Economy showing signs of improvement

With most schools out for the summer, the United States has entered its gasoline peak demand season, a time when prices generally rise due to increased consumer fuel usage as many families take off on traditional summer vacations. Conventional wisdom has it that the summer driving season runs from about June 1 to October 1, give or take a week or so, depending on what part of the country you live in. This is usually good news for the petroleum industry. However, this year oil and gas refiners and retailers are taking a wait-and-see attitude because initial reports would seem to indicate that the public may be staying closer to home and driving less due to concerns about the economy and family finances.

As of this writing, crude oil prices are still hovering around $70 a barrel. Brent crude and WTI prices have been trending upward since falling to about $34/bbl in mid-February. It looks encouraging when you plot it on a line graph.

Market bulls are pointing at this as well as other key economic indicators as a sign that the worst of the economic slowdown and market slump is over. Even OPEC commented in June that “the worst appears behind us.” Not everyone agrees, of course, but there is reason for optimism.

First, the Chinese economy is showing clear signs of improvement. Chinese energy demand is returning, and their oil and gas companies have been actively acquiring oil reserves around the world – for example, Sinopec’s bid to acquire Canada’s Addax Petroleum for an estimated $7.2 billion, which would give the Chinese access to Addax’s extensive oil reserves and currently estimated 135 Mbbl/d production in West Africa and the Middle East.

As we know, geopolitical events also influence the price of oil. The current protests over the election in Iran have increased concern among oil traders that an escalation of this conflict could lead to a curtailment in supply from OPEC’s second-largest oil producer after Saudi Arabia. In addition, there have been ongoing attacks against oil facilities in Nigeria.

In addition, OPEC production cuts have been steadily chipping away at bloated US crude inventories.

An analyst at Raymond James & Associates believes that one reason oil prices moved up sharply in the second quarter is that investors have piled into oil and other commodities to hedge against the prospect of rampant inflation pounding the US dollar. He points out that oil prices have more or less tracked with the weakening US dollar. With a weaker dollar, oil imports become significantly more expensive for the US consumer, and since oil is denominated mainly in US dollars, the nominal price of oil will increase. Since the euro bottomed versus the US dollar in February, WTI oil prices have doubled.

As a result, Raymond James on June 22 increased its 2009 oil price forecast to $56/bbl (from $48/bbl) and raised its 2010 price forecast to $80/bbl (from $65/bbl). Although the company’s global research group expressed “lingering concerns” that crude has traveled too far too fast, RJ says the increase in their oil price forecast is more of a realization of high-than-anticipated oil prices thus far and not because they are necessarily more bullish about the short-term direction of crude.

“Longer term, our bullish oil call remains in place,” says RJ in their recent newsletter. “If anything, we are more bullish than we have ever been…If the global economy meaningfully improves in 2010 (as opposed to merely stabilizes, the latter being our working assumption), these estimates will likely move much higher.”

As good as higher commodity prices can be for the petroleum industry, they can be an indication of trouble for individual oil and gas companies. Ernst & Young says that the oil and gas sector has been unevenly impacted by the global economic downturn, which has created new risks for the industry that may threaten the survival of a number of companies.

Some of the major risks, according to Wendy Fenwick, E&Y’s global oil and gas leader, are political issues, including resource nationalism; the growth of land areas designated as environmentally sensitive; and concerns about energy security that have made it increasingly difficult for companies to secure their future.

“Operating in politically uncertain regions can expose companies to challenges such as unpredictable government interference, changing fiscal regimes, annulment of contracts or civil unrest,” said Fenwick. “Policy uncertainty is likely to be ongoing in 2009 as government finances deteriorate. Fragmented and incoherent energy policies create ambiguity, forcing oil and gas companies to repeatedly make decisions in a vacuum.”

As economic indicators began to improve and commodity prices bounce back, it’s always a good idea to reevaluate the risk landscape.