When most energy analysts were calling for the price of oil to decline at the start of the year, Phil Flynn, vice president of Alaron Trading, was predicting it would climb to $40 a barrel.
If that seemed like a wacky estimate at the time, it's all too real today. This week, Nymex crude oil futures closed above $40 for the first time in 13 years,
and were heading higher Thursday morning . So what is Flynn saying now?
Even though oil prices have risen 25% this year, Flynn believes they could be heading higher still, possibly to $45 a barrel before they begin to moderate.
"I think that $45 area is going to do the job and lighten up the demand a little bit," he said. "
But I don't see a crash in oil prices. Forty dollars is going to be the new norm."
If true, that bodes well for energy stocks, which are already expected to post record earnings in the second quarter. It bodes less well, however, for consumer spending.
The rise in crude oil this year has surprised most analysts, who initially expected it to fall to around $24 in 2004 from $32.52 at the start of the year. Few predicted that demand would be so strong and supply so constrained. Analysts also underestimated the effects of continued unrest in Iraq.
Flynn said demand is likely to remain strong this year as the U.S. economy continues to recover and China's economy expands further.
"The Chinese government right now is doing everything it can to slow this demand for oil, and so far they haven't had any success," Flynn said. "There's a false assumption that the Chinese can curtail this tremendous demand for commodities ... you can't expect the bubble to burst tomorrow regardless of what the Chinese government does."
The International Energy Agency said global oil demand will rise this year by the most since 1988, due to faster economic growth and increased Chinese fuel consumption.
Meanwhile, Flynn argues that supply remains tight. On Wednesday, gasoline inventories fell 1.5 million barrels to 202.5 million in the week ended May 7, according to the Energy Department. Analysts were expecting an increase of around 1.5 million barrels.
Although Saudi Arabia has proposed that the Organization of Petroleum Exporting Countries increase oil production by at least 1.5 million barrels per day, some people have questioned whether that would be enough to cool the market.
Flynn also noted that the only excess production capacity to be had is in the hands of Saudi Arabia. If it raises production by 1.5 million barrels, OPEC will be "tapped out with no excess to draw on."
"Most theorize Saudi Arabia has roughly 2 million barrels in excess capacity," he said. "If they raise production by 1.5 million barrels, they'd have precious little left, maybe 500,000 barrels. ... In this world of geopolitical unrest, 500,000 barrels is a small drop in the bucket."
Late last year, OPEC said it wanted to keep the price of oil above its target range as a result of the falling dollar. Oil-exporting countries sell oil in U.S. dollars and buy products in a basket of currencies, so a drop in the value of the dollar can impact their purchasing power.
"OPEC has lost control of the market," Flynn said. "At this level, I think powers much greater than the OPEC cartel have taken over."
While Flynn thinks the environment is bullish for energy stocks right now, a number of analysts seem to disagree. Banc of America Securities recently lowered its rating on the oilfield services to underweight from overweight and Prudential Equity Group rates the major oil and refining companies unfavorable.
"While we continue to believe that oil prices, natural gas prices and refining margins will all average well above normalized levels in 2004, we also believe that all three of these key earnings and valuation drivers will fall materially over the next six to 12 months, barring a meaningful supply disruption," said Prudential analyst Michael Mayer.
He expects oil prices to drop back to the $25 to $30 range over the next 12 months, noting that the physical market for oil appears oversupplied. Oppenheimer analyst Fadel Gheit said much of the rise in oil recently has come from terrorism fears, not from a supply/demand imbalance.
"It's really not fundamental factors," he said. "It's really all the images and savagery in Iraq -- it's a very tenuous situation."
Gheit believes that oil prices are trading at a $10 to $15 premium because of geopolitical concerns. "There is between 3 and 4 million barrels more supply in the market today than the year-ago level, but oil prices are 50% higher," he said.
Because oil prices are being driven by geopolitics, he said it is very hard to determine whether investors should hold on to energy stocks at these levels. He recommends owning quality large-cap integrated oil companies like
. "We think the downside risk is not as great as smaller companies," he said.
Rob Lyon, a portfolio manager at ICAP Select Equity, also likes large-cap names, particularly BP, which he said has an attractive dividend yield and a good production outlook. "They're saying that all profits they make from the price of oil being over $22 are going to be returned to shareholders either in the form of share repurchases or higher dividends," he said. "It's really big and really diversified."
Lyon also likes
Although Lyon believes the price of oil might be peaking right now, he doesn't expect it to collapse. "I think the price is only going to come down to the low- to mid-30s and then stabilize," he said. "Non-OPEC supply is really disappointing. Meanwhile, demand out of Asia in general is growing rapidly."
Despite a 25% rise in crude oil this year, the
Amex Oil Index
is up just 7% and the
Philadelphia Oil Service index
has climbed less than 4% for the year. "It isn't like these stocks have gone up an enormous amount," Lyon said. "This isn't the dot-com boom."