Oil Prices - An Analysis

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MolaKule

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$100 Oil is the Solution by John Mauldin April 1, 2005 The $100 Solution Venezuelan Madman and Other Problems It's a Very Demanding World The Demand for Infrastructure London, Majorca and Regulatory Exams How can we go from oil priced in the low teens only a few years ago to oil now holding steady in the mid-50s? This week we have seen a projected price spike of $105 from Goldman Sachs. Can you say $4 a gallon gasoline, boys and girls? $100 to fill up the tank of your SUV? This week we look at the price of oil and why $100 oil is the solution and not the problem. Since I'm writing this on April 1, I was tempted to start out the letter as an April Fools joke. My topic would have been why the Dow is going to 36,000, but then I realized that James Glassman and Kevin Hassett wrote about that over five years ago in their book "Dow 36,000." So I guess we'll stick with $100 oil. The $100 Solution Oil prices may temporarily spike to $80 a barrel during the next two years if there is a major supply disruption, said OPEC's Acting Secretary-General, Adnan Shihab-Eldin, last month. "I can stress that the probability that the price of a barrel of crude rises to $80 in the near future is a low probability," Shihab- Eldin told leading Kuwaiti daily al-Qabas in an interview in Vienna. "However, I can't rule out the rise of a barrel of oil to $80 in the coming two years," he said. "But, if the price rises to this level for one reason or another (for example a shortage of supplies from a producer nation by one or two million barrels per day), it's not expected that this spike will last long." Prices around $50 or $60 a barrel, if they continued for two years or more, would increase investment to expand supplies and curtail demand, pushing down prices in the end, he added. "This is an essential law of economics," Shihab- Eldin noted. (Source: Reuters). OPEC is becoming increasingly comfortable with $50 oil. Only a few years ago, the consensus was that $50 oil would reduce demand and create the potential for a worldwide recession. Since a global world recession would not be good for world demand, and thus oil prices, OPEC leaders targeted $22-$28 oil. They were not being nice. They simply wanted to make sure their customers would be financially sound enough to keep paying. This is somewhat like cocaine dealers being concerned about their customers in order to keep up their business. Since $50 oil has not created a recession, there is no constraint upon OPEC to work to reduce prices from here. However, the fact is that OPEC can do little about bringing down oil prices even if they wanted to. Here's how it used to work. In the 50s and 60s America produced all the oil it could use and essentially controlled the price of oil. Much of US oil was then produced in Texas. The Texas Railroad Commission had (and still maintains) regulatory authority over the production of oil in Texas. They limited the production of oil so as to maintain a price that would allow oil companies to make a profit and thus continue to be able to pump oil. In 1971, the Texas Road Commission allowed oil producers to go to full production, as demand had outstripped supply. That gave control of oil prices to OPEC and they moved to increase prices dramatically in 1973-74. Up until then, the TRC could raise or lower the price of by simply increasing or decreasing their production. World oil demand is around 80 million barrels of oil a day. If you increased oil production by, say, 2 million barrels a day over world demand, within three to four months there would simply be too much oil sloshing around and no place to put it. Prices would drop, and if production did not also drop the price of oil could go down dramatically. The consensus view is that OPEC has maybe-possibly-potentially the ability to produce an extra 1 million barrels of oil a day. Given that much of the world's oil producing capacity is in politically unstable countries, it is quite easy to imagine a disruption will affect far more oil production than this estimated 1 million barrels of oil a day. Venezuelan Madman and Other Problems The various tribes and factions in Nigeria are constantly threatening war with each other. Iran, Iraq and Saudi Arabia are not paragons of political stability. And then there is the madman that runs Venezuela. I offer you this quote from a recent Dennis Gartman newsletter: "Turning away from the Middle East to the Americas we cannot help but report the following statements by Venezuelan President Hugo Chavez... the Americas' closest thing to N. Korea's Kim Jung-Il. Speaking on television recently, Chavez said "Capitalism makes democracy impossible. Capitalism makes social justice impossible. If we don't change this system, the world is going to end. The eternal existence of our planet is not guaranteed. Look at other planets. In Mars there was water. It's possible they will soon find remains of living beings. Who knows how many years ago there was life on Mars? Mars is very similar to Earth. It rotates around the sun almost the same as Earth. It's very likely that there was life on Mars. It's possible that the Martians couldn't keep life going