Stephen’s Posterous

From FT.com

Crude oil prices have drifted below $50 a barrel this year as the global recession has dented energy demand in the world’s biggest importers. As stockpiles build up, producers have cut capital expenditure on exploration and new production facilities.

But this could be sowing the seeds of the next bubble, some analysts say. Any failure to gear up output to meet the needs of a recovering economy, could create a gap between supply and demand similar to that which drove crude prices to $150 less than a year ago.

Francisco Blanch, head of global commodities research at Banc of America Securities-Merrill Lynch, answers readers’ questions on the impact of recession and recovery on oil prices.

Where will we see the increasing utilisation of alternative energy sources (such as electric powered cars) bring the price of oil to a permanent low, or will the continuous drainage of oil to a point where the resource is fast running out keep prices elevated?

This is the trillion dollar question. In my opinion, $50/bbl oil is not high enough to encourage a massive shift out of oil towards alternative energy. As an example, most biofuels plants around the world will lose money with oil prices below $60/bbl, while wind farms do not really make much sense in a low oil price world.

Will policymakers focus on energy efficiency when oil is a cheaper alternative and other political issues are more pressing?

We believe that continued upward pressure on energy prices will be needed to focus policy on energy efficiency. Limited spare capacity, strong underlying trend demand and the need for efficiency improvements all suggest that energy prices may have to increase again in the coming years relative to other prices in the economy. Our long-term WTI crude oil price forecast is $72/bbl in real terms.

In the midst of a global recession (depression?) with oil demand so low, one would expect prices to be low and remain low, and yet there still seems to be massive volatility in the price on a day to day and week to week basis. Why is this?

Fundamentally, price volatility in the commodity markets is linked to inventories. Commodity stocks, in effect, serve as a cushion to adjust supply and demand shocks in the physical market. In commodities such as oil and natural gas, where there storage constraints are a feature of the physical market, high levels of inventories can result in high levels of volatility.

Thus, we should not be surprised that the massive demand shock resulting from the global economic meltdown has pushed up oil price volatility. Similarly, low inventory levels can also drive volatility up in oil markets, as we saw last summer.

Technically, commodity price volatility is linked to volatility in other markets including equities, rates, credit or FX. I like to say that volatility is contagious. What will happen to oil price volatility going forward? In the second half of this year, we believe that the oil market will tighten and move from a very large surplus into a deficit, as demand stabilises and Opec maintains low output levels.

A tighter balance should mean that oil inventories could start drawing down in the coming months towards their 10 year average. In turn, a shift towards average inventory levels could help bring oil price volatility lower.

In 10 months, oil prices have decreased around 65 per cent. Do you see the recession as the one and only reason for this decrease?

Yes, we believe supply and demand fundamentals, and changes in the money supply and the velocity of money have been the key drivers of oil prices in the last five years. Industrial production across a broad range of developed and emerging economies came down very sharply in the fourth quarter last year and first quarter of 2009.

In the case of Japan, industrial output is now at the same level it was back in 1983, while German and American industrial activity has taken a step back of almost 10 years. These dramatic swings in economic activity are enough, in my judgement, to create such a large swing in prices.

Opec decided at its last meeting not to reduce output. After this decision, and coupled with poor demand and a move away from carbon fuels, can we seriously expect prices of $150+ ever again?

My simple answer to your question is yes, but a more important question perhaps is when. Due to their high exposure to the business cycle, oil prices have been seriously beaten by the current crises and are unlikely to stage a recovery until there are convincing signs that the global economy has turned the corner.

By then, another set of consecutive years of underinvestment in production capacity, coupled with a massive government debt overhang, will end up exacerbating the very same problems that created the most recent spike in energy prices, in my opinion. This situation could develop as soon as 2011 or 2012 and as late as 2015.

Another important factor that could push oil prices to $150/bbl in two to three years could be the tsunami of monetary and fiscal policy measures aiming to offset the recent private sector credit contraction. In our view, it is still uncertain how governments will be able to service the increased debt. In a world of fiat currencies and large government debts, higher inflation is not an unlikely scenario and a run-up in nominal commodity prices could develop.

In addition, with emerging markets poised to grow at a faster rate than OECD economies in the next decade and limited spare productive capacity, commodity markets could be among the first to experience inflationary pressures.

Is for example extraction of oil from the Alberta tar sands developments operationally economic at $50/barrel? What oil price is required to sanction capital expenditure on further tar sands projects?

It is important to differentiate between operational costs to maintain existing facilities and operational and incentive prices for new investments in productive capacity.

The current price level of $50/bbl will keep the existing tar sands projects in Alberta operational, but will not encourage new investment into the sector. As recently as 2008, our equity analysts estimated that new tar sands projects would only make sense financially at $90/bbl. Fortunately, improved labour productivity, lower steel and component pricing, and an end to the cost inflation environment of the 2006-2008 oil sands boom period are bringing incentive prices lower.

For oil sands projects, our equity analysts estimate that a cost reduction of 25 per cent in new projects is achievable over the next few years. If achieved, this could drive the required oil price to generate acceptable returns from $90/bbl back down to the $70-75/bbl range.

Our calculations suggest that the oil industry’s marginal source of supply will fall to US$70-75/bbl. However, we still expect to see continued price volatility around marginal costs particularly in periods of significant positive or negative divergence from trend levels of growth.

How much of the $150 per barrel oil do you feel was the result of institutional investors buying oil futures instead of, for example, asset backed securities as the crisis unfolded? If the impact of such speculation was significant then do you believe that speculators will continue to play a large role in a potential future oil bubble? Or have we learned our lessons for now?

