The downturn in the global economy brought into sharp focus the sensitivity of commodity demand to the health of consumers and industry. It also highlighted the benefits and drawbacks of a localized market (like natural gas) versus a market characterized by more global trade flows (like crude oil). Emerging market economies (notably China and India) have contributed significantly to the current global recovery and are now crucial in determining the global supply/demand balances of commodities. At the same time, the U.S. will continue to be major consumer of commodities, especially crude oil and natural gas, and the health of the U.S. economy remains important in any discussion relating to the commodities market. In this note, we take a look at the dynamics of the crude oil and natural gas markets, as well as our preferences for bonds in these sectors.

China Driving Crude Oil Demand, While Supply Remains Tight

We are constructive on the crude oil markets in both the short and medium terms. While the global recession impacted oil demand in 2009, economies worldwide appear to be in relatively better shape currently and the U.S. economy is generally expected to perform better in the next two years. As a result, oil consumption in the short term is expected to increase both in the U.S. and globally. In 2010, the U.S. Department of Energy’s Energy Information Administration (EIA) projects an increase in global crude oil consumption of 1.2 million barrels per day (mmbpd) over 2009 — to 85.3 mmbpd (i.e., a 1.4% year-over-year increase) — and a further 1.6 mmbpd expansion in 2011. China is expected to be responsible for 33% of this increase in crude oil demand.

While we expect demand to grow steadily going forward, non-OPEC production — which currently accounts for about 60% of total oil supply — is expected to be flat to down in the next few years, with declines expected in areas like the Gulf of Mexico and the North Sea. Although OPEC has spare capacity (estimates range up to 6 mmbpd), it will try to support crude oil prices at higher levels; OPEC officials have indicated $70/bbl as the price that ensures investment in new supply. As a result of these factors, crude oil supply will remain tight.
 
Crude oil demand

 
Projected global supply of crude oil

 
OPEC surplus capacity

 
The Energy Information Administration forecasts oil prices to average $80/bbl and $84/bbl in 2010 and 2011, respectively. The forecast is predicated on U.S. GDP growth of 2.3% and 2.5% over the next two years and global GDP growth of 2.7% and 3.6% in the same period. Notably, the International Monetary Fund has more aggressive expectations for world GDP growth — 3.9% in 2010 and 4.3% in 2011. Bloomberg crude oil price forecasts for 2010 and 2011 are $78/bbl and $85/bbl, respectively, while the forward curve indicates 2010 West Texas Intermediate crude (WTI) prices of $80/bbl for 2010 and $83/bbl for 2011. This implies that current 2011 forecasts are slightly bullish relative to the market (although the markets are more affected by short-term issues like currency movements).

While it cannot be denied that booms in crude oil markets are caused partially by speculation, the cost of the “marginal barrel of oil” — i.e., the cost of supplying a barrel of oil to satisfy an increase in demand beyond the current level — provides a reasonable floor for prices. As demand grows and production rates on existing oil fields decline, the marginal barrel of oil will come from the deepwater oil fields in the Gulf of Mexico, Africa and Brazil, and the oil sands of Canada. The cost of this marginal barrel of oil is generally computed to be $50-90/bbl, assuming acceptable rates of project returns.

As a result of the expected tightness in non-OPEC production, OPEC’s pivotal role in determining global crude oil supply and a steady growth in demand, we expect oil prices to increase in the medium term from current levels.
In the long term, the International Energy Agency expects crude oil demand to increase at a compound annual growth rate of around 1%, to 105 mmbpd in 2030 from 85 mmbpd in 2010. While crude formed 35% of global energy demand in 2008, its share is expected to decline only marginally, to 33.3% in 2030, assuming no change in government policies.