on their planet. "Old Karl Marx was right. Capitalism, monopolies, the exploitation of man by man, Karl Marx's theory was correct. We have to break this model of domination. "His comments stand on their own; they need no other amplification: This man is a kook of the first order, but we must take him seriously for Venezuela remains one of the United States five most important suppliers of crude. Politics and energy needs make for very strange bedfellows. And now let's look at the report by Goldman Sachs analyst Arjun Marti. In this 40 page report, he predicts a "super spike" period in which oil can range from $50 to $105 a barrel. He thinks this will have the same type of psychological impact that high oil prices in the 1970s had, ultimately changing consumer spending patterns and leading to a new drive for energy efficiency. Quoting from a story about the report in the Calgary Globe and Mail: "First, its analysis suggests that hedge funds have had nothing to do with rising oil prices, only contributing 'day-to-day trading noise.' Oil is up, and will stay up, Goldman said, because of often-cited geopolitical turmoil. Another factor is that 'light' crude, which is what costs $55 a barrel and is the primary source of gasoline and jet fuel, is becoming a premium product compared with "heavy" oil, which is what Canada produces. "Finally, and not noted by many others, the rising costs at energy companies to produce oil is directly correlated with the rising pricing of the commodity. As part of increasing its price forecast, Goldman mulled the idea that the world 'may have entered the early stages of what we have referred to as a 'super spike' period.' In the absence of a gusher of new crude hitting the market, such a price surge is essentially what is needed to restore balance to the oil universe, Goldman said." Notice Goldman is calling this a "Super Spike." They define a Super Spike as a multiyear trading band of oil prices which are high enough to meaningfully reduce energy consumption and thereby create a cushion of new supply for the market. The key factor that will create a sufficient destruction of demand would be higher gasoline costs. Goldman says "we've entered the early stages of a super spike without any threat of supply disruption. The spike is likely to continue even without a supply shock, but any disruption would accelerate it." They think that $105 oil will dramatically decrease demand, not only from the recession that it would cause, but because consumers would start to change the way they act. Among other things, the demand for SUVs would slow down, consumption patterns would change, and the price of oil would then drop. Following such a super spike and the follow-on demand destruction, Goldman believes a "normalized" market will emerge, with oil in the $35 (U.S.) range, the average of the past 35 years. (As a comparison, if gas returned to the same level it was in the 1970s as a percentage of consumer spending, oil would be $135 a barrel.) It's a Very Demanding World World oil demand is currently surging far higher than normal rates. In the period 1991 to 1999, annual world oil demand growth was about one million barrels a day. In 2004 that spiked to an additional 2.5 million barrels per day. The Energy Information Administration (EIA) in Washington, DC estimates that world oil demand growth will be more than 2 million barrels per day for the next two years. A third of that oil demand growth comes from China, which is no surprise, of course. The need for oil comes from two primary sources. First, China now has 20 million cars. That demand is only going to increase as estimates are that China will have between 120 million and 145 million cars a mere 15 years from now. (China's air pollution is already among the worst in the world. It is going to get worse.) Secondly, all the new industry in China creates a huge demand for electric power. Electricity is primarily produced by coal in China. The problem, however, is that there is simply not enough electric power production capacity, and thus much of Chinese industry has resorted to buying their own generators, most of which are powered by diesel fuel. Optimistically that means that as China brings on more power plants, it is possible that the diesel generators will be replaced. This will more than be offset, though, by increased demand for oil brought about by new cars and an emerging middle-class lifestyle. For those interested, you can go to the web site of The Center for Strategic and International Studies (CSIS) (http://www.csis.org/) and read some fascinating presentations, under "China's Energy Craving." It is clear the demand for oil is only going to rise. And this is just China. When you factor in India and the rest of Asia, there is a real potential for global demand to out-produce near term potential supply. Any increase in demand over supply by 2 million barrels a day will ultimately mean much higher oil prices. And that does in fact bring us to the super spike scenario that Goldman predicts. Now let's be clear that nobody really knows how high oil prices will go in the rest of this decade. Personally I think that a rise to $70 oil would start to negatively impact the American economy, and increase the likelihood of a recession. The US recession