ENERGY 2008: HIGHER PRICES AND VOLATILITY

Futures, Feb 2008 by Rafield, Linda, Mower, Jeff, Field, Stanford

While the $100 print in crude oil futures at the beginning of the year was apparently the result of a glory seeking pit trader and not legitimate price discovery, there is no magic to that number and oil will most likely breeze past it in 2008. But it won't be a straight line and will likely have a few severe corrections along the way.

Prepare yourself for some stickershock because 2008 will be another year of eye-popping oil prices. Tightening supply/demand balances will put a floor in prices, not unlike what has been seen in the past five years, surely sending the light, sweet crude futures contract on the New York Mercantile Exchange (Nymex) easily soaring above.what some would deem a magical number and what others will view as another day at the races: the $100 per barrel level.

A marked deterioration in U.S. crude oil inventories over the past six months and erosion in European stocks leave the OECD (Organization for Economic Cooperation and Development) vulnerable to any supply shock. Supply disruptions translate ultimately into price spikes. With or without a supply disruption, low inventory levels in the United States and Europe will keep oil prices well supported.

According to the Energy Information Administration (EIA), U.S. commercial crude stocks fell to 289.6 million barrels at the end of 2007, the seventh consecutive decline in inventories and the lowest level since the week ending Jan. 5, 2005 (see "Dwindling supply," page 24). At 289.6 million barrels, U.S. crude stocks were 6.6 million barrels below the five-year average and 30.099 million barrels below year-ago levels. Stock declines at this time of year are not out of the norm and inventories tend to replenish throughout the first quarter. However, the tightening trend that has been in place since the onset of the fourth quarter was spread across both crude and products in contrast to prior reports (see "The whole complex," page 24). Over the past six weeks, tightness has been relatively confined to the crude sector, but a less-than-optimal rate of refinery output and a solid enough pace of demand have now eroded product inventories as well.

Market focus will remain on the U.S. Gulf Coast, the refining heartland, and on Cushing, Okla., home of the Nymex delivery point, and any stock changes in those two locations.

In May, Nymex crude went into a steep contango and was trading over $6.00 per barrel under ICE Brent - an unusual situation considering that the United States is a net importer of crude - because of a glut of light sweet barrels at Cushing. Inventories at Cushing climbed to a record 28 million barrels in mid-April 2007, and remained high through the end of the second quarter, as refinery problems in the U.S. Midwest eroded demand in the region.

The price distortion, although short-lived, was a dramatic reminder that the price of crude ultimately reflects local fundamentals. Any similar refinery snags in the near future should have a similar impact on the price of crude, as, structurally, it is much easier to get crude into the Cushing area than it is to get crude out.

Crude storage at Cushing has been growing, and will continue to expand, in response to higher demand for U.S. Gulf Coast and Canadian barrels moving into the Midwest. Enbridge was supposed to have boosted its Cushing storage capacity by 3.9 million barrels to 16.7 million barrels by the end of 2007.

U.S.-based pipeline company TEPPCO, which currently owns roughly 3 million barrels of crude storage at Cushing, plans to add another 250,000 barrels of storage in 2008.

By the first quarter of 2009, Enbridge hopes to have expanded its Chicago-to-Cushing Spearhead pipeline to 190,000 barrels per day (bpd) from 125,000. By 2010, TransCanada is planning to have its 590,000 bpd Hardisty-to-Cushing Keystone line completed. However, in late December BP dropped plans, for the time being, to reverse its 100,000 bpd Chicago-to-Cushing Viridian Pipeline after receiving tepid response from shippers.

Market sources said what was needed was not more pipeline capacity into Cushing, but out of Cushing into the U.S. Gulf Coast refining center. Don't expect that capacity to materialize in 2008, however. In December, TEPPCO said it was in the planning stages with Kinder Morgan to build a crude pipeline that would run all the way from Alberta, Canada through Cushing and into the U.S. Gulf Coast. Exxon Mobil and Enbridge are considering a $3 billion pipeline that would ship up to 400,000 bpd to the Gulf from Chicago by 2010. TransCanada said it will study an expansion of its Keystone line to the Gulf Coast.

TEPPCO has considered reversing the direction of its 300,000 bpd U.S. Gulf-to-Cushing Seaway pipeline, but has yet to announce firm plans.

When it comes to pricing, the supply of low sulfur, high API gravity crude, (light, sweet crude) matters most. The general media has a tendency, for the sake of simplification, to talk about the price of crude as if there is only one type of grade being bought and sold on the market. Unfortunately, like any factual error, this only creates more confusion down the road, for instance when WTI crude prices continue to rise despite assurances from OPEC that it is putting more barrels on the market. The market is not short of OPEC barrels, which at this point are predominately sour, but rather light, sweet barrels. And that demand for light, sweet crude will continue to climb as demand for lower sulfur distillates expands, which leaves the market vulnerable to price spikes.