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.