WASHINGTON | Colin Fenton is the global head of Commodities Research and Strategy at J.P. Morgan. Fenton believes that there is margin for higher energy prices, with limited economic damage.
Brent and WTI are behaving virtually like “two different commodities”, as one trader put it last week. Asia, tied to Brent oil, has relatively strong oil demand and limited supply, while the US is experiencing an energy production renaissance in the context of an economic soft patch and constraints on export infrastructure. There is something we must keep in mind when talking about energy, and it is something about human civilization—we are a bunch of 20th century people trying to build a 21st century economy, and the large structural changes associated with that transition create a sense of queasiness. That is particularly visible in the field of energy. Shale and other sources of energy are changing the industry and the economy. The price of oil and LNG is going to be higher in Asia than in, let’s say, Indiana. And this translates, for instance, into an obvious interest by China on putting infrastructure in Canada and the U.S. to facilitate energy exports. Because, we must remember that the U.S. is already the number 1 gas producer, and the 3rd oil producer in the world.
Is the boom of unconventional oil and gas going to displace renewable energy? No, because the total demand of energy is going to grow and there will be room for all solutions that make economic and environmental sense. But gas is definitely increasing its market share relative to coal. In China, 71% of primary energy use is from coal, whereas just 4% is gas. In India, 12% is gas, and the world’s average is 24%. China has massive gas shale reserves and has made the strategic decision to develop this resource, as is clear in the 12th Five Year Plan. While China’s domestic gas production is growing strongly from a low base, gas demand in that country is growing even faster: an 18% compound annual growth rate. Last year, China’s gas consumption equaled about 1/5 the size of the U.S. gas market; as soon as 2015, it will reach 1/3.
But, going back to the first question, are the WTI and Brent going to keep separate paths? The progressive exhaustion of the North Sea reserves plus the expansion of the U.S. oil shale and Alberta’s oil sands is going to make the U.S. a regional market, isolated from the rest of the world? On the one hand, the demand in Asia is growing faster than in Europe and the U.S., and the supply is just coping with that demand increase. In the U.S. the supply is growing, but there are factors of uncertainty: firstly, the U.S. still needs to build an export architecture; secondly, we have to see if it will be permitted by the policymakers, as the Keystone XL pipeline controversy has made clear.
The U.S. will not be a net exporter of crude oil anytime soon, because crude demand in the U.S. is so much higher than domestic production. But it has already approved plans to become a net exporter of LNG and in 2011 became a net exporter of refined petroleum products for the first time since 1949. I think it is easier for the U.S. to become an exporter of “oil and gas” in the processed form of food, chemicals, fertilizers, plastics, and other oil refined specialty products, partly because these goods have fewer political sensitivities.
Let’s keep in mind that we are witnessing oil at 100 dollars a barrel when the world is only in the early stages of recovery from recession. Though China is in a soft landing, U.S. economic activity is still very soft, and Europe is in recession. At the same time, let’s put Chinese demand in context: in recent months, Chinese crude oil imports have at times been 1.5 million barrels per day above their own trailing trend of about 4.0 million barrels per day. That is larger than the total amount of daily oil production lost last year from Libya, a major OPEC producer. In 4Q2011, Chinese total petroleum demand crossed 10 million barrels per day for the first time in a global market of about 90 million barrels per day.
So, there is margin for higher prices. Yes, significantly higher with limited economic damage, but not yet. At JP Morgan since November we have been recommending an underweight investment allocation to commodities as an asset class due to the European recession and what have proven to be correct expectations for a generally warm winter. December was a terrible month for commodities, with declines in all of the benchmark total return indices. However, conditions have been so ominous that policymakers have responded forcefully and in positive ways: the Chinese have lowered reserve requirement ratios for the first time in years; the Fed has announced it will keep its zero interest rate policy through 2014; the ECB has made enormous commitments in bond markets, reversing course on its policy for bond purchases, and so on … so, January was positive. At JP Morgan we think that in 10-15 weeks there will be a bottom in global economic activity and then a recovery, and actually equities are, as they usually do, anticipating it.
But in the meantime, the weather drives prices. Now, what will happen in the future? If policymakers remain committed on the fiscal process, then oil will go up, which in turn is a sign of hopes for a recovery. We forecast oil at 130 dollars/barrel by the end of this year, and at 130 as next year’s average, but that forecast may prove to be conservative.
Iran… As I mentioned before, the weather is the dominant factor for now, much more powerful than geopolitical considerations. Neither we nor the market are expecting an actual war. Moreover, even if there were to be a larger-than-expected disruption, we would expect a vigorous coordinated response from the IEA, and also the Saudis, following the pattern of what happened in Libya last year. So, even if there were an Iranian disruption, its price effects would likely be limited and probably short-lived. From a global markets perspective, now the risk is being too aggressive in betting for such a disruption. It is more likely that there will be no disruption whatsoever.