The energy markets are clearly at the centre of powerful forces, sometimes cancelling each others, sometimes pulling in the same… … direction.

Currently it seems that these forces are combining once again to set oil on fire, but can it last?

Oil demand from Asia remains strong but, with the slowdown in the OECD, the IEA has recently lowered world demand growth for 4Q07 by 250,000 BPD.

The North Atlantic Hurricane season is in full swing. But so far there has been no impact on capacity.

Refinery capacity utilization in both Europe and the US currently stands at about 92%. At this time of year, it should be higher.

US stocks levels are still very healthy and, thanks to three years of playing to stor age from steep contango, almost as high as they have ever been this decade.

The US$ stands at a fifteen-year low (and we have amply argued about the strong negative correlation between oil price and the US$).

OPEC stance remains somewhat bullish for oil despite the recent concession to add 500,000 BPD to exports.

Geopolitics in the Middle East seem as bad as ever.
One could argue that there is nothing particularly exceptional about this background, yet WTI has now reached a new high of $84.10. Just as impressively, winter contracts for heating oil are printing above $95/bbl (or $45 more than three years ago). Record new highs in the absence of solidly bullish news are often seen as very positive news. Moreover, the fact that energy's new highs are occurring when global liquidity growth has been decelerating is undeniably noteworthy. Nevertheless, we tend to believe that we should keep in mind the following possibilities:

The Marginal Cost of the Barrel: Undeniably, marginal costs are now clearly much higher (because of both extraction and refining costs) than they were a few years ago. But there may be some good news in the pipeline or, more appropriately, from the refinery. Indeed, today, low-yield high sulphur fields cannot easily be refined. So while OPEC may promise us an additional 500k barrels of sour crude, what the world really needs is an extra 500kbd of sweet Nigerian crude (which we cannot get). However, China is going to add 700,000 bpd of refining capacity in 2008 (about half of all new capacity to come next year), and most of that will be for high sulphur intake. The infrastructure to better use OPEC's excesses is thus being built. By 2010, estimates are that 10M BDP of new refining capacity will have been built worldwide (the bulk of it in Asia, Central America and the Middle East). This means that by next year onwards, the marginal cost issue should be going down structurally.

The US$-Oil Relationship May Be Getting Overdone: We have strongly emphasised that, as the US$ weakens, OPEC members invariably try to get more for their barrel. However, there comes a point when that relationship breaks down and this point may have been reached. At US$80+/bl, the price of oil is no longer in OPEC's long-term advantage and keeping a bullish bias purely because of a weak dollar basis (and doing so when both Europe and the US are facing a slowdown) seriously risks killing the golden goose. Having said that the weakness of the US$ is clearly a worry for OPEC today.

The recent injection of cash by central banks has lowered the cost of money and increased its foolhardy use. This has clearly benefited a rally in oil. But, as highlighted in the previous pages, while investors focus on the increase in M, they may be missing the collapse in V….

Altogether there still remain issues about OECD economic activity and global liquidity growth. To us, this means that oil prices should ease over the medium-term, though there is no doubt that the short-term looks like fertile ground for a price spike. If WTI fails to close the next few weeks above US$79, then technically the current rally will have to correct to trend support (around $74). By then, a clearer picture for world demand growth in 2008 will have emerged.

Conclusion

Your looking to the fourth quarter for guidance analyst,

John F. Mauldin
johnmauldin@investorsinsight.com
www.investorsinsight.com

Disclaimer

John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.