Financial Professionals


Oil Market Update


Oil inventories continue to rise here in the United States; in fact, they are approaching the uncomfortably high levels of May 2009. The ample supply of domestic oil is reflected in the oil futures market with continued steep contango - the long dated futures are priced at a premium to the short dated futures. Oil for delivery in December 2010 is worth about $80 while oil for delivery one year out is worth about $85.

US Oil Inventories 8-11-06 to 7-23-10


Source: Bloomberg

Given that abundant supply circumstance, an investor would easily determine that the spot price of oil should decline. However, offsetting the increase in domestic inventories is a subtle increase in U.S. oil demand, as well as the return of a voracious emerging market appetite for energy. Total Chinese petroleum demand in June was 9.21 million barrels per day, the highest figure ever recorded for the Chinese economy.

U.S. Oil Demand Per Day 8-11-06 to 7-23-10


Source: Bloomberg

The oil demand story is tracking the global GDP story. The Organisation for Economic Co-operation and Development (OECD) countries are struggling to grow, and their demand for oil clearly displays that. Six months ago, OECD oil demand was 46.9mbd; as of June 30 it is 45.1mbd. The offset is the rest of the world - non-OECD - six months ago, their oil demand was 40.2mbd; as of June 30, it is 41.0mbd.

Looking at the supply story, I view non-OPEC supply as most critical to the price of oil. One of the reasons the price of oil has not declined dramatically, I believe, is because the non-OPEC supply of oil is stagnant. Six months ago it was 49.5mbd; as of June 30 it was 49.3mbd. With OPEC oil fields in decline, it is imperative that non-OPEC suppliers such as Norway, Russia, Brazil, and Egypt grow supplies. The evidence suggests THEY CAN'T. The incentive to increase production is not present in those regions.

Spot Price of Oil 8-03-09 to 7-30-10

Source: Bloomberg

Turning back to the U.S., the moratorium in the Gulf Of Mexico (GOM) as well as "shut-ins" from summer weather storms will begin to reduce our domestic supply of oil. While $100 oil prices might not be present in the near term, I do believe the trajectory of prices is headed directly to $100. As I see it, there is no room for error in the price of oil. Something always goes wrong, especially in the oil market. With oil prices resting at a much higher base, currently $70 to $80, than the historical norm of $40 to $50, $100 is just one misstep away.

I wouldn't be reducing portfolio exposure to oil currently. In fact, I believe street estimates on the valuations of large cap integrated oil companies are way too cheap.

British Petroleum (BP) appears to be a forced seller of assets, not a willing seller. They have announced plans to sell another $20 to $30 billion worth of global assets. Large cap integrated oil companies that acquire some of those prime BP assets will witness their valuations rise quickly on the acquisition.

Keep in mind how the price of Apache (APA) has appreciated since acquiring $7 billion of BP's prime assets on July 20th. And that includes APA selling nearly $2 billion dollars worth of common equity at the same time.

Apache APA 4-5-10 to 7-30-10


Source: Bloomberg

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.