The influx of investment in commodities sparked an intense and politically charged debate last year on whether speculation somehow caused the price of commodities to become disconnected from the fundamentals of supply and demand. Having analysed the available data in detail, we believe there is simply no evidence for that assertion.

Instead, we can find a clear link from sharp changes in monetary policy to abrupt commodity price movements. Looking back thirty years, our analysis concludes that a 1 per cent reduction in real interest rates results in a 17.5 per cent increase in spot commodity prices 10 months later. Our estimate thus suggests that loose monetary policy played a much more important role than speculators in the commodity price rally in the first half of 2008.

If the prospect of a future price bubble is so obvious why are not speculators already driving up the price, which in turn would encourage investment in oil exploration, extraction and refining?

The short answer is that long-dated oil prices are already on the rise. ICE Brent crude oil contracts for delivery in December 2017 closed last Friday at $78.71/bbl, a 60 per cent premium to current spot prices. The oil futures curve is currently pricing in nominal price appreciation of around 6 per cent per annum for the next 8 years.

I would like to clarify, however, that long-dated oil prices are not just driven by ”speculators”. Key participants in the oil markets include consumers, refiners, producers, inflation hedgers and speculators, defined here as investors that have the ability to go long or short any given contract to take advantage of market conditions). At the moment, a number of consumers have re-entered the market to take advantage of relatively low prices to hedge forward consumption.

Is it possible for the world to exceed more than 90 million barrels of oil production per day? If not, what alternatives is Merrill Lynch investing in to fill the demand gap of 10, 15, 20 years from now?

Perhaps 90 million barrels a day is a reachable target, but the chance of world oil production ever exceeding 95 million barrels a day is very low, in my view. On our estimates, if global GDP grows by 3.6 per cent every year over the next decade, annual energy demand will increase by 4 million b/d of energy in oil equivalent terms.

For oil, this figure could mean an annual net increase in global demand of 1 million b/d. Given the natural limits to supply, policymakers will have to shift their attention to energy efficiency. I can not really comment on what Merrill Lynch is investing, but I certainly see the need to increase global energy supply by 1.7 per cent per annum and global energy efficiency by 1.8 per cent per annum every year over the next decade.

What does that mean for investors? I think sectors such as energy productivity, alternative fuels, renewable electricity generation, but also conventional fuels such as coal or natural gas, will all provide very good opportunities over the next decade as we struggle to fill the ”demand gap” left by oil.

Is the persistent contango structure of the future oil market a sign of increasing dislocations in the oil market or is it just the result of normal market expectations? When do you think the curve will go back to its prevailing backwardation structure?

The persistent contango structure is primarily a function of the extremely high level of inventories, and the ongoing supply/demand imbalance. Keep in mind, however, that the second quarter of the year is the seasonally low point in demand. Thus, we should see a sequential improvement in global oil demand based both on seasonal factors as well as on a slight improvement in underlying economic demand.

In my opinion, with the oil market turning more balanced and Opec keeping over 3.5 million b/d off the market, inventories are heading for a draw in the second half of 2009. Thus, we believe that oil prices will likely continue to strengthen in the next six months.

However, long-dated prices are unlikely to follow suit, as the demand recovery will likely be very shallow in 2010. In a market with abundant spare capacity and a tightening balance, the pronounced crude contango should lead to a flatter curve or even to backwardation. Thus, we believe that the term structure of WTI crude oil prices will continue to flatten from here.

Given that some oil resources are uneconomic to exploit at current prices, what price does oil need to reach for post recession demand to be met?

We believe that two forces will need to be at work over the next decade to prevent further oil price spikes: (1) increased investment into the oil sector and (2) increased energy efficiency and substitution. Thus, oil prices need to be high enough to encourage a relatively slow oil demand growth path going forward and oil prices need to be high enough to encourage investment in marginal sources of supply, which we believe are Canadian oil sands and biofuels.

Keep in mind that commodity production utilisation rates are still high compared to other sectors, so any rebound in economic activity will likely have an impact on commodity prices before it hits other parts of the economy.

Low spare capacity availability on a relative basis, strong underlying trend demand and the need for energy efficiency all suggest that WTI crude oil prices may have to average $72/bbl in the long-term in real terms. In turn, a high oil price will keep energy’s share of global GDP above historical averages.

Did Peak Oil get it wrong and now it’s Peak Demand?

No doubt, global industrial production and economic activity has fallen sharply, with OECD economies contracting at an unprecedented rate in recent quarters. However, this extraordinary ”demand vacuum” created by the collapse of the credit bubble could be filled up quickly by demand for durables in Emerging Markets, in our opinion. We estimate that about 1.7 billion consumers sit on an annual GDP per head of $5,000 to $20,000, mostly in Emerging Markets and mostly unlevered.

This bracket of income is a sweet spot for the consumption of durable goods and for taking on leverage, as appetite for washing machines, freezers or cars rises rapidly when per capita income hits $5,000. As a reference point, Americans had a real GDP per capita of $12,000 in 1980 as the multi-decade long credit bubble began, while Portugal did not cross the GDP per capita mark of $10,000 until 1990.

Thus, as a higher consumption of durables comes with a substantial increase in energy use, supply constraints could soon resurface. As a reference point, global energy demand in oil equivalent terms increased by 6 million b/d in 2007. For China, India and other Emerging Markets to drive and fly, we need all the oil we can get, or a viable alternative to the existing transportation technology.

Given that the fall of oil prices have revealed that countries like Russia and Venezuela have failed to diversify their economies outside of commodities; do you see any oil producing economies making progress to diversify their economy in this climate?

