Special Market Commentary: September 2005

Domestic and world oil markets have been subjected to increasing pressure for more than a year. Increasing global demand for oil, with the most rapid growth coming in developing countries with rapidly expanding economies including China and India, has strained the global supply and production capacity. Hurricane Katrina’s devastation of the gulf coast region has taken an almost incomprehensible and continuing toll on a human level. When fully absorbed, the physical destruction of property could easily represent the most costly natural disaster in the history of the United States. As we have observed the disaster that has unfolded in the wake of Hurricane Katrina, our thoughts are with those whose lives have been affected by the tragedy.

The full impact of Katrina on the U.S. and potentially even the global economy will not be known for some time. Based on early reports, however, it is clear that the temporary halt of most of the region’s oil producing capacity and the destruction of many of its drilling, production, and refinery facilities will have an effect on domestic oil stockpiles that will last beyond mere days or even weeks. While expectations are that some of these facilities may be operating shortly, others suffered more extensive damage that may require months or longer to be repaired; some of the more severely damaged or destroyed facilities will need to be completely rebuilt, which will take much longer.

The Economic Impact

For those old enough to remember the energy crisis of the ‘70’s, reports of gas stations closing due to a lack of product, gas lines, energy conservation, and car pooling are doubtlessly reminders of that difficult time. This type of stagflationary environment -- economic recession coupled with rapid inflation -- creates significant challenges for consumers, investors, the business sector, and governmental entities. Some fear that the current oil situation could blossom into a greater crisis that could have a ripple effect throughout the U.S. and perhaps even global economy. Despite the continuing shift from a manufacturing to a service economy, the goods that we purchase still require transportation from their point of origin to their point of delivery.

The structure of our economy today is much less dependent upon oil than it was thirty years ago. As our domestic manufacturing base has shrunk relative to the economy as a whole, replaced by service and information based drivers, the importance of oil has declined. To be certain, a prolonged elevation of energy costs will place a drag on economic growth. Economic estimates of its potential consequence vary. Data from a variety of sources that we review indicates that a $5 increase in the price of a barrel of oil shaves 0.25 percentage point from GDP growth. Higher gasoline prices undoubtedly have a dampening effect on consumer discretionary spending. However, other economists offer differing views as to the degree of impact. Moreover, the price of oil is only one dynamic that will influence consumer spending and economic growth. We are somewhat ambivalent about the specific mathematics of such estimates as the specific effect will be lost among the wide range of factors that drive consumer behavior and the economy. That being said, higher energy prices will clearly be a drag as consumers will be forced to either modify their behavior by reducing savings, curtailing other discretionary spending, or more efficiently managing their energy usage.

From January 1 through September 12, the average price of unleaded gasoline in Michigan rose from $1.75 to 2.91, a 66% increase.1 In the days after Katrina came ashore, gasoline prices spiked over 80 cents per gallon (almost doubling its price since the beginning of the year). 2 Assuming price increases are prolonged, the hit to discretionary consumer spending could exceed $200 billion by some estimates. While that represents a significant amount, it pales in comparison with aggregate consumer spending which currently exceeds $8.6 trillion annualized.3 Nonetheless, such a hit to consumer spending would severely dampen GDP growth and, if prolonged, could push the U.S. into a recession. All things considered, we do not expect that to be the most likely scenario, as oil and gasoline prices have already pulled back more than 10% from their post-Katrina highs.

Oil prices: Which way will they go?

Oil exploration, production, and refinement are capital intensive and time consuming processes. When demand growth has exceeded expectations as in recent years and production capacity peaks, producers simply cannot flip a switch and increase the supply. Some oil industry analysts suggest that we are closer to this tipping point than most want to believe.

Two distinct factors appear to be providing the current impetus for rapidly increasing oil prices. The first, and debatably the one with the longest lasting effect, is the acceleration in global demand for oil. Led by the developing markets, most notably China and India, the growth in petroleum demand over the past several years has not been fully offset by augmented supply, creating inflationary pricing pressure. In its recent report “The Oil Market: Towards a More Comfortable Balance”, the International Energy Agency (IEA) noted that “the oil supply situation looking ahead is much more robust.” Further, they noted that “....the underlying supply and demand for oil are roughly in physical balance and should improve.” Should this forecast prove accurate, it would be good news.

Some have recently suggested that hedge funds and speculators have contributed more to recent rapid increases in prices than underlying fundamentals of supply and demand. Indeed, it appears likely that speculators have to some degree contributed to surging prices in recent weeks, although it is difficult to quantify that impact. Further, the fundamental impact of increasing demand remains unchallenged and is generally expected to continue for the foreseeable future.