However, it can be reasonably expected that the adverse effects of fossil fuels (in the form of greenhouse gases and carbon footprint) will compel governments (including the U.S.) to promote the use of cleaner fuels and greener technologies. The International Energy Agency’s 2009 energy outlook report outlines a “450 Scenario” wherein an “aggressive set of actions” in different economies limits the long-term concentration of greenhouse gases in the atmosphere to 450 parts per million of CO₂ equivalent*. Even in this 450 Scenario, oil prices are expected to increase through 2015 before plateauing at $90/bbl in real terms.

It is worth keeping in mind that a number of these renewable fuel technologies that form an integral part of the 450 Scenario — like fuel from waste, renewable fuels (biodiesel), etc. — have not been proven on a commercial scale and face such meaningful issues as a high cost structure and lack of capital. It also remains to be seen whether these clean technologies can generate energy on a scale large enough to help gain independence from fossil fuels. Further, most of the renewable fuel technologies are commercially viable only with substantial support from the government, in the form of loan guarantees and subsidies.

Booming Natural Gas Supply but Minimal Demand Growth

The dynamics of the natural gas markets are different from those for crude oil primarily because natural gas markets are less global. Natural gas is less easily transported across continents, even though liquefied natural gas (LNG) technology is making it possible to bridge the distances. Our discussion below relates primarily to the U.S. natural gas markets.

The big debate — especially in the context of North American exploration & production (E&P) — is over natural gas prices. Despite significant withdrawals, storage remains high, production remains robust (especially from shales, such as Haynesville and Barnett) and the rig count is trending back up; none of this bodes well for the supply/demand balance. Shale natural gas formed 10% of U.S. production in 2008 versus only 6.2% in 2007; 2009 data will likely be even higher. Further, LNG imports are also expected to increase in the next two years — from a 2009 average of 1.3 billion cubic feet per day (bcf/d) according to EIA — with worldwide additions in LNG capacity.
 
U.S. and lower 48 states natural gas gross production

 
U.S. natural gas storage

 
North American natural gas rig count

 
While residential and commercial natural gas consumption has been stable (aggregate 33% of total natural gas demand in the U.S.), industrial consumption of natural gas has declined materially during the downturn. Electric consumption got a boost of late, as lower natural gas prices and cold weather drove demand for natural gas. That said, the Energy Information Administration forecasts natural gas consumption for electricity generation to decline 1.3% in 2010 due to increased coal-fired generation capacity and higher natural gas prices. The Energy Information Administration expects natural gas demand in the U.S. to increase only 0.4% (to 62.5 bcf/d) in 2010 and another 0.4% in 2011; these increases are primarily due to marginally better economic conditions boosting demand in other segments (such as residential, commercial and industrial).
 
U.S. natural gas demand — total

 
U.S. natural gas demand — industrial

 
On balance, U.S. natural gas supply is expected to remain stable to increasing, while demand is entirely dependent on the strength of economic recovery; therefore, a conservative outlook on natural gas prices in the U.S. is appropriate. The Energy Information Administration expects the natural gas Henry Hub spot price to average $5.37 per million Btu (mmBtu) for 2010 and $5.86/mmBtu for 2011; both represent fairly significant increases over the 2009 average of $4.06/mmBtu.

We Prefer Oil Exposure

In conclusion, crude oil has better fundamentals than natural gas. While natural gas is cleaner and may well be the fuel of the future, booming production in U.S. shales and the global recession have clouded its short-term outlook. We prefer credit names with less exposure to natural gas — Hess, Husky, Occidental and Nexen fall in that category. In natural gas, the companies with the lowest cost structures have a distinct advantage — including EnCana, Devon, Noble, EOG and XTO (to be acquired by Exxon). n 

 

 
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This report does not make any recommendation about your investments, and this information should not be considered investment advice. Any opinions expressed herein reflect our judgment at this date and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management's current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels and (4) increasing levels of loan defaults (5) general competitive factors (6) changes in laws and regulations (7) changes in the policies of governments and/or regulatory authorities. ING Investment Management assumes no obligation to update any forward-looking information contained in this document. Past performance is not indicative of future results.