Monday, November 23, 2009

Is the price of oil headed for $100 per barrel again?

Many say it is. But to be frank, the "fair price" is much lower than the current range of $75-$83 per barrel.

If you focus solely on the current fundamentals – supply, demand, refining margins, seasonality – crude prices should be at $65-$70 per barrel. And that's why I believe the oil market is set for a sharp downturn within the next year.

But in today's reality, no one particularly cares about the fundamentals of overwhelming supplies and feeble demand. Fact is, there is more oil than there is storage.

The latest report from the Department of Energy showed that U.S. crude oil inventories were nearly 6.5% higher than last year – a total of 336.8 million barrels of oil. Meantime, about 50 million barrels of crude are on short-term storage vessels and another 75 million barrels of distillates are in the Atlantic until storage clears up.

And to make matters worse, demand isn't jiving either.

Demand is Slack… But Speculation is Not

Demand at oil refineries totaled about 13.8 million barrels per day – one million barrels lower than a year ago. Furthermore, they're only operating at an average of about 80% capacity.

A telltale sign of this is Valero's (NYSE: VLO) recent decision to shut down its New Jersey refinery for a month for repairs, rather than work through the maintenance. The plant is responsible for 160,000 barrels per day.

And the underlying reason is because of problems that face the entire industry: poor profit margins, reduced demand and big stockpiles of product that has nowhere to go.

So how did oil prices reach $80?

In a word: speculation. Following the stimulus package, the drop in interest rates, the printing presses running 24/7 and the U.S. dollar plummeting, commodities became a hot ticket for investors.

In fact, the money flowing into oil from investment firms has added about $20 per barrel to the fair price of crude.

These investments figure future demand growth into the equation. But the economic recovery has yet to significantly improve oil demand.

Given that, crude oil prices are destined for a sharp fall. How far?

When Interest Rates Go Up, Oil Will Go Down

When the Fed starts to increase interest rates and the economy improves, many investors will sell their long positions in oil.

Once that happens, crude oil could slide by $20-$30 per barrel from the price at that time.

Considering the U.S. dollar has dropped for the past nine months, I wouldn't expect a firm rebound for at least another nine months into 2010. Simply put, investors cannot keep crude prices artificially pumped up forever – and a drop in price is coming.

Sheena Martin