Oil price rebounds on Thursday October 5th, 2006 on the news that OPEC will cut 1 Million barrels per day production effective immediately. Saudi Arabia, the largest OPEC oil producer, will reduce its output by 300,000 barrels per day. Will this production cut help oil price? OPEC members certainly hope so.
In the short to medium term, I feel that it is a futile effort. For starters, after a nearly harmless hurricane season over the summer, winter is predicted to be warmer this year. As a result, energy consumption is expected to be less burdening.
Secondly, the US crude distillate stocks rose by 3.3 Million barrels last week. That signals the buildup in inventory which is bearish for oil price going forward. Furthermore, the rise of oil price this past year was accompanied with rising inventory, which is puzzling. Therefore, it is about time that oil price declines, no matter what the inventory figure is. That being said, it will take a lot of declining inventory to help prop up oil price.
Thirdly, the rise of oil price has triggered a new oil exploration that would otherwise will not be funded. This project will bear fruit after five to ten years. It is expected that the first batch of this new project will come online within the next one or two years. To recover the huge capital expenditure, it will be best for this new oil production field to keep producing oil. That will put pressure on oil price further.
Fourth, the federal fund interest rate is at 5.25% versus 1.00% several years ago. This would scale down speculations which we believe has contributed significantly to the rise of oil futures. When you can get 5.25% by doing nothing, you would be inclined to not borrow huge and simply put your money in the bank. Furthermore, the effect of interest rate change is felt 9 to 12 months ahead. The Federal Reserve started lifting its fed fund rate on June 30th 2004, until now. Therefore, the effect of 5.25% interest rate will still be felt around one year from now.
Fifth, housing market in the United States has slowed down considerably. Home builders had reported declining profit expectation in the midst of severe slowdown in some areas. There are some bold predictions that forecast a double digit decline in home price until 2009, however, even the most optimistic forecast still foresees a modest decline in home price. This is a picture of a slowing economy, which will dampen demand for oil.
Sixth, natural gas blown out by Amaranth hedge fund, showed how dangerous speculating in commodity market is. This will temper down speculative bet on oil, natural gas for quite some time. We feel that those speculative bet has helped prop up oil price in recent past. Further, the Amaranth blow out clearly shows that commodity price has many speculative excess that can burst anytime.
Seventh, natural gas price and other energy sources has declined sharply. Energy price will generally go hand in hand. If natural gas price has dropped by more than 60% while oil price dropped merely 25%, it brings us two possibilities. Either natural gas price will rise while oil stays constant, or natural gas price will stay constant while oil price will drop. With the action of OPEC members to hastily cut production immediately, we believe that it is the latter.
Eighth, technologies has helped companies getting smarter in locating oil patch. On September 5th, 2006, Chevron announced that it has successfully discovered oil in deep Gulf waters that boost US's oil reserve by 50%. Yes, you heard it right. 50% more. While it will need billions of dollars to extract the oil and distribute it, it shows that high price of oil will stimulate more exploration and deep drilling. Therefore, oil price cannot rise indefinitely.
Ninth, OPEC members are as addicted to oil as we are to our SUV. They need the oil money. Who would oversee that OPEC members reallly abide by the production cut? In the past, some OPEC members will ‘cheat’ by overproducing and sell it on the black market. While price has dropped over the last two month, oil price by historical standards is still quite high.
Tenth, one of the culprit for high oil price is China, where it has been gulping up oil for its rapid economic growth. That may be true, but China's economy has grown in the double digit each year way before oil price gets this high. We believe that the recent commodity sharp rise has anything to do with China hosting the Olympics on 2008. It built up its infrastructure ahead of the game and as 2007 approaches, I believe that the construction is almost complete and commodity demand will slacken in the next year, including oil.
In the long run, as oil is in limited supply, its price should rise. However, in the short to medium term, oil price may have taken a breather due to the ten reasons above. All these forces has made it extremely difficult for us to be in the bullish mode for oil, at least for the next twelve months or so.
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