MARKET WATCH: Falling demand pulls down energy prices

Sam Fletcher
Senior Writer

HOUSTON, Oct. 15 -- Having escalated Oct. 13 as US and European governments moved to revive a shaky economy, energy prices fell Oct. 14, wiping out most of the previous session's gain with traders expecting a major drop in demand in the coming months.

"Premarket, crude is trading down on expectations that economic weakness will hamper global crude demand. In fact, some oil-producing countries such as Iran and Saudi Arabia have been seeing signs of government spending cutbacks on infrastructure and expansion projects, which were initially budgeted with expectations that oil prices would remain high," said analysts Oct. 15 in the Houston office of Raymond James & Associates Inc.

In a briefing on a new economic report by Chatham House, home of the Royal Institute of International Affairs in London, officials said: "The global financial system has suffered a once-in-a-century meltdown that almost brought the world economy to a halt in late September. Confidence and trust have been shattered. In spite of concerted and extraordinary efforts on the part of central banks and political leaders, including recapitalizing the banks, it is not yet certain that the waves of panic and destruction have been halted. Many of the repercussions have yet to emerge, including possible legal action as well as economic damage."

Even earlier the leading economies with in Organization for Economic Cooperation and Development appeared to be heading into "an unusually synchronized recession, driven by the simultaneous collapse in consumer and business spending. This will now get worse," said Chatham House analysts.

They said, "This time round, the outcome for China will be much more important because it has doubled its share of world GDP over the last decade and is now the single largest contributor to global growth." Chatham House surmised, "Without doubt, this crisis will require substantial, persistent, and coordinated global efforts to turn around—possibly including yet more extraordinary 'out of the box' measures."

Olivier Jakob at Petromatrix, Zug, Switzerland, argued, however, "For all the doom and gloom, we also need to realize that oil prices have had a significant retreat. The economy does not look good, but many made the mistake of underestimating the impact of high prices on demand, and we will need to be careful to not discount too greatly the impact that lower prices can have on demand."

Jakob expects at least some of that pent-up demand to materialize. "The US refining system is currently pricing maximum output of distillates and minimum output of gasoline, and when combined with the sharp price falls at the US gasoline pump (which has a potential to revive some demand) we view the gasoline cracks to be currently seriously undervalued," he said.

Companies cut spending
Some energy companies are already preparing for reduced demand by cutting budgets. "E&P spending cuts make it clear to us that operators will not simply 'drill through' this period of natural gas price uncertainty," said analysts at Pritchard Capital Partners LLC in New Orleans. "We have begun to see spending reductions or deferrals that will negatively affect oil service demand. Key markets are oversupplied with natural gas, with prices below $4/MMbtu in the Midcontinent, West Texas, and the Rockies."

Pritchard Capital analysts reduced earnings estimates for 11 oil service companies due to "a far less bullish environment in the quarters ahead." They said, "We expect service companies to communicate varying degrees of uncertainty regarding their outlook and give subdued guidance for 2009 in their earnings calls." They expect the US rig count to pull back to 1,830 rigs from a peak of 2,031 on Sept. 12. "However, a 20% pullback would be within reason if global markets experience a protracted recession. Recent history offers several examples of the US rig count declining by more than 20% from peak to trough, including a 48% downturn in 1991-92, a 52% decline in 1998-99, and a 43% pullback in 2001-02," Pritchard Capital Partners reported.

Pritchard Capital analysts said, "Service companies could also struggle with cost challenges as oil country tubular goods prices are expected to continue to increase. A ramp-up in production both in the US and abroad is likely to alleviate shortages, but this will likely occur only after demand has ratcheted down."

The analysts said earnings will tend to hold up better for companies with less North American exposure and less drilling-related exposure. "We expect national oil companies to reduce spending plans to reflect an environment with lower commodity prices and reduced energy demand, but we anticipate that this will be moderated by their focus on strong long-term fundamentals. Also, companies driven by factors other than rig count, such as those engaged in production-related or infrastructure-building activities will be more insulated from earnings declines, in our view."

Analysts at Friedman, Billings, Ramsey & Co. Inc. (FBR) in Arlington, Va., said recent meetings with the management of three independent production companies "suggests willingness at this juncture to think about 2009 capex plans" based on average prices of $80/bbl for oil and $7.50/Mcf for natural gas. With the current capital constraints in the financial sector, they said, "Hedging costs are expected to increase and liquidity on the long end of the curve is expected to decrease. Management teams also expect bank debts, whenever possible, to be repriced to match funding cost increases. Also, bank debt capital available to the industry in general and smaller players specifically is expected to go down reasonably."

At midday Oct. 14, the US Minerals Management Service said 81 of the 694 manned production platforms in the Gulf of Mexico are still without crews that were evacuated ahead of Hurricane Ike. Officials said 38.9% of the oil and 37% of the natural gas usually produced from federal leases in the gulf are still shut in.

In its oil market report for October, the Organization of Petroleum Exporting Countries said the average price for its basket of benchmark crudes dropped $15.56 to an 8-month low of $96.85/bbl and continued to trend sharply lower to a 12-month low of $72/bbl Oct. 13 because of an "increasingly weaker outlook" for the world economy and demand growth. OPEC's basket price has dropped almost $69/bbl in little more than 3 months.

OECD oil demand growth has declined more than 1.8% or 1 million b/d this year primarily because of reduced consumption in the US. Non-OECD demand growth increased 1.2 million b/d through September. Total world oil demand growth for 2008 has been reduced to half of the initial forecast to 600,000 b/d. That is expected to continue in 2009, and OPEC has reduced its estimate of global demand growth by 100,000 b/d to 800,000 b/d next year.

Energy prices
The November contract for benchmark US light, sweet crudes fell $2.56 to $78.63/bbl Oct. 14 on the New York Mercantile Exchange. The December contract dropped $2.73 to $78.95/bbl. On the US spot market, West Texas Intermediate at Cushing, Okla., was down $2.56 to $78.63/bbl. November heating oil lost 8.13¢ to $2.26/gal on NYMEX. The November contract for reformulated blend stock for oxygenate blending (RBOB) declined 3.28¢ to $1.88/gal.

Natural gas for the same month gained 3.9¢ on NYMEX. On the US spot market, gas at Henry Hub, La., rose 9¢ to $6.71/MMbtu.

In London, the November IPE contract for North Sea Brent crude dropped $2.93 to $74.53/bbl. Gas oil for November lost $2 to $744.25/tonne.

The average price for OPEC's basket of 13 reference crudes gained $1.53 to $73.49/bbl on Oct. 14.

Contact Sam Fletcher at samf@ogjonline.com.