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Global Economic Outlook
Energy Markets: Q1 2010 Outlook
By Rachel Ziemba and Mikka Pineda
The main energy commodities (oil, coal, gas) diverged in 2009 as the global economy navigated toward stabilization. Oil outperformed by far, benefiting greatly from increased global liquidity and risk appetite and a weakening dollar. Supply gluts in natural gas helped keep prices much weaker than the traditional link with oil would dictate. Although natural gas regained some ground in H2 2009, its ample supply should continue to depress price gains. While energy markets continue to be well supplied, even over-supplied by some reckoning, the revival in demand in comparison to weak Q4 2008 levels and the availability of liquidity should support prices in 2010. Ample energy supply will mute—though not extinguish—the risk of spikes from geopolitical shocks. Reversals in risk appetite toward equities stemming from worse-than-expected macro news should alternate with moderate demand increases.
Spot and futures prices of oil have inched upward over the course of 2010. West Texas Intermediate (WTI) crude oil futures averaged US$70 per barrel from May to December 2009, rising sharply in a liquidity-fueled rally that peaked at US$81. The demand outlook stabilized and began to climb from the pallid levels of 2008, when petroleum prices reached all-time highs on a real and nominal basis. The oil market continues to be well supplied, and perhaps even overly so. OPEC surplus capacity and OECD commercial inventories remain high. U.S. inventories in December 2009 rose 5% y/y while the 2009 average rose 10% y/y.
RGE expects WTI crude to trade between US$70-US$95, a narrower range than in 2009, and average closer to US$80 per barrel in 2010, higher than the 2009 average of about US$62 but well below that of 2008 (just under US$100 per barrel). The monetary policy stance of the Fed will continue to support energy commodities but uncertainty about U.S. and Chinese monetary tightening and regulatory changes poses a risk. In RGE's view, increased production from OPEC and non-OPEC members will offset a continued, gradual demand recovery. A sharper-than-expected economic recovery that prompts strong petroleum demand from both emerging markets and OECD countries poses an upside risk to RGE's forecasts.
Several factors point to the average oil price rising to a higher level in 2010:
1) The production costs of new oil discoveries and fiscal breakeven costs for many oil exporting nations are estimated to be around US$70 per barrel. OPEC production cuts have helped stabilize the supply side of the market, suggesting that it would take a double-dip recession to retest 2009 lows.
2) Weather risks may again be muted. The National Oceanic and Atmospheric Administration forecasts that the El Niño effect will carry into winter 2009-2010. Even some cold periods in the northeastern U.S. have done little to erode the heating oil surplus. Moreover, similar patterns suggest 2010 could again be a year with limited hurricane risk. No major hurricanes affected oil installations or refineries in 2009, alleviating a spike risk.
3) With demand picking up, geopolitical shocks could be more significant in 2010. The biggest geopolitical uncertainty continues to be Iran's nuclear program. With oil prices higher and the country trying to reduce its energy subsidies, it may be even less willing to make concessions. However, still high surplus capacity tempers oil's vulnerability to a supply shock from geopolitical turmoil.
4) Future supply risks from the pick-up in demand and reduced production are boosting today’s prices beyond fundamentals. Current estimates of an increase in supply from Russia, Iraq and other countries will be constrained.
Some downside risks will mute oil's rise in 2010:
1) The placement of position limits or exchange limits on purely financial hedges by the Commodity Futures Trading Commission may tame speculative activity and moderate oil prices.
2) Demand for distillates continues to be limited. U.S. demand for gasoline has held up better than other fuel products as prices per gallon remain below year-ago averages. Miles-driven by Americans has started to climb slightly from the weakest levels of early 2009, but remain well below trend.
3) In contrast to base metals restocking, storage limitations may account for Chinese officials' delay in taking advantage of cheaper prices early in 2009. Chinese crude oil import volumes did not climb from 2008 levels until near the end of 2009. Adding to China's strategic reserves may rely on lower prices
4) With the increase in refinery capacity for processing heavy, sour crude, China has not only increased its ability to meet domestic demand. China has increased refined fuel exports. Other Asian and Middle Eastern countries have likewise added refinery capacity, alleviating a bottleneck.
