Credit Suisse Energy Petroleum: Ratcheting up but still range bound (update 2)

Refining capacity is also robust
The second leg of the oil price rises of the last decade stemmed from two problems that hit the refining sector. First, came the devastation wrought by Hurricanes Katrina and Rita on the US Gulf Coast, shutting in over 8-million b/d of Gulf Coast refining twice in September/October 2005 and keeping much of this capacity off line for well over a year. For most of Q4 of that year more than 4.5-m b/d of refining capacity was unavailable, resulting in a huge drawdown of production inventories globally. Second, on the heels of that, the legislators and regulators of OECD countries decided to eliminate sulfur from transportation fuels, severely straining already constrained global refining capacity and its ability to supply these fuels. The results were an increase in the price of light transportation fuels and from that a pull on crude oil prices, which saw no relief until new refining capacity was brought into the market in 2008. Almost no one anticipates a squeeze from refining any time soon, and just as there is no reason from a supply perspective for there to be a sustained rise in prices, so too there should be no factor from the now ample global refining situation.

Demand is back, growing faster in 2010, at a lower pace in 2011
There is no doubt that 2010 has seen extraordinary growth in petroleum product demand. Our balances show demand growth globally of 2.2-m b/d this year, which is higher than the EIA’s 2.02-m b/d and significantly lower than the IEA’s 2.4-m b/d growth. As on the supply side, there are critical differences in the way different analysts interpret this growth. There is a tendency in some quarters to point to accelerating demand growth in emerging market countries and to argue that the historical relationship between GDP and product demand is tightening. We believe that, as with every other price spike historically, so too with what occurred in 2008, it is being followed by significant investments in energy savings technologies and this will result in loosening of the historical relationship between GDP/IP growth and petroleum product demand. 2011 should be a testing year for this, just as it will be on the supply side.

There is little doubt that emerging markets are driving demand growth in 2010 and will continue to do so in 2011. Of this year’s estimated 2.16-mb/d demand growth, 1.6-m b/d appears to be coming from emerging markets and a surprising 500-600-k b/d is coming from the OECD, largely because of weather and tangible growth in the US. But a significant amount of what remains largely immeasurable is also responsible. For the 20 years before 2008 there was a relatively good rule of thumb to estimate global petroleum product demand – take global GDP growth, subtract 2.3% and the result is a reasonable approximation of global demand growth. In 2010, with global GDP of 4.8%, the expected result should be 2.5% petroleum product demand growth. That would translate into 2.12-m b/d of demand growth – just about identical to what we now estimate demand growth to be.

For next year we are projecting global GDP growth of 4.4%, which would imply 2.1% product demand growth. Top down, that would imply 1.8-m b/d of product demand growth. We are projecting 1.7-m b/.d demand growth – higher than the projections of the IEA, OPEC or the EIA, but lower than historical trends. The reason we believe demand growth will be slightly lower than historical trends is that we believe 2010 apparent demand growth has been restocking of secondary and tertiary inventories that were de-stocked in 2008-09, when global product demand fell 1.3-m b/d below 2008’s level. But we are also looking at demand growth more microscopically, on a bottom-up basis.

Most of this growth should come from non-OECD and in particular from China, India and the Middle East. As these economies continue to grow rapidly and above trend, they will see not only continued growth in demand for transportation fuels, but also for power generation. We also expect continuing exceptional demand growth for middle distillates from the non-OECD as a whole, mostly for transportation (road, rail, air and sea). Strong economic and population growth as well as latent demand for mobility should also sustain and reinforce growth, whereas transportation fuel demand growth should stagnate in the OECD. Diesel demand growth is directly correlated with GDP growth. This correlation forms the basis of our bottom-up forecasts of diesel demand in 2011. The exhibits below show the regression for diesel demand over GDP; for the US the regression brings an r-squared of almost 90%, with an elasticity of 0.72; the correlation is even more stunning in China with an r-squared of 95%, where the elasticity is 0.5. Furthermore, looking at the change of the correlation between diesel demand and GDP growth in India and Brazil demonstrates a further point: the more an economy growths and the more it is developed, the tighter the correlation. For example, in India, from 2000 to 2005 the correlation was only 7%, but running the regression up to 3Q10 it jumps to 70%.

Based on this observation and using the Credit Suisse Economics group’s GDP growth estimate, we project strong growth for diesel demand throughout 2011, growing in the US by 2.6% qoq saar and heading towards 4-m b/d by the end of 2011. Chinese demand should be even more robust, growing by 5% qoq saar. China will more than likely become the largest consumer of diesel in 2011 – exceeding the US – with distillate demand heading to 4.2-m b/d in 4Q11.

Before turning to our forecast for 2011, we should note one additional difference between today and what happened in the run-up in oil prices between 2007 and 2008. Since then there has been a significant amount of financial de-leveraging around the world. The highly leveraged global situation of 2007-08 fostered a more bubble-like environment than is likely to be supportable today. As a result we feel that fundamentals are now more important than they were then, and fundamentals point to a well-supplied market next year as well as this year.


Well-balanced market in 2010
For 2010 as a whole, we see crude oil supply lagging slightly the growth in product demand. We also see a market that, while it is well supplied in inventory, should see lower inventory come January 2011 globally than might have been the case had there not been a cold snap in early winter. Our base case therefore is for a well-balanced market, which will, by definition mean that if current levels of inventories globally remain constant, they will cover fewer days of forward demand. Our base case sees no decrease in OPEC spare capacity next year. If markets do tighten, it is more likely they would do so in 2012 rather than 2011.
We forecast Brent crude oil average prices to rise by roughly $5 /bbl from 2010 $85 and to ratchet up further in 2012. By contrast, Brent averaged $98.52 in 2008 and $62.67 in 2009. Our forecast is below the forward curve through 2012 and above the Bloomberg forecast average through Q1 2011, after which we fall considerably below the consensus.