Broadly speaking, I think commodity producers have been more cautious with their spending in the past business cycle than during the oil and commodity boom of the 1970s. In Latin America, Mexico, Brazil or Chile are good examples of oil price hedging, economic diversification, and precautionary savings ahead of the commodity price downturn.

In the Middle East, emerging trading centres in the United Arab Emirates or Qatar could well gain increasing traction in sectors such as finance with global taxation on the rise, partly thanks to heavy investment in infrastructure. Similarly, a broad range of commodity producers sit on large Sovereign Wealth Funds that should allow them to endure the oil price downturn.

There is a long-lasting dispute on the impact of speculation on oil prices. Has the relation between fundamental (physical) and financial (speculative) factors changed after the financial crisis, and are oil bourses (ICE, Nymex) gaining influence compared to OTC deals?

In our view, a global misallocation of capital sits at the heart of the current economic crisis. In simple terms, capital markets failed in recent years and channelled too much money into real estate, too little into energy. Having analysed the available data in detail a few months ago, we found no link between speculative activity and systematic price increases in commodity markets.

As part of a general growth in derivatives across all asset classes trading volumes and open interest in commodity derivatives surely increased, but only some commodities experienced significant price swings in the last two years. What has changed after the credit crisis?

Naturally, listed products are gaining ground across all asset classes, not just commodities, as regulators and market participants press for greater transparency and lower credit risk. Still, activity in the over-the-counter market continues unabated because it offers a customized angle that listed markets can’t provide. Having said that, market participants will now choose to clear trades on the exchange to limit counterparty credit risk, when possible.

Opec regularly states that they require an oil price around 70$/bbl to sustain projects. Where do you see Opec production cost at the moment and do you have an estimate of how many projects have already been postponed or cancelled?

Opec production cutbacks have been very significant. From a peak of 30.3 million b/d in July last year, Opec-11 crude oil production has come down to about 26 million b/d, helping create a floor to global crude oil prices. However, actual oil production costs for most Opec members are substantially lower than $70/bbl, perhaps as low as $10-20/bbl.

Similarly, social oil costs for Opec, or the oil price required to balance the member governments’ budgets, differ by country. For Saudi Arabia, Kuwait, Qatar or the Emirates, we estimate that $50/bbl would suffice to roughly bring government budgets into balance, while members such as Iran or Venezuela probably require higher prices of $70/bbl to break even. Then again, we are talking about social costs, not production costs or incentive prices for new supply.

Having said that, new investments in Canadian oil sands and biofuels production require a $70/bbl price tag, but these projects sit mostly outside Opec. So far, over half of all planned oil sands-related projects in Canada have been delayed or cancelled, while many biofuels producers have cut back on their investment plans.

With collapsing global oil prices and the rapidly increasing cost of funding, we expect delays on expensive development projects like Canadian oil sands to continue. Within Opec, we have also seen significant cutbacks in capital expenditures, as financial resources are being diverted to other sectors of the economy.

Currently there is well over 100 million bbls of crude and 25 millions barrels of products in floating storage. This, combined with record shore stocks will surely provide a buffer until production increases to meet any increase in demand and therefore prevent a price bubble?

I agree that there are very low chances of an oil price spike in the next 12 to 18 months, but I also believe the market could start to tighten again in 2011. Remember that 125 million barrels in floating storage is only 1.5 days of global oil demand, so this cushion is not as large as it seems if economic activity ticks up.

However, given the shallow demand recovery ahead, the high inventory levels, and the increased spare capacity in refining and crude oil supply within Opec, I do not see much upside to oil prices until the end of next year.

Our current forecast for WTI crude oil prices in 2010 is $62/bbl. Beyond next year, the limited growth prospects in rich OECD economies stand in stark contrast to the middle income emerging economies.

As I have pointed out in another question, we estimate that 1.7 billion consumers sit on annual GDP per head of $5k to $20k, a sweet spot for the consumption of durables and for taking on leverage. Thus, the medium-term energy demand prospects are a lot brighter as EM economies start to recover.

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The slowdown in investment in oil and gas production could lop off nearly eight million barrels a day of future oil supply growth, setting the stage for another big crude price surge in years to come, according to a new study.

The global credit crisis and falling oil prices have squeezed oil companies' finances and forced many to cut capital spending and postpone projects. That could have big implications for supply when the global recession ends and demand for energy recovers, the report by Cambridge Energy Research Associates (CERA)  says.

CERA projected last summer, before the economic crisis set in, that world oil production capacity would rise to 109 million barrels a day by 2014 from the current 94.5 million barrels a day. It now says 7.6 million barrels a day, or slightly more than half of that increase, is "at risk" due to project deferrals or cancellations.

The report says that reduction in capacity is a "potentially powerful and long-lasting aftershock" following the oil-price slide of 2008, when within a few months crude fell from a record high of $147 a barrel. Crude-oil futures rose $1.57, or 3%, to settle at $54.34 a barrel Thursday.

"A price collapse of this magnitude really registers on the Richter scale, and its impact on levels of future investment will be felt for years," CERA Chairman Daniel Yergin said in an interview. The report comes amid ample evidence companies are scaling back on investment in costly projects that require a high oil price to be profitable, such as the oil sands of Canada or the ultra-deep waters off west Africa.

Middle East oil producers, hit by falling export revenue, have reined in spending plans. The Organization of Petroleum Exporting Countries says as many as 35 new projects in OPEC countries could now be delayed past 2013. Most Western oil companies say they are sticking to their investment plans but are slowing down some developments.

