Energy Prices Can Shoulder the Load

Those expecting big calendar-driven declines in oil and gas overlook the underlying bullish fundamentals.
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This column was originally published on RealMoney on Aug. 23 at 2:08 p.m. EDT. It's being republished as a bonus for readers.

For crude oil investors, the shoulder season is close at hand, and that means more hand-wringing over the future price.

It is true that peak driving season -- the period in which many Americans take to the roads for family vacations -- will officially end with the passing of the Labor Day holiday.

That will likely provide marginal relief for gasoline prices, which were lower midday Wednesday, after the Energy Department's weekly inventory report showed an unexpected increase of 400,000 barrels vs. expectations for a decline of 2 million barrels. But the increase in gasoline inventories is a result of increased refinery utilization and imports, rather than a meaningful reduction in demand.

Crude futures were down as well after the government said inventories dropped by 600,000, but remain nearly 5% above year-ago levels.

However, those who are hopeful for a precipitous fall in crude oil and gasoline prices need to consider not only the fundamental figures, but also a couple of very important data points unique to the 2006 fall shoulder season.

Supply and Demand

Some argue there is now plenty of oil coming to market and that the acceleration in drilling will add even more in the coming months. However, a careful read of the fundamental oil barrels (the tea leaves of the petroleum business) suggests otherwise.

The argument that there is a plethora of crude sitting in tankers around the globe ignores the crude-quality argument. While the Saudis, for example, may well be producing crude that is not currently used in global markets, it lacks a market because it is heavy and sour and not readily usable by most refiners.

Moreover, the argument that the world will be awash in crude in the coming months (and years) as a result of increased drilling overstates the impact of additional drilling. As we have

discussed in these pages before, rig intensity -- the number of rigs needed to produce an additional increment of crude oil or natural gas -- continues to increase as the decline rate in current wells accelerates.

Take, for example, activity in Saudi Arabia's legacy fields, such as Gwar.


will double the number of rigs drilling development wells this year -- from approximately 60 to 120 -- with little change in production. Rather, the additional wells simply are making up for the production declines in existing wells. The Saudis are likely to increase the rig count another 50% in 2007 simply to stem the decline.

As a result, even with new crude oil discoveries -- which may well take years to get to market --- supply isn't likely to flood the market. Rather, we may well find such new crude supplies will be required simply to assure supply keeps pace with steadily growing demand.

The above analysis does not factor in further disruptions in crude supply stemming from geopolitical events. While the cease-fire between Israel and Lebanon has helped reduce the risk of Middle East instability, there are plenty of other hot spots that could impact crude supply, including Iran's quest for a place at the nuclear table.

Add to that concerns in Iraq, Nigeria, Venezuela and Russia, and the list of smoldering conflicts that could impact oil supply lengthens. As noted before, it's not how big the "risk premium" is, it's how long its lasts. From where I sit, it doesn't dissipate anytime soon.

Strong Winds Remembered

While the basic fundamentals likely support crude prices in the $60s over time, it is important to remember a couple of special issues that could impact both crude and product prices as we approach winter.

It's hard to forget Hurricanes Katrina and Rita, as their fallout continues to make national news on a weekly basis. However, some investors may have forgotten the lingering impacts on Gulf of Mexico activity.

Those investors should have been reminded of that impact on Monday, when

Helix Energy

(HLX) - Get Report

purchased three GOM energy projects from


(CVX) - Get Report

and its partners. The deal was a stark reminder of just how challenging recovery in the Gulf has been, as two of those fields remain offline even today, the result of damage from Rita. In addition to that sale, Chevron is set to spend millions on Gulf of Mexico reclamation, work that is likely to take at least another year.

Companies like

Superior Energy Services



Hornbeck Offshore

(HOS) - Get Report

and many others continue to talk of nine to 12 months of additional work related solely to the storms' damage.

While the government has discontinued issuing regular reports on production outages related to last year's storms, expectations of additional production anytime soon seem unrealistic.

In addition to production challenges, this fall is likely to see a significant amount of refinery turnaround maintenance as refiners -- especially those with Gulf Coast exposure -- work overtime to deal with refineries that have been pushed to the limit in the past year and and are in need of preventative servicing. This situation will limit the ability to build large stockpiles of gasoline or heating oil and could have a surprising impact on inventories and, as a result, price.

Sure, Labor Day may bring some moderation in gasoline prices. But to expect a sharp drop in crude oil and gasoline prices is simply to be ignorant of the energy reality facing the U.S. and the world.

Christopher S. Edmonds is partner and managing director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. 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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