The Aleph Blog » Blog Archive » Ten Notes on Crude Oil: The Fixation

Ten Notes on Crude Oil: The Fixation

In different economic eras, different things attract the attention of the media, investors, politicians, etc.  Today a leading attention grabber would be crude oil, and the energy complex.  It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).

1)  Fuel is subsidized across much of the world, particularly in countries where there is a large state owned oil company.  Current high prices are making it difficult to maintain those subsidies, so countries like Egypt and Indonesia are reducing subsidies.  Yet subsidies are not being eliminated everywhere yet.

2) Speculators — perhaps they need a new name, and a branding campaign.  Risk bearers, maybe.  I don’t know.  But discouraging speculation by raising margin requirements will not necessarily decrease the cost of crude — those who are short crude also face margin requirements.

Now, many commodities have no futures contracts.  On average their prices have increased more than those that have futures contracts recently.   That indicates to me that those that have futures contracts are not in a bubble.

Some look at the dollar change in prices and think that speculation must be high.  Bespoke does a good job in breaking it down into percentage terms, which indicates that the oil market has been more volatile more than half a dozen times in the past.

Do speculators include the ordinary shmoes like you and me who use ETFs?  I’ve used currency and stock and bond index ETFs, but not commodities so far.  Amazing how the trading interest on commodities has grown through ETFs — here’s another good chart from Bespoke.

As I have commented before, I think the run-up in the price of oil is fundamental, not manipulation.  Ignore the futures, and just look at spot prices — it is hard to affect where the real buyers and sellers trade in a global commodity.  If prices get too high, like the last move of OPEC in the 1979, where they overshot, and supply eventually overwhelmed their too high price.

3) We could be in overshoot mode now; it’s hard to tell.  As I have said before, sustained high prices are necessary to create the investment in alternative technologies that save energy and produce energy
more cheaply.  I don’t think that it will happen quickly though… in the early 80s, oil prices edged down, and then came down rapidly in the mid-80s.  It took a while for the new supply to be developed, and for conserving technologies to be created and deployed.

If you want a current example, think of the new big oil field found off the coast of Brazil.  It will be three years or so until we see new production there.  Another example is that it is hard to ramp up additional production from existing fields.  If you try to force more oil out more rapidly than is prudent, you can destroy the long-term viability of the oil fields.

4) But, there are dissenting voices, whether wishful ones like this one from a Japanese Vice Minister, or this article from Fortune which is more nuanced.  His arguments sound like mine, but on a faster timetable, with less consideration for future depletion.  This article from the Dallas Fed is similar; though it says that it will be difficult for oil to stay over $100/barrel in 2008 dollars, they have a ten-year horizon on that forecast.  Hey, even I think that oil will drop below $100/barrel within 10 years.

5) Now, there is demand destruction.  We are already seeing it in the UK.  We are not seeing it in China, yet.  Part of the difference has to do with China subsidizing gasoline, which blunts the market effect.

From this article, within a year gasoline demand is pretty inflexible with respect to price.  Beyond one year, people adjust their behavior.

And, it is worth noting that OPEC thinks demand in the US and globally is shrinking.  They are probably right, though the effect on price is problematic, because many oil producers can’t produce what the used to — Mexico, Venezuela, Indonesia…

6) Now, this article indicates that changes in demand for oil have been more significant than changes in supply.  Whether that will be true in the future remains to be seen, but as the rest of the world gets better off, they will demand more energy.  A wealthy life is energy-intensive.

7) Inventories are light compared to average, but I’m not sure that is as big of a factor as many indicate.  At the edges when inventory is close to capacity, or when it is close to running out, that has a big impact, but in the middle zone, the impact should be modest.

8) When I read this summary of a speech by Donald Kohn, I concluded a few things:

  • The Fed is stuck.
  • Because the Fed is stuck, it will let things drift for a while.
  • A certain amount of idealism is waning inside the Fed, with a creeping suspicion that they aren’t wizards, but only sorcerer’s apprentices.

9) It has been a long term theme of mine that the oil that is easiest to refine would get relatively more scarce.  This article from Naked Capitalism is another demonstration of that.  And, for those who want a stock pick, that favors Valero, which can refine the heavy and sour crudes.

10) A large part of the US current account deficit is the increase in the price of crude oil.  Eventually, the decline in the US Dollar will stimulate exports, but for a while, the J-curve effect remains in place, and the Dollar takes a beating.  That beating isn’t happening at this instant, but it has gotten hit over the past several years.  I’m not sure that this recent rise is the reversal, but there will come a time when the current account normalizes.  Hopefully other nations will liberalize trade; that would do it in its own.

Full disclosure: long VLO

PS — I am market weight in energy stocks.






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8 Responses to Ten Notes on Crude Oil: The Fixation

  1. Mel says:

    The eleventh note should be that there will be more energy/oil wars–Iraq is just the first one this go around. Too much money and too many resources are now in the hands of defenseless sovereigns. The US and China will use their military might for energy–as will local “liberators.”

