the economy, especially the domestic consumer economy. While it doesn't appear that $2 gasoline has had a dramatic impact on consumer behavior, higher prices will begin to impact consumer decisions. Signs of a crack would include SUV sales declines over a multimonth period and reports from AAA and other travel-tracking services that suggest driving is slowing down.
- Again, the wild card is China. Watch data from the International Energy Agency and others that suggest demand for hydrocarbons in China is slowing. While CNOOC's (CEO) - Get Report attempt to wrestle Unocal( UCL) away from Chevron (CVX) - Get Report suggests the yearning for oil reserves continues to grow in China, signs of a short-term slowdown in energy demand could have a meaningful impact on crude prices.
As the length of the roadmaps suggests, the bullish crude argument is easier to make than the bearish argument right now. That said, sometimes the road less traveled is the road to follow. While I remain constructive on the crude markets, it is important to know the signs that might persuade one to change directions.
Whichever path you choose to travel, I hope this map will get you there.
Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback;
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