Bursting the Bubble

Factors pile up to collapse crude-oil prices; 2009 mixed bag of opportunity, challenges

Samantha Oller, Senior Editor/Fuels, CSP

OMAHA, Neb. -- It has been a year of highs and lows in the fuel market, but perhaps one of the most distinguishing characteristics of this year's pricing dynamic has been the massive impact from outside influences. "The rapid decline in oil prices is unprecedented, just like the rally to those highs," said Brian Milne, the refined fuels editor for DTN, Omaha, Neb., during a web seminar on the first-quarter 2009 fuel-market outlook.

Milne said several factors that have triggered and continued to sustain the quick selloff, which has pressed crude-oil futures to lows last seen [image-nocss] in February 2005-factors that have less to do with oil-market fundamentals, and more to do with the sad state of the economy in the United States and globally.

"Economic turmoil, which froze credit this fall and remains extremely difficult for many businesses to secure, pricked the oil bubble," said Milne. "Demand destruction and expectations that consumption would remain low throughout the economic downturn, fueled by a loss in freight hauling, job losses and conservation efforts by businesses and consumers alike, continues to weigh on the complex."

Analysts are comparing the severity of the current recession to that of 1981-1982, which lasted for 16 months, Milne noted. He highlighted several factors hovering around the deflated oil-price bubble:
Road less traveled. In 2008, the country saw its first decline in road travel in 28 years, according to figures Milne cited from the Federal Highway Administration. While the driving slump stretches across the country, the South and south Atlantic states are seeing the greatest declines, attributed to supply issues after Hurricane Ike. Gasoline loses gas. The drop in gasoline demand is expected to remain below 3% for the rest of the year. "In 2009, gasoline demand is expected to edge up to 9.035 million barrels per day, but expect a sluggish consumption rate in the first quarter, which is seasonally the weakest demand period for gasoline," said Milne. Over the long-term, gasoline demand will continue to drop, pressured by increased fuel efficiency standards and an increasing mandate for renewable fuels, he predicted. From a supply standpoint, gasoline output should remain below year-ago levels for the rest of 2008 and into early 2009. Ethanol loses discount-but keeps its position. While corn-based ethanol is trading on the spot market at a 50-cent premium to gasoline, providing no incentive for discretionary blending, Milne expected the increasing renewable fuels mandate will provide adequate demand support. Current concerns about supply are keeping prices high, but regions that rely on reformulated gasoline will also provide a reliable market for ethanol. Distillate-the long and short of it. The decline in distillate demand, which includes diesel and heating oil, is expected to remain just under 6% for the rest of the year. Milne cited the loss in freight hauling, noting that 2,500 U.S. trucking fleets declared bankruptcy in 2008 under pressure first from $5 diesel, and then from economic contraction and a difficult credit environment. For refiners, "distillates remain a bright spot," said Milne, mainly because of the long-term global demand outlook. He cited a recent analyst call with the nation's largest refiner, Valero Corp., which predicted that distillates "will continue to fuel the economic engine when recovery begins-not gasoline," and who expects demand for distillates to grow at twice the rate as that for gasoline into the future. End of the golden age. Average refining margins are holding at their lowest level in five years, with the worst being seen by refiners in the mid-continent and Gulf Coast regions, while those on the East Coast are seeing the best. During its analyst call, Valero warned that refiners have to scale back more on production, and said it sees independents without upstream operations as the most financially at risk in this environment. Crude bottoms out-soon. Milne said that determining when to contract for gasoline and diesel for 2009 can be a tricky proposition, especially when the price of crude oil shows no sign of settling soon. "We saw a lot of people get hurt on bad hedges this year," he said. "We saw people who were under-hedged early, and as prices rallied, we saw people try to hedge at higher levels thinking they'd sustain at high price points for a long time. And now they're getting smacked again as those hedges they put out are forcing them to pay higher rates than where the spot market is at. It was simply treacherous."

Milne advised that buyers wait until they see signs that the price is bottoming out, an occurrence that will hinge closely on good news about the state of the economy. He expects the country will find that bottom in the $40 range.

"I think it's going to be difficult for crude oil to hold below $40 for that long," he said. "I would wait to see if $40 holds. That would be my signal to look at longer-term contracts and start getting some fuel contracts."