Rising demand should push up crude oil prices in 2011

Commodities in general have rewarded investors with huge, in some cases, historic, returns in 2010, primarily in anticipation of an ever-strengthening global economic recovery and low interest rates in the U.S.

However, one of the premier commodities, crude oil, has lagged, trading range-bound with great volatility, unable to crack the $90 per barrel level (for most of the year).

Prices were largely unaffected by some significant events, including the Gulf oil spill and the debt crisis in the euro zone. After plunging from all-time highs of about $148 in the summer of 2008 to a bottom in early 2009 (coincident with the expansion of the global financial meltdown), oil prices have struggled mightily to claw back.

Now, as 2011 dawns, oil might be turning the corner. Indeed, crude oil recently touched $92, a 26-month high.

Many investment banks and commodity analysts have taken a highly bullish stance on crude oil prices for 2011, based largely on economic recovery in the U.S., continued money-printing by the Federal Reserve (thereby, weakening the U.S. dollar) and persistent high demand from the emerging markets, particularly China and India.

Indeed, after growing by an estimated 5 percent in 2010, global GDP is expected to expand by 4.2 percent next year; once again, with almost three-quarters of that growth coming from commodity-hungry emerging markets. China and India are anticipated to witness 9 percent and 8.7 percent economic expansion next year, respectively.

For example, Goldman Sachs forecasts oil futures jumping to $105 per barrel in 2011; Morgan Stanley predicts prices will climb above $100.

J.P. Morgan expects oil will cross $100 in the first half of 2011 and surpass $120 before the end of 2012.

I believe the age of cheap oil is over, said Fatih Birol, chief economist for the International Energy Agency (IEA).

There may be zigzags in the future according to the economy, this and that, but the general trend is we will see higher oil prices.

Francisco Blanch, head of commodities at Bank of America/Merrill Lynch, told Bloomberg News that global oil demand is set to hit a new record in 2011. The underlying economic picture is still positive. We are still looking for economic growth because of quantitative easing and accelerating growth in [the] emerging markets.

The key is a restoration in global demand.

Indeed, oil demand climbed 3.7 percent in the third quarter of 2010, the fourth consecutive quarter of growth -- a trend many oil analysts contend is likely to continue into the new year.

The IEA predicts that global energy demand will climb to 88.2 million barrels per day (bpd) in 2011, up from 86.9 million bpd this year. Moreover, the IEA noted that global oil demand will grow by an average of 1.4-million bpd annually between 2009-2015.

Still, the demand picture diverges -- much of the higher expected demand will come from the emerging markets, while demand in the developed economies will likely either remain flat or edge up modestly. In fact, consumption in the advanced economies remains 8 percent below 2007 (pre-crisis) levels.

It comes as no surprise that the geographic distribution of oil demand growth follows that of economic growth: Emerging markets, rather than the OECD, drive the increase in global oil demand in 2010 and 2011, said BNP Paribas SA.

It is hard to overstate the growing importance of China in global energy markets, said Birol of the IEA. The country's growing need to import fossil fuels to meet its rising domestic demand will have an increasingly large impact on international markets.

Birol points to auto-ownership rates -- in the U.S., 700 out of every 1,000 people own a car, while 500 out of every 1000 in Europe do. In China, only 30 out of 1,000 own cars -- Birol thinks that figure may spike to 240 out of every 1,000 by 2035.

The eternal irony is that if energy prices rise too high it would sap demand, which would then start declining again.

Related to this issue, oil companies will not justify expanding production unless oil prices persist at high levels, perhaps north of $100.

The other side of the oil price equation -- supply -- is likely to tighten. OPEC, which controls 40 percent of the planet's crude production, will surely seek to control output in order to push prices higher.

Oil prices increasing to $100 [per barrel] would not hurt the global economy, said Mohammad Ali Khatibi, Iran's OPEC representative, in November.

Not only producers, but consumers have reached this agreement that $70 to $90 is a suitable price for oil because it encourages investment and does not hurt the global economy.

The Fed also plays a key role in oil's fortunes, since crude is priced in dollars. Oil prices have climbed more than 7 percent since early November when the central bank announced it will purchase an additional $600 billion of U.S. Treasuries. Given Ben Bernanke's commitment to increasing liquidity even more, the price of oil is likely to keep rising.

Brian Gambill, managing director of capital goods at Manning & Napier Advisors, Inc. in Rochester, N.Y., notes that crude oil is becoming more expensive and difficult to extract each year. And because oil reservoirs deplete every year, it is becoming harder and more capital-intensive to simply keep production flat let alone actually grow it.

Gambill explains that the price crash in 2008 compelled major oil companies to drastically cut capital investments.

Integrated oil companies such as Exxon-Mobil (NYSE: XOM), British Petroleum (NYSE: BP), and Chevron (NYSE: CVX) collectively reduced capital spending by about 20 percent in 2009, he said.

This will negatively impact the project pipeline in 2012 and 2013. Thus, if demand stays on its current trajectory, we will need more oil by then; and unfortunately we may not have enough. If supply is in question, it is possible that prices will need to rise high enough to knock out demand.

While crude oil has at least remained above water during in 2010, a closely-associated commodity, natural gas, plunged more than 30 percent in price this year, making it among the worst-performing commodity assets.

Natural gas supply has surged, while consumption has remained anemic.

The U.S. Department of Energy indicated that U.S. natural-gas production increased nearly 6 percent in the past two years while consumption climbed roughly 2 percent,

Gambill explains that the divergence between crude oil and natural gas prices is abnormally high and that historically US natural gas has traded closer to parity with oil.

However, the development of unconventional reserves in the U.S. and Canada, namely shale and tight gas reservoirs, has changed this dynamic.

The market for global natural gas is really quite distinct from the US natural gas market, Gambill said.

The global market is largely defined by liquefied natural gas (LNG), which trades more closely, or even at parity, with oil prices. The US market, on the other hand, is driven by high rates of production in these prolific unconventional shale and tight reservoirs. Demand has stagnated in the US, while supply has grown enormously.This is the perfect recipe for an environment of low prices that have very little connection to global oil prices.

Gambill explains that the technology behind shale exploration and drilling has advanced so rapidly over the past two or three years, that it has become extremely economical to produce natural gas this way.

We now have a glut of natural gas, he noted. The supply is plentiful and highly visible, which has resulted in a current environment of very low natural gas prices.

Over the next five years, Gambill believes the combination of low prices and highly visible supplies will lead to the development of new markets.

First, utilities will become increasingly more confident in the visibility and reliability of supply, and that should lead to an expanded use of natural-gas powered generation for electricity, he noted.

Secondly, I think that we will see a robust market begin to develop for compressed natural gas as a transportation fuel. It is still very early, but the writing is on the wall. It simply makes too much economic sense with compressed natural gas selling for less than $2.00 per gallon while gasoline is selling for well north of $3.00.

Lastly, due to new air and emissions standards expected to be handed down from the Environmental Protection Agency (EPA), Gambill expects that by 2014 we should begin to see a wave of coal-fired plant retirements.

In order to replace this lost capacity, utilities will need to turn increasingly to natural gas, he said.

So while demand should increase over the next two to three years, the elevated level of supply should keep prices in their current range. If prices do rise over $5.00 to $5.50 per thousand cubic feet (mcf), Gambill explains that exploration & production companies will simply sell forward their future production, attempting to lock in those prices.

Companies are not hedged well for 2011 and 2012, so anytime gas prices rise into this range, we should see a lot of supply come onto the market from the natural gas futures market, he said.

As such, he predicts prices will range between $5.00 and $5.50 per mcf over the next two or three years.