  2. dblwyo says:

    That’s a good survey. My view is that more than sufficient reserves are available but existing ones are aging and declining due to under-investment. And that the potential new ones are trapped behind political barriers that prevent appropriate investments in exploration and production. As a result we’re going to be on the ragged edge of S/D imbalance for a long-time until a concerted effort is made to transition to alternatives – which will take $Bs and decades if we muster the will. If you’d like the back readings, sources and analysis try these three blog posts:
    Energy & Oil:
    Oil Industry I: Prices, Fundamentals http://tinyurl.com/5wxuo9
    Oil Industry II: LT Supply-Demand, Outlook http://tinyurl.com/5jcah5
    National Energy Policy: http://tinyurl.com/5kcv6a

  3. Markus says:

    David, very good summary of this complex matter, e.g. nobody mentions that higher margins are hurting shorts, too. In general there is a lot of oversimplifcation and populism and few analysis in this issue (yet). I think what we see now is exactly the scenario H.W. Brock from Strategic Economic Decisions described in his report in September 2005. http://www.sedinc.com/fileadmin/user_upload/pdfs/energy2005.pdf)

  4. jack carter says:

    Interesting post and likely correct as far as it goes. What you did not say is that the dollar will continue to be hurt by inflation imports until the economy is slowed and inflated, nor did you note that the coming Congress will likely force the Fed’s hand by continuing to run deficits that will be large, intractable and probably can be sterilized. The net effects are: energy prices will rise until the Marginal supply = Marginal demand at the relevant prices (which change but the market knows). Demand destruction is possible and is now happening and slowing demand for fuel – slowing growth further. It will induce employment problems. We call this a decaying series. A ruin path.

  5. crzyeye says:

    you said it yourself “subsidized across much of the world” and look here at home. The demand is not there at higher prices. look at the spread of oil and retail prices or the 123 crack spread. looks likes refiners are eating the cost and subsidizing demand.

  6. Mysticdog says:

    “It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).”

    Not to mention unscrupulous economists…

    I mean, be a litle realistic here. Breaking swings down into percentages or comparing to other commodities are both invalid approaches to the oil market- this is not a commodity where production prices and availablity have wild swings. Weather less than hurricane intensity just doesn’t affect this commodity much – even major changes in winter heating or summer cooling hit oil prices far less than a drought or bumper crop affect animal or vegetables.

    Break open the records for who is buying oil futures, how many are buying, and how much is getting resold to other “investors”. That is where speculation would be seen, if it is there.

    There is no “free” market for oil, and it doesn’t take a conspiracy for a bunch of independent actors to create a bubble.

  7. Bingo7 says:

    Nice survey, I would add a few things:

    1) The price that gets reported in the papers is WTI or Brent, sweet light crude, but the vast majority of crudes out there are neither light nor sweet. Heavy crudes require complicated refineries to be transformed into gas, diesel, kerosene–the profitable products. (Sometimes, as with some Venezuelan crudes, the refinery needs to be specifically retooled in order to handle the crude, becoming basically a that crude only refinery.)

    There are not too many refineries in the world that can handle heavy crudes, which sell at a large discount from WTI, in fact you might say there’s a shortage. This is one reason that Iran is sending their heavy crude production into storage in tankers in the Persian Gulf. However, there are many complicated refineries coming online between 2008-2012, a partial sample would be Jamnagar, Jubail, Yanbu, Sosan, and Fujian (Exxon/Saudi Aramco/CNPC refinery expansion in Fusou, if I remember correctly) which alone would account for additional capacity of over 2 million b/d. That’s 2 million that can handle complicated crudes. If demand slows enough, that should put the market back in balance–for a time.

    2) Crzyeye is right … refiners are under a lot of political pressure just now and appear to be reluctant to pass costs on to consumers. Witness the pretty prominent API ads all over pointing out that ownership of oil companies is pretty broad, deep, and diverse. Even though folks poo poo the notion, oil companies are well aware of the dangers of nationalization and have basically the worst public image possible for someone to remain in polite society.

    But over 25%–likely much more, but this is what I added up from big consumers–of worldwide demand is directly subsidized. The two countries with the largest demand growth–China and India–both regulate prices to reduce the burden on consumers. All governments are getting nervous about the situation and remember that over 70% of world oil reserves now held by national oil companies that will not let market forces prevail if it is politically inconvenient to do so under all conditions.

    3) The high price environment will drive investment in alternative technologies, etc., but the time line on that is quite long, and the number of Americans who are seeing whatever disposable capital they had left completely disappear is going to be high. Bad news for the economy generally and ultimately for the oil producers. The number of pedestrian-friendly, mass-transit equipped, cities west of the Mississippi can be counted on one hand. It is almost insurmountably difficult to reorganize them efficiently.

    Populations in the big producing countries feel even more entitled to cheap energy than we do in America–which is part of the reason, for example, that Iran is facing a gasoline shortage–and many of the big producers are also big consumers (for example, Saudi Arabia consumes well over 1 mb/d), don’t expect any let up in demand from that particular demographic.

    Given that subsidized energy kind of acts like a universal micro loan and that nearly all emerging nations have them, they will likely subsidize as much as possible until their currencies come under pressure deemed dangerous. Kind of like a game of chicken.

  8. Walter O says:

    I found your site and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you down the road!

    I can not agree with you in 100% regarding some thoughts, but you have got a good point of view. Thanks for your thoughts.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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