Demand Likely to Support Black Gold

Despite hitting a wall due to ambiguity over the stability of the global economic recovery and the negative publicity brought on by the massive Gulf oil spill, the forces of supply and demand may enable an opportunity in black gold to prevail.

On the supply side, the BP PLC (BP) Gulf oil spill could potentially reduce future domestic crude supply.  The spill will likely result in more stringent drilling regulations making it more costly and difficult to explore and bring new oil production online.  In fact, the Obama administration has already placed a 6-month moratorium on most deep water drilling in the Gulf, which, if kept in place, could cut nearly 25 million barrels of U.S. crude production next year.   

As for demand of crude oil, it continues to remain healthy.  According to the International Energy Agency (IEA), worldwide oil use is expected to rise by 1.7 million barrels a day this year.  Over the first five months of 2010, China imported nearly 30 % more crude than it did in the first 5 months of 2009, indicating that demand remains well and alive in the fast-growing emerging market.

In the developed world, demand in the United States is expected to increase by 110,000 barrels per day (bpd), pushing overall oil consumption to 1.57 million bpd, reports the U.S. Energy Information Agency (EIA).  This increase is being supported by improving manufacturing data in the U.S. and a jump in consumer sentiment.   According to the Reuters/University of Michigan consumer sentiment index, which grew to a 75.5, U.S. consumer confidence is on the rise.

The increase in demand for black gold in the U.S. has already started to take effect, illustrated by the recent decline in oil and gasoline inventories.  The EIA reported that U.S. oil inventories declined by 1.9 billion barrels in the weeks ended May 28 and June 4 and gasoline inventories dropped 2.6 million barrels in the week ended May 28. 

Another force likely to support crude prices is an increase in investor risk appetite.  Panic and concerns over the European crisis and sovereign debt have started to ease, primarily driven by recent reports indicating that industrial production in the euro zone increased 9.5% year-on-year; giving hope to investors. 

Ultimately, as long as the global economic recovery continues to show signs of sustainability and inflationary pressures ease in China, two forces that are likely to be rectified, the demand for petroleum in both the developed world and emerging markets is likely to increase.  This will further result in future capacity constraints in crude oil, which can only be answered by higher prices to balance supply and demand. 

Three ways to play the oil markets include:

  • The US Oil Fund (USO), which holds futures contracts in crude oil and seeks to replicate the performance of West Texas Intermediate (WTI) light sweet crude oil.  USO closed at $34.33 on Monday.
  • The PowerShares DB Oil Fund (DBO), which seeks to replicate the Deutsche Bank Optimum Yield Index.  DBO closed at $24.52 on Monday.
  • The iPath S&P GSCI Crude Oil TR Index ETN (OIL), which seeks to track the Goldman Sachs Crude Oil Return Index and aims to mimic returns based on the unleveraged investment in WTI crude oil.  OIL closed at $22.35 on Monday.

Although an opportunity may prevent itself in crude oil, it is equally important to consider the inherent volatility and risks involved with investing in commodities.  To help mitigate these risks the use of an exit strategy which identifies when an upward trend in crude could come to an end is important.

According to the latest data at www.SmartStops.net, these price points for the aforementioned equities are: USO at $32.89; DBO at $23.65; OIL at $21.37.  These price points change on a daily basis and are reflective of market volatility.

Disclosure: Long DBO

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2 responses to “Demand Likely to Support Black Gold”

  1. Jack Larsen says :

    Why was USL not mentioned? I’m sure the author has his reasons and I’d like to know. Also, I keep bouncing back and forth between favoring etfs like XLE rather than buying the commodity alone, as it seems ‘safer”, but that may be faulty logic. Any thoughts?

    • smartstops says :

      Jack,
      USL is a great choice and there is no rhyme or reason why it was not mentioned. In fact, I prefer it over USO because it mitigates some of the effects of contango by using 12-month forward rolls.
      As for XLE or VDE, they are generally safer than a commodity-based ETF, however, holdings, like Schlumberger and Halliburton, will likely feel the consequences of increased regulations that are expected to be imposed on drilling due to the Gulf Oil Spill. Additionally, the negativity publicity that BP is seeing could potentially have a contagion effect on other large players like Exxon Mobil and Chevron (the two top holdings in XLE and VDE). Once the negative publicity over the oil spill has calmed, both XLE and VDE will be worthy to look at.

      Hope this helps,
      Kevin

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