Crude oil prices have fallen nearly $30 per barrel and natural gas prices are off $3.50 per million British thermal units (MMBtu) since the beginning of July. This sudden, dramatic correction has sent shockwaves through the energy patch and prompted some unusual volatility in our favorite energy-related publicly traded partnerships (PTPs).

But don’t panic. It’s easy to forget that oil prices are still up $55 per barrel over the past year and $30 since the beginning of 2008. Meanwhile, natural gas prices have soared 40 percent over the past year. Although the bull market in these commodities may have paused, it’s certainly not over.

What’s more, most of the PTPs we cover have little or no actual exposure to energy prices. In fact, the market is already starting to reflect this, with the Alerian MLP Index down less than 4 percent this month compared to a 16 percent decline for the S&P 500 Energy Index.

Oil’s Well

We’ve all heard numerous explanations for oil’s rise to nearly $150 per barrel and the subsequent slide to under $125 over the past few weeks. Oil’s gyrations have been blamed on everything from speculation in the futures market to the weak US dollar. Here’s our take.

The speculation argument is convenient for politicians; after all, if financial speculation were the only reason for oil’s rise, politicians could solve the problem with a stroke of the pen and a bit more regulation. But check out the chart below of crude oil futures over the past few years.


Source: Bloomberg

The top pane of this chart is the actual price of crude oil in dollars per barrel. The lower pane is open interest in the oil futures market, a measure of the total number of oil futures contracts outstanding.  

If traders were voraciously buying crude oil futures, it would show up in the open interest figures. In other words, total open interest in oil futures would, by definition, expand as those traders took on positions.

But exactly the opposite has occurred. The price of oil began rising sharply in the late summer of last year, roughly doubling from its July/August lows to its recent high. Over the same time, total open interest in the crude oil futures market has actually fallen from about 1.6 million contracts a year ago to roughly 1.23 million today. That means futures market participants have actually been shrinking their exposure over the past year, even as oil prices have been rising.

Of course there are speculators in the crude oil market, just as there have always been. Some of these traders have undoubtedly taken profits off the table since the end of the second quarter, booking gains after a big run in oil over the past year. In fact, we can see that in the chart above–open interest has declined over the past few weeks. But speculation certainly isn’t solely responsible for the climb in crude oil prices and an unwinding of speculation won’t send oil back to the 80s.

The primary reason for oil’s rally: simple supply and demand. Oil demand growth, led by emerging markets, has been rising at a faster pace than available supplies. Consider the chart below.

This chart shows annual growth in oil demand in terms of barrels per day over the past few years alongside non-OPEC supply growth. It’s clear that non-OPEC supplies have not been keeping pace with growth in demand since 2002.

There are two reasons for this. Strong growth in demand from emerging markets such as China and India has pushed up global oil consumption by an average of 1.2 million barrels per day each year since 2000. That compares to average annualized growth of less than 1 million barrels per day per year in the 1990s and just 120,000 barrels per day in the ’80s.

Meanwhile, despite rising prices supply growth from countries outside of OPEC has been consistently disappointing. Since 2000, non-OPEC supply growth has averaged just 750,000 barrels a day each year.

And this situation is getting worse. One of the only non-OPEC countries to show meaningful production growth in recent years is Russia. But earlier this year, the Russia’s Ministry of Energy reported that production growth slipped into negative territory; as of May, Russian oil production was running just less than 1 percent lower than one year ago. Meanwhile, Mexico’s oil production is falling sharply as is output from the North Sea of Norway and the United Kingdom.

Over the past few years, the International Energy Agency (IEA) has consistently been over-optimistic in estimating non-OPEC supply growth. Consider the chart below.

The IEA begins estimating non-OPEC production growth for the following year in July; for example, the agency began estimating 2007 production growth in July 2006.

Back in July 2006, the IEA was forecasting non-OPEC production growth of 1.7 million barrels per day, a figure well above growth in prior years. In fact, optimistic estimates of non-OPEC supply growth were one factor that caused oil prices to drop in the summer and fall of 2006.

But note what happened in the months following that initial estimate: Non-OPEC supply estimates consistently fell. By July 2007, one year later, production growth was forecast at just 600,000 per day. That’s a near 70 percent drop over just one year. And reality was even worse: The IEA’s most recent estimate is that non-OPEC production growth last year was just 459,000 barrels per day.

The same pattern continued this year, as the following chart shows.

Last July, the IEA first published 2008 forecasts non-OPEC production growth of nearly 1 million barrels a day. That figure has once again steadily dropped, reaching 422,000 as of the most recent report published July 10.

Even less encouraging, from a supply standpoint, is that IEA estimates for 2009 non-OPEC supply growth currently stand at just 639,000 barrels a day. It’s quite likely that supply growth forecast will drop even further in coming months, following the pattern witnessed in each of the past four years.

