Most investors are aware that since bottoming in March 2009, the financial markets have staged a strong rally. One sector at the forefront of that surge is energy. Like stocks in general, most of the rise in energy can be attributed to a hope or an expectation of an improving economy. Official reports, however, indicate that stockpiles of oil, gas and other liquid energy resources are more than sufficient to meet current demands.

The overview and consumption information below is taken directly from the U.S. Energy Information Association web site. http://www.eia.doe.gov/

“Overview.  EIA is currently projecting a weaker global oil market for 2009 than anticipated in last month’s assessment.  Expectations of global economic recovery and a resultant increase in demand were offset by initial data for the first quarter showing high oil inventories, weak consumption, and higher-than-expected production.  Price increases will likely be muted by the substantial surplus production capacity held by members of the Organization of the Petroleum Exporting Countries (OPEC), along with very high level of inventories among members of the Organization for Economic Cooperation and Development (OECD).  The expectation that prices should rise in 2009-2010 because of future economic growth will need to be tempered with the current market reality of this supply overhang.  The main downside risk to this Outlook’s oil price forecast remains a prolonged global economic slump, as well as the possibility of reduced compliance with OPEC production targets in the months ahead.

“Consumption. World oil consumption remains weak because of the global economic downturn.  Based on revised data and a re-estimation of the impact of the economic slowdown on oil consumption, EIA has reduced its forecast for world oil consumption from the fourth quarter of 2008 through the end of the forecast period. World oil consumption is now projected to fall by 1.8 million barrels per day (bbl/d) in 2009, a decline that is 0.4 million bbl/d larger than the decline projected in last month’s Outlook.  The forecasts for Asia and the Former Soviet Union (FSU) show the largest revisions.  In total, OECD oil consumption is expected to fall by nearly 2 million bbl/d in 2009, with oil consumption in Japan alone expected to fall by over 0.5 million bbl/d in 2009.  Partially offsetting declining OECD oil consumption is a growth of 0.2 million bbl/d in non-OECD consumption, particularly in the Middle East, China, and India.”

In other words, based on global supply and demand, there seems to be no real reason for the recent increase in oil prices or for continued increases in the near future. 

Below is a chart showing the daily price movements of United States Oil Fund (USO) an exchanged-traded fund (ETF) that tracks U.S. oil prices. The gold line on the chart is the S&P 500, included for comparison. Notice that during a period when the S&P 500 has been especially volatile, the price of oil has been dramatically more so. 

 
The middle portion of the chart shows the trading volume of USO. As the price of oil plunged, look how daily trading volume spiked, peaking in February. Although the volume has declined since then, as the price of oil has risen over the past three months, trading volume is still two to three times as high as during the latter part of 2007 and early 2008. The only real explanation for this increase is speculation by traders who are hoping for even higher prices if the economy rebounds.

The sharp spike in oil prices a year ago no doubt helped deepen the recession. Much of that rise was the result of speculation as traders anticipated growing demand from developing nations like China. As prices reached record highs, global demand waned and excess inventory piled up. As the chart shows, the resulting price decline was dramatic and provided welcome relief for consumers.

High energy prices create a tremendous drag on the economy. Energy costs are built into industry and service at every level and higher prices are generally quickly passed on to consumers, creating rising inflation. Rising oil prices could dampen or stall an economic recovery.

The bottom two sections of the chart provide a technical picture showing that oil prices can continue rising. The moving average convergence divergence (MACD) reflects that while oil prices are nearing an overbought level, there is still quite a bit of room before that overbought status would be considered extreme. Similarly, the relative strength index (RSI) is also at a high level, but based on price behavior over the past couple of year, tshe RSI can maintain this momentum for extended periods.

For decades, the oil market has been heavily manipulated. Obviously, oil producing nations want the price to remain high. But in recent years, many of those nations have gone on spending sprees in anticipation of high oil prices. Now they find themselves in a situation similar to that of American homeowners who borrowed all the equity from their homes and today realize they owe more than the home is worth. Those nations need oil prices to rise above current levels in order to meet their debt obligations.

It would not be surprising to see oil prices rise from these levels, even though supplies are plentiful and demand is weak. That creates a situation where volatility can be very high–something for which the energy sector already has a reputation. Investors who want to dabble in this sector should do so with full understanding that risk levels are always high and suitable only for the most aggressive investors who are risking money they can afford to lose.
F.S.