Where Is Oil Headed? A Contrarian Says $45
Interview With Mike Rothman, Senior Managing Director, ISI Group
By SANDRA WARD

AS THE ORGANIZATION OF THE PETROLEUM Exporting Countries convened last week in Vienna, we naturally turned for the inside scoop to Mike Rothman, head of integrated oil research of the ISI Group, an economic research and investment-strategy firm based in Manhattan. A regular at OPEC meetings since 1986, a top-ranked energy analyst and a consultant to governments, Rothman is nothing if not in the know. Before joining ISI in 2005, Rothman was the former chief energy strategist at Merrill Lynch, where he worked for 20 years. It has been his contrarian contention the past few years that the dynamics surrounding the spike in oil prices have been out of whack with certain fundamental industry truths, and a day of reckoning is at hand. Here's his case for $45 oil and why investors should be underweight the energy sector.

Barron's: What's the view from the OPEC meeting? The Saudis agree to increase output and crude goes to new highs.

Rothman: That's not the story. The story is not the increase, the story is why the Saudis are pushing for an increase in production. A big part of the answer is that it seems that the Saudis want to try to take the froth out of the oil price because they are concerned about what higher prices have done to supply and demand. Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. It wasn't that they were depriving people of barrels, but OPEC had less demand for their oil -- and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that's an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn't been at nearly the pace people thought it would be.

What are your forecasts for demand growth?

My forecast for the fourth quarter, excluding Angola and Iraq, is for about 26.6 million barrels a day. Their production right now is about 26.8 million barrels a day.
[pic]
Mike Rothman

Zero growth?

From these levels it doesn't look like they have to raise output. Mind you, it's not the consensus view. The consensus view, which is from the International Energy Agency, is that demand is going to be about a million and a half higher than what I am talking about, and most people use the IEA forecast. OPEC is producing at a level that even their internal supply-demand model suggests is probably the right number for what they would need to supply -- in other words, what the market is going to demand. Qualitatively, you should know nobody is being deprived of barrels. Now, with the Saudis pushing for a higher quota, it is not about making barrels available to meet demand. It's about sending a signal or trying to lever down oil prices. The reason they want to do that is because the higher average price levels we've seen for the last couple of years have affected demand growth, and they have affected supplies from non-OPEC countries and for alternative energy supplies. The Saudis are the ones bearing the brunt of that because as demand for their oil has dropped, they have been the ones that have had to cut back.

There was talk they would delay increasing output because of concerns about the impact on prices.

That issue, of how do you engineer a soft landing, is really a tricky issue because the amount of speculative paper in oil has increased dramatically. The level of open interest in crude on the New York Mercantile Exchange has tripled in the last three years. The over-the-counter market, according to data from the Bank of International Settlements, suggests outstanding positions in oil about 20 times as big as the Nymex. Now we didn't have a big OTC market back in '85, '86 or '88 or '94, nor in the '98-'99 price crashes, so the big concern right now is when the unwind happens, it could be terribly disruptive. If you look at an oil-price chart back to 1983, when crude started trading on the Nymex, all you will ever see in the price patterns are V-tops and V-bottoms. What happens when hedge funds who have been net long in crude since October '03 decide to go short or sell? You can understand the concern. It's not just about easing prices; there is the potential for a blood bath.

So how do you explain crude prices rising to new highs after the Saudis announced they would increase production?

It would be an understatement to say I was taken aback by that. In a few days, the market went from expecting no hike in production, to expecting a largely symbolic increase, to getting a final agreement to inject 500,000 barrels a day above existing levels -- which is the equivalent of a 1.4-million-barrel-a-day boost in quotas. The big question at the meeting is, "What is bolstering the price?" I'm not sure, except the market seems to still believe the world is running out of oil.

What about the demand from China and India and the notion that supplies have peaked?

The data doesn't show it. If you look at the International Energy Agency industry data and you do an apples-to-apples comparison of non-OPEC supplies, supplies from all of the countries outside of OPEC, you will see growth rates are running substantially higher than people believe to be the case. Growth in non-OPEC supply this year looks like it will be about 1.3 million barrels a day, and that number is about twice what people believed would be the case. And the Saudis clearly have the barrels available. They are bringing on new fields. Khursaniyah is coming on in the fourth quarter, Nuayyim next year and Shaybah next year and Khurais in 2009. These are fairly big additions.

So what are people missing?