New supplies from regions like Brazil and Kazakhstan are due to come online over the next five years, but these supplies will do little more than make up for declining output from mature fields. There’s growing evidence that the IEA and other major agencies that follow the global energy markets are consistently underestimating the decline rates of global oilfields. In other words, production from existing oilfields is falling at a faster-than-expected rate. This is the main reason estimates have proven too optimistic in recent years.

And more than half of the projected increase in non-OPEC production for 2009 is to come from a jump in biofuels output. Biofuels such as ethanol and biodiesel are derived almost exclusively from crops like corn, soybeans and rapeseed. Already, the dramatic increase in biofuels production of the past five years is straining the global agriculture market and prompting large jumps in prices of basic foodstuffs. There are real questions as to the sustainability of growth in biofuels output.

When demand growth exceeds non-OPEC supply, there’s only one possible outcome: greater reliance on OPEC oil. But OPEC’s ability to supply oil is also not unlimited.

The chart above shows OPEC’s spare capacity over the past few years. Spare capacity is surplus oil production capacity that can be brought online within a month and reliably produce oil for at least 90 days. Current OPEC spare capacity is below 2 million barrels of oil per day, a tiny fraction of the 85 million barrel-a-day oil market.

What’s more, most of that 2 million barrels spare capacity can be found in one country, Saudi Arabia. Saudi Arabia alone accounts for some 1.85 million barrels per day of that spare capacity. And Saudi Arabia recently boosted output again to help ease supply concerns; according to the EIA, current global spare capacity is likely closer to 1.2 million barrels per day. That means the global oil market is running at close to 99 percent of capacity, leaving little cushion to offset supply and demand shocks.

And there are legitimate concerns as to just how reliable that capacity really is. The IEA has noted in the past that much of this spare capacity is for heavy, sour crude types that can’t be refined in all countries; increasing production of these oils probably wouldn’t be sufficient to ease supply shortfalls.

Saudi Arabia has expressed plans to increase its effective oil production capacity to 12.5 million barrels per day in 2010 compared to just less than 11 million today. Theoretically, given constant world demand, this would add another 1.5 million barrels per day to the nation’s spare capacity. But there are real questions as to whether such an increase is actually possible, given the advanced age of some of Saudi Arabia’s largest fields.

Moreover, the country hasn’t announced any plans to go beyond 12.5 million barrels per day of capacity; in fact, Saudi Oil Minister al-Naimi stated that he sees little need to expand beyond 12.5 million barrels per day. This doesn’t seem to be a logical comment in light of the obvious increase in global oil demand from emerging markets. The statement was seen by many as a sign that the country is having difficulty raising production much beyond current levels.

Oil’s Range

A combination of weak supply growth and strong secular growth in demand paints a bullish long-term picture for oil and suggests that the era of cheap oil prices is over. Nonetheless, crude clearly sees short-term ups and downs within that broader uptrend. The recent pullback is a classic example.

Shorter-term gyrations are typically driven by two factors: inventory data and short-term demand trends in the developed world. The main fundamental factor currently pushing down oil prices is demand destruction in the US, a fancy term for the fact that consumers are using less oil.

High oil prices and a weak US economy are the main drivers of demand destruction. Higher oil–and, by extension, gasoline–prices have prompted US consumers to cut back on their driving.

This chart presents data from the US Federal Highway Administration over the past few years. The lines represent total miles driven in the US and are based on machines that automatically count traffic at 4,000 locations all over the US, both highways and rural roads.

The data is released with a time lag, but it’s clear that driving activity is down sharply so far this year. Americans typically drive more during the summer months, the so-called driving season. But data for April 2008 show that driving activity isn’t ramping up as it normally would.

There’s also evidence that US drivers are changing their habits. Sales of light trucks and sport utility vehicles (SUVs) are down more than 20 percent in 2008, a far more serious decline than for smaller, more fuel-efficient vehicles. This change in buying habits likely represents a more permanent form of demand destruction; consumers are beginning to come to the realization that higher energy prices are here to stay and are acting accordingly.

Weak US oil demand is starting to show up in the weekly oil and gasoline inventory figures released by the Energy Information Administration (EIA). Inventories are nothing more than a measure of how much oil and gasoline is held in storage in the US. This report is by far the most influential factor when it comes to short-term gyrations in the crude oil market.

To make a long story short, US gasoline inventories are above average for this time of year. US refiners have scaled back gasoline production from their facilities to bring those inventories back under control. For now, however, a gasoline glut will continue to put downward pressure on pricing.

The crude oil inventory picture is more bullish for oil; US crude oil inventories are well below average for this time of year. This is partly a reflection of the fact that US refiners aren’t importing much oil because they don’t see the demand for gasoline to warrant large imports. However, the lack of excess crude oil inventories suggests that refiners are behaving rationally, and there’s no US oil glut on the horizon.

