Oil prices dropped precipitously this week from what was a sharp rally a week ago, as the market digested a hefty inventory figure at a time when the global economy is on wobbly feet. But the downside momentum should be limited thanks to QE3 measures designed to spark U.S. economic growth, Matt Smith, analyst at Summit Energy—an energy management firm that manages more than $20 billion in annual energy spend for more than 650 companies—told IndexUniverse Correspondent Cinthia Murphy.

Murphy: What do you make of the sudden collapse in oil prices this week?

Smith: It has definitely been a strange turnaround in markets this week; after the bullish stars had all aligned for a rally last week, we have seen the complete opposite this week. Saudi Arabia saying it will increase supply to keep prices in check has had a huge impact this week.

Murphy: We did get a huge inventory number on Wednesday, but it seems prices started dropping precipitously on Monday. What happened there?

Smith: Prices started dropping from the outset of the week, as last week’s euphoria due to the U.S. stimulus announcement was shrugged off, as was geopolitical tension to a certain extent, and focus switched back once again to the euro debt crisis and general global economic weakness. Wednesday’s huge build was bearish, but the market was already heading much lower on the day due to other factors such as the comments out of Saudi Arabia. The inventory build could also be explained away somewhat by a return to normalcy after Hurricane Isaac; imports reached their highest level since January after all.

Murphy: Has QE3 anything to do with the recent price action in oil? Should it impact the market?

Smith: QE3 had a lot to do with last week’s run-up; the inverse relationship of a weaker dollar/stronger oil has meant that oil was naturally going to be propelled higher. Combine this with the positive sentiment and hope that QE3 promotes, along with the attractiveness of commodities in general as an inflation hedge, and it is no surprise we moved higher. Oil rallied strongly through QE1 and QE2, and we will likely see upside through QE3 as well.

Murphy: The Brent/WTI spread widened. What are some of the fundamental forces here shaping this price gap?

Smith: The spread widened recently due to tightness in the North Sea where Brent is priced, combined with geopolitical tension in the Middle East, as any supply outages on this front will impact Brent more than U.S.-based WTI.

Murphy: Where do you see the spread headed?

Smith: It is very difficult to predict; this is exemplified through experts such as Bentek who think the spread will stay wide, while Goldman Sachs and Bank of America expect it to narrow. I believe it is probably as wide as it will get, and will likely slowly narrow over time as infrastructure alleviates the supply glut at Cushing.

Murphy: Do you expect U.S. oil production to continue to rise?

Smith: Yes. Just as we have seen production ramp up for natural gas, the same will likely happen for oil, especially as it is more profitable. With shale plays such as Bakken outperforming estimates each month and other shale plays just getting started, the supply side looks bright for the U.S.

Murphy: About natural gas, what do you make of the recent price action there?

Smith: Despite the low price environment, it has been fascinating. The fact that production remains at near-record highs despite such low prices for so long indicates that prices should not go crazy anytime soon. 

Murphy: At what price does natural gas become too expensive for electric generators to switch back to coal?

Smith: We see gas-to-coal switching being considered around the $3 level; as soon as prices breach this level, demand starts to wane, and prices swiftly sell off back down to closer to $2.50, where we see the opposite happening—coal-to-gas switching.  

Murphy: We just saw several coal mines shut down in the East Coast, many miners lost their jobs. But coal shipments to Europe are up. Should we expect coal prices to remain pressured? Why?

Smith: Coal prices will remain under pressure in the U.S. as natural gas captures more of its share of power generation (they are both at approximately 33.5 percent of total production, while only last year this was 42 percent for coal and 25 percent for natural gas—an incredible turnaround). Coal prices will remain under pressure globally as long as China shows signs of economic slowing—it is the largest global consumer of coal after all. Europe is receiving U.S. shipments because not only are natural gas prices higher in Europe, but coal is needed to replace nuclear power that has been taken offline in response to the Tohoku disaster in Japan last year.

Murphy: Does alternative energy such as solar or wind power go away when subsidies go away?

Smith: Potentially; advancement in technology to drive down prices is needed to make alternatives a truly competitive alternative.

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