The recent reasons for the surge in Oil prices to record highs, USD62.10, have prompted...

... us to review the market to see whether or not these prices are sustainable in the near future.
It is generally accepted that the driving forces behind the recent surge have been as a consequence of the Chinese revaluation of their currency, the Weather patterns in the Gulf of Mexico, Terrorism threats, and economic demand from the two largest consumers, China and the US.

This report will focus on these main reasons and analyse their medium term effects on the oil market to see whether or not they are sustainable in doing so provide some rational to suggest that prices above US60.00 are also not sustainable for the time being.

We hold a view that Oil at USD62.00 is expensive given the current price environment and is cheap at USD53.00. Why?

The revaluation of the yuan has been in the headlines for the last week, a surprise move that many expected later in the year. As a guide to further expectations the one-year non-deliverable Yuan forward is currently trading at 7.72 indicating that the market is expecting it to appreciate by another 5% in the next twelve months. The 2.1% appreciation of the currency is one of many steps the Chinese are making in order to promote a socialist market economy.

Briefly after the announcement on 22nd July 26, Crude oil prices surged 3.8% as it was widely anticipated that the appreciating yuan would make it cheaper for domestic refiners to import and to help restore losses for Chinese refiners who have reduced imports due to high prices. Growth in domestic oil imports so far this year is up 3.9% according to the Beijing based, Customers General Administration of China, which importantly represents a tenth of the pace in 2004.

Although economic growth remains robust in China at 8.5% it is widely expected that economic development in the region will slow down over the coming quarters. The impact of higher primary input prices will, as always, ultimately have a dampening effect on economic growth.

Overall, as China is the second largest consumer of Oil after the US the appreciation of the currency and continued efforts of liberalisation by the authorities will help promote a base for the commodity however, as depicted by the import numbers so far this year Chinese refiners understand what is cheap and what is expensive. Currently they are viewing prices as expensive.

If China is off the economic boil, what should we expect in Oil demand from the U.S.?

As the worlds largest consumer of oil the US economy is a focal point for demand for Oil. Economic growth is important for the ongoing demand for Oil. Currently, US inventories are anticipated to show a decline due to the recent weather concerns in the Gulf of Mexico, however this is viewed as temporary. Oil from the Gulf of Mexico contributes a quarter of US production and any disruption to supply will have an adverse effect on the price.

So far this year we have had the strongest start to the hurricane season on record. Last year's Hurricane Ivan shut off 45 million barrels of oil production over several months after it ripped through platforms and tore up pipelines. So far this year storms have cut 6 million barrels, with the most recent hurricane “Emily” shutting nearly 3 million barrels per day for a couple of days.

As this is the Hurricane season we can see any weather threat adversely affecting the price, however, we view any spike as a temporary situation as supply, depending on the extent of the storm will be resumed as soon as it passes.

Outside the weather influences economic growth in the US remains solid averaging 3 to 4% over the last couple of years and it looks on track to achieve this again this year. So demand for Oil should continue to be steady from this perspective.

One interesting feature is that although economic demand for Oil will be relatively constant in the U.S, domestic producers with the prices at current levels are seeing it more profitable to re open old and drill deeper wells. This provides an increased flow of domestic oil to refiners.

The US Government has aided this flow and stepped in to provide permits to allow companies such as Frontier Oil, which have spare refining capacity to increase production. At their Cheyenne, Wyoming Refinery, the Wyoming Dept of Environment has permitted them to increase capacity to 52,000 barrels per day. Although this is relatively small in the scheme of production in the US it highlights the moves by the Government to increase capacity where they can.

Ultimately we will see increased capacity and a greater surplus or increase in inventories as supply picks up due to sustained price rises. Once again this is only an issue of timing.

Is there anything outside these scenarios that could keep crude above US62.00? Terrorism.

We now live with Terrorism. An interesting aspect to the acts of Terrorism is that in the past we have seen the price of Oil remains firm after an act occurs, whether or not the price action has been as a result of the USD or supply is hard to define.

Acts in the Middle East have seen prices in the past sharply higher as the perception in the market is that it potentially causes supply hiccups. However, acts outside supply regions affect confidence and ultimately consumer spending/economic growth. As summarised by a UK official these acts are likely to remain with us and the potential for them to escalate remain a real possibility.

As a result we can only expect to see consumer confidence and spending deteriorate. Further down stream this means the likely hood of a contraction in economic growth and less demand for Oil. A flare up in terrorism in supply regions will always be a concern however the market is not focusing on this at the moment. Do the forward prices show a potential for a decline in prices?

In one of our earlier reports (05/05/04) we showed a chart of the Oil complex out for seven years. Traditionally, disruptions in the market were contained to the front month, as supply has always been on hand to cover any disruption, however during the Gulf War and subsequent demand from China we saw that forward prices were shifting higher with the spot prices. This provided us with a clue that prices would remain relatively strong for some time.

This has been the state of play in the Crude curve for some time now. Currently we are seeing the commencement of a reversal of this situation. The spot month is trading below the nearer forward months. This is providing us with a clue that either the spot month is cheap or the forward months are expensive.

Given the above fundamental analysis we believe that the forward months are expensive. What does the technical picture show?





Technically, we cannot confirm that a high is in place and pricing continues to edge higher. Trying to pick highs is not good trading. The best possible solution is to stand aside the market until we see a sign that the market is rejecting the highs. This will come around if, basis the Sept contract; we see a break of US58.75 on a daily close.

If this occurs then we can see the price of crude commencing a trend that could see it down to US50.00 over the next six months.



In concluding, the fundament picture suggests that supply remains robust and that the longer prices remain at these levels the longer producers have to consolidate profits in supplying crude at these levels.
Combining an increase in supply and the capacity to refine with the lack of demand via economic growth can only develop into a scenario that sees prices lower. Technically, we have not yet seen confirmation of the high, however, momentum and simple trend analysis suggest that we are getting close. If US62.50 is broken on a daily basis the we have to re think our analysis.


Technicals:
NYMEX Crude
Initial Secondary Primary

Support:
58.70 56.50 52.00
Resistance:
62.00 65.00
Daily Direction Weekly Direction Monthly Direction




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contact Jonathan Barratt

www.tricom.com.au