5) The increase in domestic fuel prices and the removal of subsidies in several countries suggests consumers will show a demand response more quickly in 2010.
6) Oil supply should keep inching up as exporters seek to maximize revenue. OPEC members have been producing more as oil prices returned to a range where more members are fiscally comfortable (most GCC countries can balance their budget in the US$60 range at current production). The prices RGE forecasts are well above levels to encourage investment, something that the recent spate of new oil finds, the restart of expensive oil sands projects and interest in Iraqi oil fields underscores.
The reduction in industrial demand and very ample supply contributed to a record buildup of natural gas inventories in North America and in Europe, pushing prices well below the marginal costs of unconventional supplies in 2009. However with natural gas drilling activity having fallen sharply, natural gas supply will gradually tighten in 2010 and 2011, putting gradual upward pressure on prices. Unfortunately, a sluggish manufacturing sector could limit industrial demand. RGE expects 2010 Henry Hub gas prices to settle moderately higher than in 2009.
The weakness in the gas price has led to a breakdown in the traditional link between oil and gas prices. However, gas will maintain some link to oil prices due to the lack of an alternate pricing mechanism. Limitations of pipeline infrastructure keep natural gas markets regionally segmented, but over time the extension of liquefied natural gas (LNG) may globalize this market.
Increases in storage capacity will have natural gas suppliers hoping for a relatively long and cold winter to raise prices, but El Niño weather conditions will work against this. The slow revival of the gas-intensive petrochemical, steel and aluminum industries in the G-3 will also cap natural gas’s rebound and partly offset strong demand in emerging market economies. However, supply shocks in particular regions, especially in Eurasia, present an upside risk to prices.
Coal, which accounts for half of the world's electricity production, enjoys more stable demand and more plentiful supply than oil, but its prices went through violent swings in 2008 as it became correlated with oil prices and responded to local supply shocks. The historically high prices in 2008 were unsustainable given coal’s abundant supply and mandates to reduce carbon emissions. 2009 contract prices for thermal coal settled 44% down from the 2008 contract price, while metallurgical coal contract prices settled around 60% lower. These prices should rebound in 2010.
Chinese demand will provide a floor for coal spot prices, even though additional railroad development programs will be lower than in 2009, when they formed a key part of the stimulus. Despite an increase in alternative energy in the Chinese power supply, coal-fired plants still dominate, supplying over 70% of China’s electricity. Transport bottlenecks may also keep spot prices elevated. India and Indonesia seek to expand coal-powered electricity generation in 2010, which could tighten the supply of coal exports.
The recovery of coal demand in 2010 will be gradual and impaired by worries about the overcapacity in Chinese heavy industry, high coal inventories in the U.S. and Eurozone and substitution into cheaper natural gas. Global manufacturing has stabilized but at low levels. Consequently, contract prices will move up in 2010 as steel production recovers but will linger below the eye-watering heights reached in 2008. Due to a warmer winter, thermal coal will underperform metallurgical coal, which is more attuned to industrial demand.
CarbonThe energy price levels RGE projects will not only be high enough to encourage continued investment, which could reduce future supply deficits and discourage some consumption, they should also support clean technologies. Carbon trading markets, which have the potential to grow quite significantly in the coming years, face policy uncertainties about carbon emissions targets. With U.S. Cap-and-Trade legislation stalled perhaps until 2011 and other countries mid-term targets uncertain, liquidity will remain a constraint for carbon markets in many countries. The weak revival of European industrial production has kept the European carbon price low, but as the global economy recovers, there will be a modest increase in demand for carbon credits. Clean tech ventures have largely benefited from government stimulus funds in 2009, but regulatory uncertainty (including changes in feed-in tariffs) remain an area of concern.