The slowdown is troubling the International Energy Agency, the Paris-based adviser to oil-consuming countries, which also has trimmed its forecast for supply growth. The agency's deputy executive director, Richard Jones, told a conference in London this week that more than two million barrels a day of expected new oil production capacity looks likely to have been deferred for now.

"Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases, possibly as early as this year," he said.

CERA said it expects many new projects in Angola, Nigeria, the Gulf of Mexico, deepwater off Brazil, Canada's oil sands and Venezuela's hard-to-extract heavy oil to be postponed or canceled.

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It has been a great week for commodities. But has the price rally got ahead of itself? Although demand has improved relative to the dismal conditions of late last year, analysts and traders warn that conditions have yet to perk up sufficiently to warrant an across the board price rally beyond current levels.

“The market is ignoring near-term bearish fundamentals,” says Adam Robinson, director of commodities at Armored Wolf, a California hedge fund. The poor prospects have not discouraged investors, fearful that the Federal Reserve’s action to buy US government debt will stoke growth at the cost of higher inflation.

Some banks are also beginning to see value in the asset class. Goldman Sachs, Wall Street’s largest commodities dealer, on Friday increased its recommended allocation for commodities to “neutral” from “underweight”.

The benchmark S&P GSCI index rose 8 per cent this week. Some commodities gained more than 10 per cent. That strong performance has brought talk among investors about a revival of the asset class, after the carnage of last year. Money flows, particularly exchange traded funds, have picked up. Most analysts are less enthusiastic than investors.

James Steel, a commodities analyst at HSBC in New York, says given that the genesis of the wider commodity rally appears to be the shift in policy by the Federal Reserve and not a sudden change in underlying supply and demand balances, “it is unclear whether higher commodity prices can be sustained.”

Barclays Capital says that a fall in freight costs, a steep decline in Chinese domestic steel prices, both good indicators of industrial activity and commodities demand, and the steady increase in inventories in some raw materials “all suggest fundamental conditions in several markets are still very weak and price recoveries [would] likely prove fragile.”

Goldman warns that it would need to “see demand stabilise before going overweight” in commodities.

Some analysts, such as Daniel P. Ahn, director of macroeconomic research at Louis Capital Markets in New York, question how much central bank quantitative easing, in which central banks inject large amounts of cash into the system in an attempt to bring down long-term interest rates, by itself will help stimulate demand.

“Japan’s example in the 1990s, though not a perfect analogy, shows how massive quantitative easing can co-exist with continued deflation in the absence of structural reforms and proper fiscal stimuli,” Mr Ahn says.

Even if the world’s central banks are successful in quick-starting the economy, it will be months, probably a year, before a pick-up in activity lifts demand for commodities and drags inventories down.

There are some bright spots. Commodities producers’ output cuts, such as by Opec in the oil market, have been in place for long enough and represent a sufficient amount of production to begin to offset demand destruction. This is supporting prices. Merrill Lynch and JPMorgan on Friday raised their oil forecasts for the second half of the year.

“Against our initial expectations, Opec production cutbacks have been very significant,” says Francisco Blanch, commodities strategist at Merrill Lynch.

Other supportive factors for commodities are the Chinese and US fiscal stimulus programmes, which involve large outlays on infrastructure. There are limiting factors. Oddly the pick up in prices is the critical one. Higher prices could lure some producers, from Opec countries to miners, to bring back output capacity even if final demand has yet to recover, opening the door for oversupply and lower prices.

The cycle of higher prices leading to more output and eventually to lower prices is exactly what has happened in the steel sector in China, where a rebound in prices in January, due to traders stockpiling, prompted steel makers to bring back production capacity. As soon as the stockpiling ended, it became clear that final demand was not there and prices fell sharply again.

The influence of speculative money is also likely to be smaller than last year, potentially capping the rally. Hedge funds, for example, have far less firepower than last year as the credit crunch has reduced their capacity to leverage. Regulators appear ready to intervene in the commodities market if they perceive that speculators are driving raw materials prices higher, particularly if oil and food prices are being pushed up.

One way to avoid getting caught out, say analysts, is to pick commodities with supportive fundamentals such as sugar and corn and avoid those with poor ones, base metals and natural gas are typically blacklisted, while also avoiding baskets of raw materials that mix good and bad picks together. The market is divided about the prospects for oil.

Some commodity hedge funds are betting on relative value strategies, gambling that the price of forward contracts, such as for delivery in 2010 and later, will increase relative to spot prices.

The question for investors is whether the economy is strong enough in the short-term to justify the gains. The International Monetary Fund, which forecast that economic growth would fall this year for the first time in 60 years, has a clear view. “Commodity prices are unlikely to recover while global activity is slowing,” it says.

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Opec has finally turned bearish on oil prices. At a meeting in Vienna over the weekend, the oil producers cartel refrained from cutting production beyond the 4.2m barrels per day pledged last September 2008, 12% of the 2007 daily average. The cartel also admitted that it won’t achieve its price goal of $75 a barrel this year.

The restraint is sensible. Opec’s statement that it is worried about the fragile state of the economy could earn points for good public relations. The cartel is pitching in to prevent a destabilising oil price spike. Such solidarity will play well in big oil consuming nations, noticeably the US.  The restraint, though, was pretty much making the best of a weak position. Opec did not have had much choice. With demand down, it would take big cuts in Opec quotas to push the price up by two-thirds to Opec’s stated target.

The members of the cartel, which produces more than a third of the world’s oil, wouldn’t agree to take the revenue strain. As it is, only 80% of the agreed September 2008 production cuts have been made, according to the International Energy Agency (IEA). That leaves about 800,000 barrels of daily production to be removed from the market.