will affect the rest of the world negatively, and thus we should see a drop in the price of oil. But as noted above, there are numerous unpleasant political possibilities. In some of the less stable oil-producing parts of the world that could seriously, even if temporarily, spike the price of oil to $100. Anything is possible, but not everything is likely. While I do think we will see $100 oil in the coming decades, I would be surprised if we see it that high in this decade. Ironically, in my opinion, $100 a barrel oil is the solution for high oil prices. Has anybody noticed that ethanol is selling for less than unleaded gas on the futures market? Today unleaded gas on the futures market is $1.66. Ethanol June futures are "only" $1.21. In the future, it may be cheaper to run you car on environmentally friendly emission free ethanol. And yes, I know the government subsidizes ethanol. But a $.45 differential is huge. Who would have thought that would be the case five years ago? Dennis Gartman tells me the Athabasca Sand Tars in Canada is roughly three Saudi Arabias. They can now get oil out of the sand at a cost of roughly $11 a barrel. In the future instead of buying oil from OPEC we will grow it in Kansas and mine it in Canada. $100 oil will force market solutions for other energy sources and whole new industries and technologies. The Casandras who predict that the world will run out of energy simply don't get it. Yes, we will eventually see oil production peak and then begin to fall. But it will not be a calamitous over the waterfalls type of event. It will simply be a gradual lessening of production. That need for energy will be replaced by other energy sources. Such a change will be disruptive, but then most change usually is. That change will of course increase the number of potential opportunities for investors. This is a sector that I want to keep a close eye on. The Demand for Infrastructure My good friend Jim Williams at the Williams Inference Center sent me the following note on the increasing demand for infrastructure throughout the world. By that they mean roads, bridges, railroads, airports, ports, canals and so forth. It is a brief piece that I think you will find interesting. "China is using 55 percent of the word's cement. Chinese businesses and the Chinese government are on a construction boom. In 1989, China had only 170 miles of highways. By the end of 2003, the country had 18,500 miles of expressways. To build all these roads, the Chinese government spent $42 billion. The Chinese Ministry of Communications states their plan is to reach 51,000 miles of highway by 2008. The Chinese government is committed to putting down roads, just like the United States started doing back in 1956. "The list of infrastructure China needs is more than roads. For example, the country has about one third as many railways as we have in the United States and about one fifteenth as many airports. But, China has four times as many people. China needs more railroads, airports, bridges, roads, parking lots, phone lines, electrical lines and power plants. The demand for this infrastructure is now. "Growing demand from China promises a lucrative future for South Africa's iron ore and manganese companies - if they can find a way to move the metals more than 500 miles to the coastal ports. The problem is that South Africa's government-run company does not have enough capacity. More trains and tracks are needed. "Brazil has a similar train problem. The Brazilian government is trying to help the country's most important railways overcome a transportation bottleneck that threatens export growth. The current overhaul aims to help sustain the break- neck growth of Brazil's soybean and iron ore exports to China. "India's shabby infrastructure, seen as a key roadblock to wooing foreign investment, stands to get a major makeover under ambitious plans by the government in the country's annual budget unveiled in March 2005. Improving India's potholed highways, congested ports and erratic telecommunications and blackout-plagued service, is vital to keep India's economy powering ahead. "The demand for infrastructure is not restricted to China and India. According to the American Society of Civil Engineers, U.S. roads, bridges, sewers and dams are crumbling and need a $1 trillion overhaul. As of 2003, 27 percent of the nation's bridges were structurally deficient or obsolete. Since 1998, the number of unsafe dams in the country has risen by 33 percent to more than 3,500. "The U.S. government is aware of the infrastructure demand. The usually fractious members of the House of Representatives, this March, found something they nearly all shared: an appetite for millions of dollars for home-state road, bridge and transit projects. On a vote of 417 to 9, House members approved a $284 billion six-year infrastructure bill. "Natural gas will become the preeminent fuel of the 21st century. Moving natural gas requires liquefied natural gas (LNG) terminals, special ships, regasification terminals, and lots of pipelines for distribution. As one energy executive put it, 'Supply is not the issue; it is the delivery of gas to the market.' Before this transition occurs, a world-wide infrastructure for natural gas, such as that now enjoyed by oil, must emerge."
 
