Oil falls below $35, and a bottom is nowhere in sight

Investors should heed the advice of energy traders: tread carefully, if you're considering an oil stock or an oil-related play.

Oil, which plunged another $3.03 to $34.03 per barrel Tuesday at mid-day amid concerns of a deepening recession in Western and Eastern Europe, is a market in search of a bottom. It would be a technical and a fundamental stretch to say that a bottom will occur anytime soon.

Oil's fundamentals certainly argue against a price recovery in the near term. The U.S. economy is in a pronounced recession, creating year-over-year consumption declines in oil and essentially flat gasoline consumption. Europe's economy, both West and East, appears to be slowing more, and Japan in Q4 recorded its worst GDP performance in more than 30 years, falling at a -12.7% annualized rate. Yes, China's economy continues to grow, but at only roughly half the 10% rate seen during the global boom. In sum, global oil demand is likely to decline in 2009 as it did in 2008 -- that's the International Energy Agency's most recent forecast -- the first consecutive demand decline since 1982-83.

A world awash in oil

Meanwhile, oil supplies remain plentiful, with inventories rising in the U.S. In a market economy, sluggish demand conditions combined with a long-term price declines compel oil producers to decrease production, and that's presently occurring in the private sector. The problem is, many major oil producers around the world are state-owned, and many need oil revenue to fund government budgets. Historically, many have maintained production levels despite a large drop in prices, due to this revenue need. That will place the largest burden on OPEC, which has already cut production by 4.2 million barrels per day (bpd). The cartel will need to cut at least another 1.5 million bpd when it meets next in Vienna in March, says economist Richard Felson, "to take some excess supply out of this weak market."

Weak oil market? The phrase still sounds slightly surreal. A scant seven months ago, oil hit $147.27, an all-time high, on surging emerging market economic growth and talk of supply shortages in selected developed economies. Economists now generally agree leverage-fueled hedge funds created an oil bubble, distorting oil's price to the upside, but the price has plunged more than $110. A $110 bubble? That's not likely, according to Felson, who believes the global recession accounted for about $30-40 of that fall. If the U.S. and global economy were growing, oil would be trading around $60 right now.

But they're not, so oil is below $35 and heading south, almost daily. Oil has psychological support at the $30 level, but unless demand characteristics change, traders say that support will not hold. Oil trading below $30 would be historically cheap, Felson says, but it's important to note that during periods of light demand, oil has traded below $30 for years.

Oil Analysis: For investors, oil's price trend and the U.S. economic outlook speak for themselves, and it's likely to remain a challenging environment for integrated oil companies. Refiners may fare better as gasoline demand picks up in the spring, but keep in mind gasoline demand, roughly flat now, could resume falling if the U.S. recession worsens.
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