Saudi Arabia, the cartel’s most influential member, has stuck to its production cuts. But leading members including Iran, Venezuelan and Angola, are still producing beyond their quotas, according to the IEA. Meanwhile, big non-Opec members, such as Russia, have kept up production.

Saudi Arabia may be tired of carrying almost all the weight of production cuts. But whatever the internal Opec politics, it certainly doesn’t make much sense to set unrealistic production targets. Opec’s credibility and authority are at stake. If those are lost, the always fragile cartel could be weakened. So Opec has followed an old maxim: when you can’t get what you want, it is better to want what you can get.

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FBR Capital Markets expects significant consumption declines to cause world-wide hydrocarbon excess capacity. Suppressed drilling activity should lead to deflation in oilfield service and driller pricing.

The international oil market and domestic-gas market should both see extended down cycles. The international spending market should remain depressed until 2012 due to less steep-decline curves (compared with domestic natural gas), available OPEC spare capacity, and rig contracts that will extend production activity deeper into the current downturn.

Domestic-gas spending will need to be cut in 2009 and 2010 in order to balance the market in our opinion. Cheaper service costs and low-cost shale production should result in a long-term 50% decrease in gas spending (compared with 2008 levels) needed to maintain production.

In FBR's bearish outlook, they recommend long-only investors hide in Halliburton (HAL) since the North America contraction seems fully priced into Halliburton and Transocean (RIG) since there is a limited number of possible negative data points over the next few months.

On a relative basis, FBR thinks Schlumberger's (SLB) valuation premium to Weatherford International (WFT) should dissipate and think Transocean will outperform Diamond Offshore Drilling (DO) as older deepwater rigs are stacked first.

The down cycle will be deeper and longer. Oil consumption should decrease for three years, the longest period since the early 1980s. The steep drop in oil prices and limited access to capital will further reduce E&P capex. Deflation will take years, not quarters, to set in; thus, we expect a "U" shaped cycle, not a "V" shaped recovery as some expect.

U.S. capital spending ("capex") has started a structural downward shift. Improved technology and methodology are making a large quantity of low-cost shale gas economical. Lower demand and excess capacity are also lowering service costs. This should lower the weighted-average marginal cost of production 20% in 2009 to below $3.

Even with more than a 60% reduction in gas capex, the natural-gas market will not be balanced in our opinion. There could need to be another 25%-30% drop in gas capex in 2010 to balance the market. The 2008 capex level is unlikely to be seen for many years.

FBR expects the natural-gas rig count to average 882 rigs in 2009 and 782 in 2010 as capex is cut to balance the natural-gas market. In 2011, FBR expects the U.S. land-rig count to average 1,220.

With more than 2,500 rigs marketed at the peak of the 2008 cycle, including 750 new builds and not including 100 under construction new builds, FBR believes 1,000 rigs need be retired/stacked for land-rig margins to rise above cash costs. Utilization for 2009 and 2010 should be around 40% and 74% long term after 1,000 rigs are retired/stacked.

Over the last several months, the market has declined at an increasingly rapid pace for both jackups and deepwater. Tender activity has dried up considerably. FBR continues to expect this to have a significant impact on drilling activity on par with previous sharp downturns in the late 1990s and earlier.

Consequently, FBR has forecasted lower day rates and utilization. They expect deepwater day rates to fall on average by 42% from peak rates while we expect jackup day rates to fall on average by 53% from peak rates.

FBR is upgrading Transocean and Halliburton to Outperform from Market Perform since they expect these names to be the most defensive in this universe. They also continue to like Core Laboratories (CLB) for small-cap investors.

We see limited downside in sentiment for Halliburton from further North American capex cuts and expect investors to remain in Halliburton. Although Schlumberger has traditionally been the defensive name, FBR is cautious this cycle due to lagging international capex cuts and a more exploration-heavy portfolio.

Transocean's highest in-class leverage to the ultra-deepwater, contracted new builds, and the limited number of potential negative deepwater data points should continue to make this name defensive.

FMC Technologies' (FTI) (rated at Market Perform) heavy leverage to the subsea makes it an attractive investment thesis, but FBR is waiting to be more constructive on the name until they see the extent of further international capex cuts on 2010 deepwater projects.

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Opec is doing all it can to talk the price of oil back up to what it calls a “reasonable” $75 a barrel. Some analysts even expect oil prices to hit that level by the year-end. But the idea that this would be a return to normality makes little sense.

Oil traded below $35 pretty consistently for decades up to 2004. Tony Hayward, chief executive of oil major BP, said at a recent conference he remembers when $40 felt like a “fantastic” price.

Why Hayward’s superlative? Because not long ago $40 was comfortably above the long-term equilibrium price at which supply theoretically cleared demand. In the late 1990s, oil companies traded on valuations that assumed a long-term oil price of around $15 a barrel.

And in the first two years of the new millennium, analysts estimated a long-term oil price of about $20 a barrel. That had risen to only $25 in 2004 when the worst of the mini-downturn was comfortably past.

There are good reasons to suppose that the comparable figure is now higher, perhaps about $40, just below its current price. Firstly, the oil price should rise at the rate of global inflation, all other things being equal. Assume it was $15 in 1995. Then today it should be $21. But production costs have risen too, and it is the last, most expensive barrel required to satisfy demand that sets the price for every barrel.

Producers increasingly have to drill in tricky locations like deep water or tar sands. For tar sands, the cost of extracting a barrel of oil is about $38 a barrel, according to estimates by Shell, the Anglo-Dutch oil major. Transportation and refining costs have also increased.

For oil producers, $40 is no longer a fantastic price. Opec members have real problems balancing their budgets at that level. The likes of Shell, meanwhile, have drawn up big capital expenditure plans whose returns are predicated on higher prices.