Looking to the rest of the developed world, the picture is more bullish for crude. European demand hasn’t been hit as hard as in the US. One reason for that is Europeans haven’t borne the full force of recent increases in oil prices because of the euro’s rise; crude oil is up 23 percent in dollar terms this year but only 14 percent in euros.  

It’s likely that the European Union won’t remain immune to the economic woes in the US. There are already real signs of a slowdown. Nonetheless, inventories in the EU and other developed countries offer downside support for crude oil. Inventories across the Organization for Economic Cooperation and Development (OECD) countries, a proxy for the developed world, remain tight at this time. According to the IEA, oil inventories across the OECD are significantly below the five-year average.

Even more importantly, in the second quarter of each year firms tend to build crude oil inventories to prepare for the summer driving season. On average, inventories across the OECD build by around 900,000 barrels a day. This year, that build was closer to 100,000 barrels a day, well below average.

Weakening demand across the OECD countries would typically result in a build in oil and gasoline inventories, and that build would, in turn, put downward pressure on prices. But we aren’t seeing that build due to weak growth in global production coupled with strong demand from developing countries. Despite what some have written in the popular press, there’s clearly no global glut of oil.

All told, these data suggest a “muddle through” scenario for crude oil prices. Oil is unlikely to sink below $100 a barrel for any length of time. Strong emerging market demand and a tight global inventory picture will offer a floor for prices. In addition, geopolitical risks remain a support for prices and are likely to remain an issue for the foreseeable future.

Similarly, forecasts for $200 oil this year look unreasonable as well. If prices were to continue to rise, demand destruction in the US and other OECD nations would likely accelerate. Such a move would also put pressure on China and India to cut back on their gasoline subsidies more quickly than planned; these subsidies are currently sheltering consumers in these key countries from the full brunt of rising oil prices. These factors would limit any rise over $150.  

Gassed Up

We’re more bullish on natural gas prices right now.

Pundits often lump energy commodities together when discussing prices, but natural gas and oil aren’t interchangeable commodities. Oil is primarily used as a transportation fuel, only rarely as a fuel for power plants. Natural gas is primarily used for heating, electricity generation and as a petrochemical feedstock.

In the US and an increasing number of other nations, the peak season for gas demand is over the winter months, when it’s used for heating. The state of the economy isn’t a particularly important factor in winter heating demand. Weather is absolutely paramount.

For example, despite reasonably strong economic growth in the US in 2005 and 2006, the winter of 2005-06 was unusually warm. Gas demand was weak, inventories of gas in storage built up to glut levels and prices collapsed.

Electricity generation is becoming a key market for natural gas. The summer months are the peak period of demand for electricity in the US, thanks to demand for power to run air-conditioning systems. Electricity demand, like heating demand, has little to do with the state of the economy.

Weather trends can affect electricity demand from year to year; hot summer weather tends to drive natural gas consumption. However, check out the chart below.

This chart shows US electricity generation from 1990 to 2007. US electricity generation grew by more than 37 percent during this period. Even more impressive, electricity output only fell in only one year. In contrast, US oil demand grew less than 22 percent over the same time frame; year-over-year oil consumption actually fell in four separate years of these 17. Electricity demand is far more stable than demand for crude oil and is growing at a faster pace.
 
Finally, it’s worth noting some additional long-term drivers for natural gas demand. First, natural gas is the cleanest of the fossil fuels; emissions of sulphur dioxide, nitrous oxide and mercury are either non-existent or far lower than for coal-fired plants.

And a global trend toward regulating carbon dioxide emissions is also stoking natural gas demand. At the Group of Eight meeting earlier this month, all members, including the US, signed on to a target of reducing carbon dioxide emissions by 50 percent or more by 2050.

Natural gas is one of the only proven ways of reducing carbon emissions. Natural gas releases roughly half of the carbon of coal to produce the same amount of electricity; rising efficiency for gas plants could even extend that advantage.

One of the only countries that will actually meet its carbon dioxide reduction targets under the Kyoto Protocol is the United Kingdom. The UK’s official Kyoto target was for a 12.5 percent reduction in greenhouse gas (GHG) emissions from 1990 levels by 2012. According to the most recent estimates, published in a white paper dated February 2008, the UK will likely exceed that target, reducing overall GHG emissions by 25 to 30 percent between 1990 and 2012. In fact, according to some estimates, the UK exceeded its Kyoto Protocol targets before it even signed the deal.

The key to the UK’s Kyoto success hasn’t been the wide-scale implementation of renewable and alternative generation technologies. Nor has the reduction come as a result of decreased emissions from the transportation industry. According to the National Statistics data, GHG emissions from that industry actually rose more than 61 percent between 1990 and 2005.