Source: Energy Information Administration (www.doe.gov)

As noted in the graph above and mentioned by numerous analysts, the current stock of crude oil is more than adequate; the problem lies in the comparative shortage of refined product – most notably gasoline. On August 31, the Bush Administration announced that it would tap the US Strategic Petroleum Reserve (SPR) to relieve some of the short-term supply and price pressures for oil and gasoline. For a variety of reasons, the true potential benefit of any release remains to be seen, although it may prove to be less substantial than symbolic in the short term. With a large number of domestic refineries temporarily shut down in the aftermath of Katrina, a loan of petroleum from the SPR might have little short-term benefit. According to a Minerals Management Service (a division of the U.S. Department of the Interior) report on September 1, over 90 percent of the Gulf regions oil producing capacity remains idle. At a rate of production of almost 550 million barrels of oil per year, a lengthy shutdown in production would be meaningful.

As reported by the American Petroleum Institute on September 1, Katrina had “forced 12 U.S. refineries to cut runs, in addition to the eight plants it completely shut down” due to a lack of crude oil. While this slowdown of operations affected less than 20 percent of domestic refinery capacity, it has and will likely continue to result in localized shortages of fuel and rising gasoline prices. Moreover, these shortages are not limited to merely the Gulf coast region, but have even crept into the Midwest. Even after the flow of oil is resumed either from drilling operations or draws from the SPR, it will still take time for the crude to be transported, refined, and distributed. In the interim, elevated prices at the pump will likely remain a reality.

Also on September 1, the International Energy Agency announced that the U.S. and European governments had agreed to release 60 million barrels of oil and refined products from their combined strategic reserves, of which 30 million is expected to come from the SPR. Kuwait and Qatar have also offered $600 million in aid, much of which is in petroleum. With a total stock estimated at 700 million barrels in the SPR, there would appear to be ample supply to release a meaningful amount which could provide a noticeable, albeit potentially short-term, benefit if enough Gulf region refineries can be brought back online, creating capacity to produce finished product. Reports suggest that some may be running again by the time you read this report; others sustained heavy damage and may require months of repairs before being ready for reactivation. As is typically the case in these situations, the picture is still unclear. The longer that the already stretched refinery capacity in the U.S. is reduced, the longer consumers will have to deal with higher prices at the pump.

Capital Market Impact

As is often the case in volatile and uncertain times, some investors have begun questioning whether or not the current situation presents an investment opportunity through direct investments in oil futures, commodity futures, or some other form of indirect investment linked to oil, energy, or broad commodity prices. Headline-grabbing predictions like that made in a report released by Goldman Sachs last April that suggested oil could reach $105 per barrel made excellent fodder for speculation over the past several months. Even that Goldman Sachs report indicated a potential range of $50 - $105, although that range was often overlooked in media reports; within the past few days, Goldman’s Abby Joseph Cohen stated that they were using an estimate of $60 per barrel as an expected 12-month price target. 4 We believe that this view, coming even after Katrina, presents a much more realistic outlook than the bleak “worst case scenario” that made headlines and engendered fear, perhaps contributing to the apparent speculation that has contributed to higher prices.

Although we have already experienced some pullback from recent peaks, it is possible that oil and gas prices may again trend higher in the coming weeks. Increased volatility in prices appears likely, as does a greater variance in prices between markets, as temporary local gasoline shortages could recur, although we believe that it is likely that the worst of this temporary shortage is behind us. Much of the localized shortages of the last week appeared to have been driven by fear, in part creating a self-fulfilling scenario. Much depends on how quickly refinery capacity is re-established. At this point, a cloud of uncertainty hangs over the market – one that already existed, but became more ominous after Katrina. Further interruptions of global supply, such as those resulting from recent unrest in Ecuador and an August fire at a large refinery in Venezuela, could provide more fundamental upward pressure on prices. Fear and greed among consumers and investors may be the wild card here; just as in other areas of the financial markets, irrational behavior can wreak havoc in the short-term.

Fundamentally, there is ample reason to expect that a portion of the current uptick in prices will be short-lived. Nonetheless, prices may move higher before pulling back. However enticing short-term investments might appear to some in a volatile and speculative market, they typically end badly for those investing after a major upward market move such as that demonstrated by oil in the past few months. One has to look no further than the significant downward move in oil and gas prices after the announcement of the planned release of product from the SPR for evidence that speculative investments driven by short-term market moves are little more than semi-educated bets.

Equity investors with broadly diversified portfolios almost certainly have exposure to oil companies that will participate in recent price changes, either positively or negatively. If these recent price moves are sustained over some meaningful period of time, those portions of their portfolios should adequately reflect the impact from movement in the market. If these price hikes are comparatively short-lived and are being excessively influenced by speculative forces, any incremental profits will be equally short-lived. In that case, the likelihood of a profitable venture into oil futures or other direct or indirect oil-related investments is diminished. On net, we expect that the risks of entering into such investments at this juncture outweigh the potential benefit and recommend against initiating new positions at this time.

Footnotes

1 – AAA Michigan (www.autogroup.com).
2 – Gross Domestic Product: Second Quarter 2005 (Preliminary). Bureau of Economic Analysis. August 31, 2005.
3 – Gross Domestic Product: Second Quarter 2005 (Preliminary). Bureau of Economic Analysis. August 31, 2005.
4 – “Goldman’s Cohen Sees Oil Avg US$60/Barrel Next 12 Mo”. Dow Jones Newswires. August 30, 2005.