But wishful thinking cannot underpin the oil price. On the fundamentals, there is little to justify the notion that its long-run equilibrium has risen by $50 in only five years.

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Demand for oil will fall this year at the fastest rate since 1982, the International Energy Agency has forecast.

The rich countries’ energy think-tank has again cut sharply its prediction for world oil demand this year, and now expects it to average 84.7 million barrels per day, down 1 million barrels per day (b/d) from last year, because of the steep downturn in the world economy. This year is expected to mark two successive years of falling demand for the first time since 1982-83.

Fuel demand has plummeted in the US and is falling in many other countries, the IEA said. Even in China, one of the countries that powered the global growth in oil demand up to 2007, the rise in consumption is expected to slow sharply.

However, the IEA also warned that sharp production cuts from Opec, the oil producers’ cartel, would mean that by the end of the year there would need to be a substantial draw-down in oil stocks, unless demand weakens even further, or supply from non-Opec countries turns out to be stronger than expected.

Opec cut its agreed production levels by 4.2 million barrels per day in the second half of last year, and could well cut production again at its next meeting on March 15, 2009, in a bid to raise oil prices from this week’s levels below $40. The IEA’s forecast for oil demand this year is 570,000 b/d lower than it predicted in January 2009, reflecting the sharp deterioration in the assessment of the world economic outlook from the International Monetary Fund.

Forecasts for oil demand in the US are unchanged, as the IEA already expected a second year of decline in 2009 following a drop of more than 5 per cent to 19.5 million b/d last year. The sharpest revisions come to forecasts of demand in the European Union and Japan. Demand is particularly weak in the industrial sector; consumption of naptha, used as a feedstock for manufacturing plastics and synthetic fibres, ”virtually collapsed” in Germany at the end of last year, and has fallen ”off a cliff” in Japan.

In China, total oil demand is still growing, but the rate of increase has slowed very sharply. As demand for oil drops, the IEA warns that its estimates of oil supply capacity are also falling, as the financial crisis and the plunge in oil prices from the summer’s peak of over $147 per barrel force companies to delay or cancel planned investment in increasing or sustaining production.

That reduction in investment is already likely to have some effect on oil supply this year, the IEA thinks, but the greatest impact will not be felt for a few years. In its next medium-term analysis of the oil market, due out in the summer, the IEA will analyse the effect of project delays on the outlook for supply over the next five years, looking ahead to the hoped-for recovery in the world economy.

When economic growth picks up, under-investment could lead to supply shortages and send prices soaring again. As the IEA puts it: ”Ultimately, low prices sow the seeds of their own destruction.”

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Every time the oil market attempts to ignite a rally, an upsurge from the sea of crude stored on waterborne tankers snuffs it out.

The accumulation of oil held in "floating storage" gained speed in December, as available space in traditional onshore storage hubs dwindled due to excess supplies. This floating storage is now among the biggest impediments to oil prices recovering any of the ground lost over the past six months. Companies are quick to sell cargoes at the hint of a turnaround, unleashing a flood of oil onto the market.

The oil sitting at sea adds an extra layer of uncertainty about the supply overhang, which traders said must be whittled down for oil prices to rebound. Tankers carrying up to two million barrels each aren't counted in official statistics. Ship trackers estimate that as many as 80 million barrels may be on the water, or more than twice the amount kept in the largest commercial storage center in the U.S., in Cushing, Okla.

"There's no database of ships sitting on storage right now. It makes it very, very difficult to speculate" on what is on the water, said one tanker broker. The flexibility that comes with holding oil on a vessel is important for companies looking to quickly take advantage of a market where oil to be sold next month costs significantly less than a contract to deliver later in the year. The sheer amount of crude floating around prevents any permanent narrowing of that discount.

"You can almost describe it as an accordion effect," said Andy Lebow, senior vice president for energy at brokerage MF Global in New York. "For floating storage to come out you want to see these spreads tighten up. When the oil comes out ... [the spreads] widen."

Members of the Organization of Petroleum Exporting Countries are the only producers capable of and willing to quickly slow the flow of oil. The group has cut output by 3.1 million barrels a day since September, according to a Dow Jones Newswires survey.

OPEC's cuts haven't resulted in lower inventories. U.S. onshore oil stocks rose by 7.1 million barrels in the week ended Jan. 30, one of the largest single-week gains ever, according to the Energy Department. Several OPEC members have raised the possibility of cutting production quotas again at the group's meeting in March if inventories remain elevated and prices stay depressed.

"OPEC will eventually win the battle, but what floating storage does is it delays the victory," said Michael Wittner, global head of oil research at Société Générale SA.

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In a challenging 2008 for stocks, big oil shares have provided some respite rising through midyear before losing ground as petroleum prices slid from the astounding peak around $147 a barrel that they hit in July.

With crude more than $100 below that level, shares of the integrated oil giants, companies that do everything from exploring to producing to refining and distributing, remain in a slump. These stocks look tempting for long-term investors, but there's no need to rush. Big oil stocks could get even more tempting in coming weeks as the companies report earnings, issue subdued guidance for 2009 results and reduce the value of their reserves to reflect the latest realities of crude pricing.

The U.S. Energy Information Administration expects oil to average about $43 a barrel in 2009, while some Wall Street energy bulls consider $60 more likely. If either forecast is right, oil stocks will benefit later this year. If on the other hand, crude slides below its current level, as some Street bears expect, the shares could stumble further.