The success is actually an outgrowth of the simple replacement of coal-fired power plant capacity with natural gas-fired capacity since the late ’80s. UK electricity consumption has risen from about 75 million metric tons of oil equivalent per year in 1989 to just under 87 million tons in 2006, an increase of 12 million tons. Over the same time period, coal consumption dropped by 13 million tons per year.

To meet new electricity demand and offset falling coal-fired output, the UK needed to add about 25 million tons of additional capacity from other sources. It should come as little surprise that the nation added more than 26 million tons of gas-fired capacity over the same time period.

Also helping the UK to reduce GHG emissions has been a reduction in the use of coal in manufacturing operations, replaced largely by natural gas.

According to the UK government’s February energy white paper, this trend is projected to continue. By 2020, the UK is projected to need 367 terrawatt-hours of electricity supply, down from around 399 terrawatt-hours in 2006. Of that total, more than 53 percent is expected to come from gas-fired plants, up from 36 percent projected for 2010. Gas is far and away the fastest-growing source of power under the assumptions of this white paper.

The UK is unlikely to be the only country to see a rush to gas in order to meet new regulations. In fact, that same trend is already underway in the US, where utilities are increasingly being forced to cancel plans to build new coal plants due to environmental opposition; often, natural gas plants are being constructed instead.

Although the longer-term demand picture looks solid, just as with oil, short-term gyrations in gas are driven primarily by the inventory picture. The following chart from the EIA offers a closer look at the current supply picture.

This chart shows natural gas inventories from June 2006 through last week. The shaded area represents the average seasonal inventory range and the red line represents the current path of gas in storage.

As you can see, inventories tend to fall in the winter months due to strong demand for gas heating. And gas inventories tend to rise in the spring and summer months; gas demand for electricity is still less than heating demand.

This single chart explains most of the action in natural gas prices over the past two years. Specifically, the extraordinarily warm winter of 2005 and 2006 meant that gas inventories exited that winter at the very upper end of their average range. Gas prices fell steadily over this time period.

Then, in the spring of 2007, inventories began to normalize. However, a collapse in gas prices in Europe and Asia due to mild weather led to a flood of natural gas imports into the US in the form of liquefied natural gas (LNG). Inventories were once again bloated by the early summer of 2007 and gas prices collapsed.

This year, however, the situation looks far more bullish. A cooler-than-average winter in 2007-08 drove higher-than-normal heating demand. Inventories collapsed earlier this year and are still under five-year average levels. Meanwhile, gas prices remain far higher in the EU and Asia than in the US; LNG imports have collapsed this year, further tightening supplies. This inventory normalization is behind the jump in gas prices since late 2007.

Two factors account for the more recent dip. First, although oil and gas are two totally different markets, the big move in oil likely prompted sympathy selling in the gas market. And second, so far July has been a slightly cooler-than-average month; for the past two weeks inventories of gas in storage have built up at a slightly faster-than-average pace.

This move has been way overdone. US gas inventories are still below average for this time of year and temperatures are slated to rise again in early August; this should normalize inventory builds. Moreover, so far 2008 has proved a more active hurricane season than either 2006 or 2007. Hurricane Dolly missed the major gas-producing regions in the Gulf of Mexico but still shut in considerable production. A single hurricane strike on the Gulf Coast could easily send inventories even further below average.

The balance of fundamentals in natural gas points to the upside. We suspect gas prices will average above $10 to $11 per MMBtu in the latter half of the year, nearly double the average price in 2006 and 2007. At those prices, most gas producers are extremely profitable. An improvement in gas prices has already produced a flurry of drilling activity in North America.  

From Commodities to Stocks

Although volatility in oil and natural gas prices can affect the energy-related PTPs on a short-term basis, these stocks rarely have any real leverage to commodity prices.

Most PTPs are involved in the midstream energy business, not in oil or gas production. This means the PTPs own pipelines, storage capacity or gas processing facilities. For the most part, these are all fee-based businesses where the PTP is paid based on the volume of oil or gas that passes through their infrastructure, not on the value of the gas itself.

Even better, in many cases pipeline operators charge a minimum fee whether or not oil and gas are actually shipped over their networks. This guarantees a base of cash flow. No matter what happens to commodity prices, we see little real impact on the midstream business.

Four of our recommended partnerships are involved in actual oil and natural gas production, BreitBurn Energy Partners (NSDQ: BBEP), Atlas Energy Resources (NYSE: ATN), Legacy Reserves (NSDQ: LGCY) and Linn Energy (NSDQ: LINE). But none is particularly exposed to near-term gyrations in commodity prices. All four run aggressive commodity price hedging programs that lock in prices for most of their production three to five years out. Any decline in commodity prices would be offset by gains in their hedging positions.

And, for all four of our recommended PTP producers, production costs are far lower than current commodity prices. At current prices, these PTPs can still economically undertake projects designed to increase their production.