I have never seen the gap between reality and the perception of reality as big as it is right now. The perception of what I call Chindia, the idea that demand growth globally is robust and is going to be led by the emerging-market economies of China and India, is still strong. It is a great idea. But when you look at the data, you will see it doesn't match, and when you talk about peak oil and see what is happening to non-OPEC supply, there is a problem because supply growth this year is going to be one of the largest in almost 30 years, and next year looks like it is going to be similar to this year. Guys like me care about the totality of non-OPEC supply growth, even biofuels, or non-oil fuel, which are a subset of the non-OPEC supply curve. Biofuel supplies, which include soybeans for diesel fuel and corn for ethanol, will be up this year roughly 350,000 a day versus last year. That's a big number, about 40% in terms of its volume. It is going to be up by a similar volume in 2008. This is in response to higher average oil prices and concerns about availability.

Why the big disconnect between perception and reality?

I've got to tell you I don't know what the answer to that is. I do feel like I'm going through the reverse of what I went through in 2000 through 2003. In 2000, I was described as a "foaming at the mouth" oil bull. At Merrill Lynch we had a view the oil price would average in the mid- to upper 20s. We thought OPEC would adjust production, and when we spoke with investors about our views, they looked at us as if we were taking drugs. The catalyst that actually repriced energy equities and moved the whole back end of the oil-price curve was when Royal Dutch Shell wrote down reserves in early 2004. That was the catalyzing event.

I don't think people are aware that demand has really fallen off so much. The rate of global oil-demand growth has really slowed pretty dramatically since '04. I've had to make a large downward revision for the second quarter, and it looks like I am going to have to make another one for the third quarter. A chart of the OECD [organization for economic cooperation and development] countries shows demand growth has been negative, with the exception of a small gain in the second quarter; that's the first time since 2005 that there's been some growth in demand, and it was modest. That's the worst showing since the '80-'82 recession.

What about demand in the U.S.?

We have seen a very recent significant slowdown in U.S. oil-demand growth. Also, jet-fuel demand historically has been a leading or coincident indicator for the economy, and jet-fuel demand has turned negative. That is not an economic forecast. But when jet-fuel demand is really soft, you have got to worry about whether something's going on with the economy.
[chart]

Well, is demand slowing because of high prices or because the economy is slowing?

That is hard to say. Guys like me count barrels. But when you see oil-demand growth slow, you figure there are two things going on: There is substitution and there is conservation. People try to do more with the same number of barrels or they use alternatives. They may use more coal. They may increase their burn of natural gas in place of oil. They drive less. They may car pool. I'm not going to sit here and make up answers that I don't know. I just know that the rate of oil-demand growth has really been much lower than what has been forecast. I know I have had to make very big negative downward revisions in demand over the last three years, and it tells me that higher prices affect consumption. Three of my five kids drive, and last summer two of them stopped driving because I wouldn't buy their gasoline.

But in the bigger picture, global demand was supposed to be so strong that it wouldn't affect oil prices.

That's the "Chindia" story. I don't debate that demand in developing countries will grow. But the argument is that it is going to grow as it did in '04, at 15% or 16%, regardless of oil prices.

And you say 2004 was an aberration?

I haven't seen anything like it in 26 years. It wasn't even clear that what happened in '04 truly represented consumption. We don't know if some of it was stockpiling for precautionary reasons by developing countries. When you measure oil demand in a developing world economy, you're looking at disappearance, because the data for actual consumption by countries is very difficult to come by, and in many cases nonexistent. Then the question is whether that volume makes sense given other types of data. All I know is that for the last three years, I've revised my numbers down for China. It is not that they are not having oil-demand growth, but it is not 15%. It is 5%. It is 4%. It is 6%. It is 3%. It ain't 15%.

So if you were the "foaming at the mouth" bull back in 2000, what would you call yourself now?

It is very hard for me to say that I am a bear when I think oil is going to land at $45 to $50; historically, oil prices eventually settling at $45 to $50 is quite high. But compared to what the market is pricing and compared to probably most of my contemporaries, my forecast makes me a bear. We recommend underweighting the sector right now.

I'd say nearly a 50% price drop is bearish.

The concern is about the magnitude and speed and timing of the unwind given a precipitous drop in prices. It will be painful for companies. I have seen this movie before. There are a huge number of similarities between '99 up to now and the '73-'80 cycle.

Thanks, Mike.