A recovery will eventually come, and higher oil prices surely will follow. The most enthusiastic bulls even see them returning to $100 within a few years. Patient investors would do well to buy the stocks of the best-positioned companies with the strongest finances and best long-term outlooks and this includes: ExxonMobil, Total and BP. Also worth considering, although more speculative: Petrobras.

Of the top three, ExxonMobil (XOM) looks the most expensive, but its strong cash position makes it the No. 1 candidate for a dividend increase. The company, the world's largest non-government-owned energy outfit, is also a low-cost petroleum producer, as are France's Total (TOT) and the U.K.'s BP (BP), each of which also has impressive natural-gas holdings. Brazil's Petroleo Brasileiro, known as Petrobras (PBR), a smaller, production-heavy player, has made some intriguing energy discoveries, but some can't be exploited profitably at current petroleum prices.

The story is not as positive for the other big players, whose shares are cheaper for good reasons. Although it has a decent cash position and dividend, Royal Dutch Shell (RDSA) trades at a discount to its peers, in part because of its miserable history of writing down the size of its reserves. ConocoPhillips (COP) has a weaker balance sheet than most of its rivals, leaving it at a disadvantage in bidding for assets to replace its maturing reserves. And Chevron (CVX) looks downright expensive, especially in light of its high reserve-replacement costs.

The challenge for the publicly traded global giants is replacing their oil and natural-gas fields on a massive scale. National oil companies, chasing profits, now control about 80% of the world's oil. As energy prices rose, ExxonMobil and ConocoPhillips were among the companies booted from nationalized projects, most notably in Venezuela.

The political realities have forced the majors to do much of their exploration in difficult terrain, where finding-costs are high. The good news is that oil-rich countries seeking to fill growing budget holes are likely to offer more attractive terms to the majors, says Daniel Yergin, an energy expert and the author of The Prize, an oil-industry history. The inducements: the majors' access to capital and ability to execute projects and to marshal technology.

The major, independent energy companies still can thrive with oil prices down because they are "so big and diverse, they benefit in the chemical and refining areas from a drop in prices...," says Sean Bogda, a money manager at Global Currents, a unit of Legg Mason.

One big bull on the sector is Tim Guinness, who runs the Guinness Atkinson Global Energy Fund (GAGEX). He contends that all the integrated oil stocks are a "screaming buy" with more than 50% upside, if you believe, as he does, that petroleum prices will average $60 in 2010 and $70 in 2011. The money manager's argument: The Organization of Petroleum Exporting Countries (OPEC) wants $70 oil and ultimately will take the actions necessary to obtain it, even if its members have an interest in "giving the world an economic break" with lower prices for now.

One threat overhanging all of the oil companies is the possibility that the Democrat-controlled Congress will revive the windfall-profits tax of the 1980s. But just how deeply such a levy would bite into earnings and whether it really would be imposed are both unknowns at this point.

Bears also fear that dividends will fall unless crude and natural-gas prices heat up. But, says Jeff Parsons, an energy analyst at Eaton Vance Management: "Integrated oil companies, even if they have a downturn in cash flows, rarely cut the dividend-they try to maintain or grow it. What they can do is reduce their capital expenditures." In fact, capex budgets are shrinking already, in line with oil prices.

ExxonMobil

This company is in a league of its own, not just for its girth and $37 billion cash stash, but for its low reserve-replacement costs -- born of many accessible energy fields and superior technology -- project-financing capability and a shrewd but conservative management team. Headed by CEO Rex Tillerson, Exxon's management gets consistent praise on Wall Street.

This is why Exxon investors have long paid a premium multiple, which today stands near 14 times estimated 2009 earnings of $5.51. That's a roughly 10% premium to the integrated oil sector, but well below the 30% the stock boasted last year. Exxon shares have been the most stable among those of the big energy firms, down only 6% over the past 12 months. In contrast, its 2% yield is the lowest among the integrated giants. But, given the company's powerful financial position, bulls argue that it's likely to boost its payout, after having emphasized repurchases in recent years.

Exxon spent $26.9 billion in 2008's first nine months, shaving its total of outstanding shares by 5.5%, to roughly five billion. The company has repurchased more than 2 billion shares over the past decade. If the buybacks were to continue apace, Deutsche Bank analyst Paul Sankey has quipped, ExxonMobil could be a private company by 2020.

ExxonMobil didn't respond to a request for comment. It noted in third-quarter filings, however, that dividends rose 13% per share in 2008's first nine months -- largely the result of fewer outstanding shares. Recently, speculation has grown about whether ExxonMobil will make an acquisition. Among the rumored targets are Britain's BG Group (BG.U.K.) for its natural-gas assets. There has even been talk of a bid for all or part of Royal Dutch Shell, a deal that would face regulatory hurdles.

Total

This big French energy company's outlook is being brightened by the appeal of liquefied natural gas, especially outside the U.S. Standard & Poors expects the company's natural-gas reserves to be significantly bolstered by a recent agreement with Russia's Gazprom. Under it, Total obtained a 25% interest for 25 years in a Barents Sea gas field that the two will exploit together.

Unexpected shutdowns in Africa and the North Sea cut production last year, but European refining margins were up 88% in the third quarter alone. With low-cost production in Africa (the source of 42% of Total's earnings before interest and taxes, according to S&P), and rapid expansion in the Middle East, Total should thrive if oil prices stay at current levels or rise. The French major had $17 billion in cash at the end of the third quarter. S&P has a 12-month target of $92 on the stock, double the current price.

BP

In recent years, BP has blitzed consumers with clean-energy ads and expanded its natural-gas operations, especially in the U.S., where last fall it agreed to pay $3.7 billion for some of Chesapeake Energy's shale assets.