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I used to make my living searching and producing oil. There is more oil in the Gulf of Mexico than exists in the Middle East. NO ONE knows what is out there. As long as the issue is a political venue, you will be deceived and lied to. My opinion is that if you double present consumption the known reserves will last for another 200 years. God gave us unlimited power using nuclear resources. Yes, it is virtually free. No, it is not dangerous. Yes, the soccer moms will resist same. Yes, they are dumber than a pile of coal. More humans died in Kennedy's vehicle that died in nuclear plants. No, I do not listen to the alphabet news programs. Pop culture does not interest me. As a chemical engineer if you supply me with enough power, I can produce ANYTHING. Yes, I want some more Sunoco 260 for my Torinos. At ANY Time feel free to contact me personally about these issues. Besr regards. Juan Mamani. Super Inginero. Las Vegas.
 
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I have been opining to friends for many years now that the only answer to energy irrationality in the US would be $5/gallon gasoline. That is what it will take to change behavior and change the political winds. All of the hydrogen hype still bypasses the essential fact that it take energy to produce the pure hydrogen which the mythical fuel cell vehicles would consume. All energy sources other than nuclear are really a form of battery, where the energy one produced by the sun, either recently or long ago, is released through a chemical reaction. The energy content of oil, natural gas and coal represents ancient sunshine which was used to power the creation of hydrocarbons by plants and in turn by animals. That potential energy was concentrated by more reactions and the action of the earth's crust over long time periods. Anyway, $5/gallon fuel will provide the economic catalyst which gets us moving both with various forms of North American production of oil (from shale, unlocked political protectorates, etc.) and "alternatives". Bring it on. We can handle it. John
 
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Torino - For what yet seems to be harnessed, I can't as yet bring myself to rule out nuclear power as a potential energy source for our seemingly endless thirst for energy. I do think that it's certainly nothing to be handled lightly, for unlike the few organic species that can actually thrive in an environment that has elevated radiation levels, most of the familiar life forms cannot. That being the case, I'd wonder what than would really be the point. An oil drip or vapor leak is one thing, a nuclear debris/radiation leak is another. As far as energy in general, I'd hate to think it be spent for little more than for the sake of getting by...but then, it seems that life has gone that way, and probably shall continue to until one physically can nolonger. Ah, the meaning of being. [Confused] Just thoughts.
 

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The article failed to mention the effect of the falling dollar on oil prices. The dollar has fallen, what? 20% to 25% against the Euro and other major currencies due to federal reserve policies. This has had a major impact on oil prices.
 
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Originally posted by Torino: God gave us unlimited power using nuclear resources. Yes, it is virtually free. No, it is not dangerous.
======= I assume Chernobyl is excluded from that statement. And I cannot see how 1100 megawatt units that cost $5 billion to build are virtually free. I think a problem with nuclear is that the liklihood of an accident is very low, but the potential consequences of an accident, if one occurs, is very high. Our society does not cope well with expected results when the equation involves a very small number multiplied against a very high number. New nuclear commercial units were essentially priced out of the market for two reasons....the cost of assuring safety was so high that the units could not economically compete, and second, investors did not like the idea of going to bed with a sound investment and waking up with a bad one. I have worked in the utility field at the policy/regulatory level for about 35 years. It has taught me that, for a project to be viable, it must be able to pass the rules of law, the rules of economics, and the rules of physics. Fail on any one of the three, and it won't get built.
 
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