Is oil heading to $100 a barrel?

A look at the bullish case for energy prices over the next few years.

By Anthony Mirhaydari Jan 27, 2010 1:31PM

MirhaydariAn exceptionally cold January has helped support energy prices over the past few weeks. This combined with regular end-of-year inventory management at refineries has pushed gasoline prices higher -- a development you've no doubt noticed as you top off your car's tank. Unfortunately, relief from high energy prices isn't likely.

 

Let's talk about the fundamental outlook for crude oil with the help of some new research from Morgan Stanley's commodities analysts. The team, led by Hussein Allidina, on Monday introduced a 2010 year-end price target of $95 and increased their 2011 estimate to $100. Here's why.

 

There are three main drivers for a bullish crude outlook: Expectations of robust economic growth driving demand domestically and overseas; a reduction in spare oil production capacity, and rising inflation expectations. Let's look at each in turn.

 

Oil vs. Inflation

 

Inflation expectations, as represented by the price of inflation-protected Treasury bonds or TIPs, continue to climb. Since December 28, the iShares TIPS Bond Fund (TIP) has climbed 1.6% while the S&P 500 has lost 3.1%. As you can see in the chart above, the TIP fund easily exceeded its 2008 highs and remains in a well established uptrend.

 

Worries over inflation both here and in China and India will act as support to oil prices. Inflation expectations tend to have a lagged affect on crude oil, so watch for the potential for a rapid rise in oil to reflect the recent jump in the TIP fund.

 

Oil Demand

 

The supply vs. demand situation for oil is very intriguing. You'll remember that worries over peak oil and constrained supplies back in 2007 and 2008, at a time when demand was rising rapidly because of growth in China and elsewhere, helped push crude oil up to a peak of $145 per barrel. At the time, the spare production capacity maintained by the OPEC cartel fell to just 2.6 million barrels per day. As high prices, the global financial crisis and recession took their toll on demand, spare capacity jumped to 6.2 million barrels and prices plummeted.

 

Allidina's research suggests spare capacity should next drop back below 3 million barrels per day by 2012 as non-OPEC production declines. Moreover, recent data out of China and India show that higher prices have done little to curtail demand. In China, since 2005 gasoline demand it up 41% despite a 122% increase in prices. In India, between 2005 and 2008 prices gained 20% while demand rose 29%. This suggests prices will have to reach higher more punitive levels before demand slows to match supply constraints.

 

Given the 98% rise in crude oil off of its 2008 low of $37 a barrel, you might think that this bullish outlook has already been priced in. This just isn't so. Looking at the price differential between crude oil and refined products -- known as the "crack spread" in industry lingo -- it seems that investors still aren't properly accounting for a strong recovery in energy demand. If they were, we would see refined products leading the way higher.

 

My play on this thesis is the ProShares Double Crude Oil ETF (UCO), which I've added to my portfolio at Wall Street Survivor and recommended to subscribers of the Strategic Advantage newsletter.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned. You can watch him trade during the day at Wall Street Survivor here.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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