But oil still looms large in the company's fortunes, and its earnings are likely to be hurt in the near term by low crude prices in Russia, where a joint venture accounts for about a quarter of production. In addition, profits could be squeezed by the restructuring of BP's considerable refining operations, including its Texas City, Texas, operation, the third largest in the U.S. Chief Financial Officer Byron Grote has said that BP's $3.36-a-year dividend isn't endangered, assuming oil stays in the 40s. Investors obviously are skeptical, however; the company's shares are off about 11% this month.

Petrobras

This Brazilian energy concern's shares have fallen about 50% in the past 12 months. While considerably smaller and less diverse than some of the other integrated outfits, Petrobras has crashed the Big Oil party because of a huge discovery under salt deposits deep off the coast of Brazil. The costly project will take years to come to fruition, and some analysts contend that it might be viable only if oil fetches $60 a barrel; the company says the real figure is closer to $40.

The uncertainty over this important discovery makes Petrobras more of a gamble than ExxonMobil, Total or BP, especially since it sells at a higher valuation than any of them. In addition, the Brazilian government, which controls about a third of Petrobras shares, has encouraged the company to return more profits as dividends. Petrobras now yields 3.7% -- a number that's likely to rise slightly this year. One possible drag: higher taxes on oil profits by the Brazilian government. As for Petrobras stock, Deutsche Bank cut its target to 35 in December. But that's still well above the recent 24.29.

Royal Dutch Shell

Natural gas has become a more attractive fuel because it burns relatively cleanly and can be transported easily in liquefied form. Royal Dutch plans to double its liquefied natural-gas capacity by 2010, according to S&P. That includes a large Russian LNG project to be completed this year. Offsetting this is that, if oil prices don't rise from current levels, profits will fall at Royal Dutch's high-cost Canadian oil sands operations.

In January 2004, before Royal Dutch Petroleum and Shell were unified under one U.K. parent company (resulting in a confusing batch of tickers), Shell was forced to remove billions of barrels of "proven" reserves from its books, resulting in huge financial restatements. Criminal investigations yielded nothing, and the whole mess is history, but its legacy endures in investors' skepticism about Royal Dutch's management. That might change a bit after the company's well-regarded chief financial officer, Peter Voser, takes over as CEO this year.

Royal Dutch Shell's A shares, which underlie its most active American depositary receipts, carry the lowest multiple among the big oil stocks, even though the company has more than $8 billion in cash and offers a nearly 7% dividend yield.

ConocoPhillips

This company, whose stock could rally as its low multiple attracts investors, has the highest exposure among the super-majors to the North American natural-gas market.

It also has one of the most capital-intensive portfolios among the U.S. integrated energy outfits. Unless natural-gas prices this year exceed $7.50 per million British thermal units, well above the current $4.70 or so, the stock has only modest potential upside this year, writes JPMorgan analyst Michael LaMotte, who has a 12-month price target of $53. The shares now are in the high 40s.

Chevron

Shares of this company, which acquired Unocal in 2005, held up relatively well in 2008; they're down 14% over the past 12 months. LaMotte upgraded the stock earlier this month to Overweight, saying that with a higher percentage of crude production, compared to Exxon or ConocoPhillips, Chevron "can move more than the peer group on crude-price movements."

While it has far-flung exploration and production projects, from those on land in Saudi Arabia to deepwater Nigeria, it also is searching for oil in deep areas of the Gulf of Mexico, where hurricanes hurt production last year. LaMotte has a target price of $95 on the stock, for an upside of 36%.

Not everyone is a fan of this stock, however. After Chevron released an interim fourth-quarter report showing that refining margins were down, Credit Suisse lowered its earnings estimates, reiterated its Neutral rating and maintained its $68 price target. The shares were around 70 at midday Friday.

In sum, the long-term picture for Big Oil is generally bright. But, given the differences in the companies' strengths and prospects, investors will have to be picky to find the biggest winners. And winners there will be, because despite the hopes of environmentalists and foes of Big Oil, it will be years before conservation and alternative-energy sources can slake much of the world's thirst for petroleum.

Source.

Goldman Sachs Group Inc. commodity analyst Jeffrey Currie said he expects a swift and violent rebound in energy prices in the second half of the year.  Oil prices may have reached their lowest point already, after falling to $32.40 in mid-December 2008, and are expected to rise to $65 by the end of this year, the analyst said. There is scope for a new bull market in oil, Currie said.

World oil demand is likely to fall by about 1.6 million barrels a day this year, the Goldman analyst said today at a conference in London. That’s bigger than the reduction expected by the International Energy Agency, which last week forecast a decrease of about 500,000 barrels a day, or 0.6 percent, this year.

A recent tactic of using supertankers to store crude oil to take advantage of higher prices later this year is difficult to profit from and is near the end of this process anyway, the Goldman analyst said. New York crude futures for delivery in December 2009, trading near $56 a barrel, currently cost some $15 a barrel more than March futures, a market situation known as contango, where prices are higher for later delivery.

The contango is likely to flatten as supply cuts by OPEC and other producers take effect, reducing the availability of oil for immediate delivery, Currie said. The Organization of Petroleum Exporting Countries, OPEC, started another round of supply cutbacks at the start of this month. The group’s compliance with its overall efforts to cut production will probably peak at 75 percent, or a reduction of about 3 million barrels a day out of an announced aim of 4.2 million barrels a day, Goldman Sachs said.

In several steps, 10 OPEC members have pledged to reduce production to 24.845 million barrels a day, a cut of 4.2 million barrels a day from September’s level.  Morgan Stanley hired an oil tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from the contango, two shipbrokers said in reports earlier today. Source.