Can a Market 'Cure' Work Magic Again in Energy?

By Jobman, Darrell | Modern Trader, October 2000 | Go to article overview

Can a Market 'Cure' Work Magic Again in Energy?


Jobman, Darrell, Modern Trader


Today's high energy prices are rooted in the low prices of just two years ago as production is not keeping up with demand and U.S. stocks are at 24-year lows. What will happen if old man winter unleashes a cold snap gripping the nation in his icy fingers for an extended amount of time?

According to a familiar market axiom, "the best cure for low prices is low prices" -- millions of automobile drivers, homeowners and businesses affected by energy costs are finding that to be all too true again.

With gasoline prices soaring to new heights in June -- with some prices topping out at more than $2 per gallon in the Chicago and Milwaukee areas -- Americans haven't given up their love affair with gas-guzzling sport utility vehicles. The soaring gasoline prices, which came on the heels of a huge surge in heating oil prices in New York last winter, are the kinds of events that attract public concern.

Traders have been watching as the price of crude oil futures tripled from a low of less than $11 a barrel at the beginning of 1999 to $34 little more than a year later. During the same time frame, heating oil and unleaded gasoline futures prices moved from the low 30[cts.] area to above $1 per gallon.

"The current situation is so bullish that I cannot even come up with any kind of bearish scenario," says a long-time energy trader in Washington, D.C.

After crude oil futures at the New York Mercantile Exchange exceeded $30 per barrel in late 1985, they crashed below $10 within a few months. Five years later during the Gulf War, crude topped $40, only to dive to $18 In a couple of months (see "Oil slicks and dips," below).

Whether the recent high prices mean low prices, however, is the other half of the cycle that has yet to show any signs of materializing. In fact, the main issue at this point is not lower prices, but whether high prices will lead to even higher prices. Two key questions arise:

* What will the Organization of Petroleum Exporting Countries (Opec) do?

* How cold will it get in New York this winter?

Some analysts believe the first question really doesn't make that much difference, although that's where the current situation began to develop a few years ago. When the 10 Opec nations were pumping 28 million barrels a day in 1998, total world oil supply was about 76 million barrels a day, according to International Energy Agency (IEA) statistics. World oil demand continued to increase year-to-year, but economies in Asia went into a slump, electric power generated by oil use declined and the northern hemisphere was experiencing mild weather. Production outpaced the demand of about 75 million barrels a day, which produced both a surplus of more than 1 million barrels a day as well as plunging prices.

As revenues fell, companies in the energy business reduced capital outlays for exploration and production facilities, and shut down higher-cost units. At the same time, Opec finally could stick to reduced production quotas, which was something it had not been able to accomplish until then. Opec accomplished this task for a period that probably extended further than it should have.

"Opec misread the situation," says William R. Edwards of Edwards Energy Consultants in Houston, suggesting that Opec, in its eagerness to "correct" the price situation, may have over-reacted in reducing its oil production quotas. The surprise may be that the quota's compliance rates were as high as they were for so long and that non-OPEC oil producers didn't jump in to take advantage of the situation in a bigger way.

Oil prices were already rising sharply and had more than doubled from their lows into the mid-$20s last winter (see "Oil slicks and dips") when the supply tightness began to catch up with the market. A February cold snap in the U.S. Northeast interrupted a mild winter, and it suddenly seemed as if every- one was scrambling for heating oil. …

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