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Oil: you ain’t seen nothing yet

July 31st, 2008 · 3 Comments

There is a large distinction between the short-term and the medium/long-term outlook for the oil market. Short-term, as we predicted, decreasing demand for oil has cooled the market. Mid to long-term, things are quite different. And mid-term might mean things could become really scary from 2010 onwards, according to a new study.

Demand for crude is going down in the rich countries

  • Oil fell more than $4 a barrel to below $121 on Tuesday, touching the lowest price since May, as signs of weakening demand outweighed a disruption to Nigerian oil output.
  • The chief executive of BP Plc Tony Hayward said on Tuesday he saw demand destruction of 5 to 10 percent for gasoline in developed OECD economies, as people drive less due to high fuel prices.
  • The Energy Information Administration said on Monday U.S. oil demand in May was 660,000 barrels per day less than previously thought. A separate government report said motorists were driving less.

This is not surprising, we argued on July 7th that prices were high enough to start having meaningful effects on demand (and this is reinforced by the weaker economic conditions).

However, the good news is not going to last:

  • When the rich economies recover, demand for oil will go up again
  • Demand in populous developing countries (China, India, etc.) has not really budged and will continue to rise as unprecedented amounts of people aspiring middle-class life styles will be able to afford that in coming years.

In addition to cyclical factors, there are structural factors at work that prevent higher prices from taking full effects:

  • Many developing countries subsidize fuel, shielding consumers from the price rises and the true cost of energy
  • Many oil producing countries do not invest nearly enough in new capacity.

The first makes whole swats of the world less price sensitive, the second is equally serious. Now, normally, an economist would argue that higher oil prices mean better prospective returns for those necessary investment to expand capacity.

Not so according to a rather alarming new study from the Dutch institute Clingendael (one of the authors was a former colleague, actually):

  • Until recently, the oil price was largely underpinned by the marginal cost of the last barrel needed to match demand, with some political and economic conjuncture mark-ups or -downs. As will be presented in this paper, the current high oil prices are still primarily driven by structural factors that can be well explained without resorting to blaming speculative investors playing the futures market or the low dollar.
  • But if prices are heading towards $200 a barrel in 12 months’ time, or for that matter even to $150 a barrel, other drivers will gain prominence over marginal costs as the main driver. In that case, OPEC will have accomplished a long-held wish: oil will then be priced at its real value in the Western world (for instance the economic value of mobility for consumers, or the value of plastic components or cargo transportation).
  • Such a new price regime, pricing at the “User Value”, also implies that the oil price will not necessarily invite new supply into the market, since income requirements of producing countries (especially OPEC member states and Russia) will be easily met through price rather than volume. In such a world the current economic logic that crude oil prices tend towards the marginal cost of supply will no longer hold true.
  • Oil will no longer perform as a commodity but will instead be priced for its economic and strategic value, with the User Value of oil further divorcing cost from price. A CIEP analysis of the recent development of demand and supply for crude oil indicates that the mismatch in supply and demand growth could cause tighter oil markets than we already experience today. In the World Energy Outlook 2007, the International Energy Agency (IEA) warned of a possible ‘energy crunch’. But what was anticipated to happen in the first part of the next decade has been fast-forwarded to today, more than 5 years earlier, and could shake the very foundation of our energy systems if no action is undertaken.

Now that’s a scary prospect. If oil prices rise to $150-200, it’s so high that most of the producing countries basically have a printing press in place, gushing so much money that they will swim in it, rather than investing it to increase capacity, which will increase supply that will bring the price down.

How likely is it that prices will go to $150-200? Very likely, according to that same report:

  • A CIEP analysis of the recent development of demand and supply for crude oil indicates that the mismatch in supply and demand growth could cause tighter oil markets than we already experience today. In the World Energy Outlook 2007, the International Energy Agency (IEA) warned of a possible ‘energy crunch’. But what was anticipated to happen in the first part of the next decade has been fast-forwarded to today, more than 5 years earlier, and could shake the very foundation of our energy systems if no action is undertaken.
  • The current high oil prices are still primarily driven by structural factors and can be explained without resorting to throwing blame at speculative investors playing the futures market or at the low dollar. Prices are mainly driven by the supply and demand imbalances and the fear that these will further deteriorate in the next decade
  • Until recently, the oil price was largely underpinned by the marginal cost of the last barrel needed to match demand, with some political and economic conjuncture mark-ups or -downs. This currently puts a structural floor of $110 a barrel under the oil price (WTI)
  • The largest part of the $110 a barrel floor (about 70-75%) is determined by the marginal cost of supply, currently about $80 (building block 1). The remaining $30 a barrel (or 25-30%) is determined by supply-demand fundamentals, a short-term risk premium, and long-term scarcity and policy (building blocks 2, 3 and 4). Percentage wise this distribution among building blocks has not changed much since 1990, whether the oil price was $15 a barrel, $20 or higher
  • Since the 2nd quarter of 2008, oil prices have started to deviate from this commodity driven price regime. Recent predictions of Goldman Sachs, OPEC and Gazprom expect that prices could increase to $200-250 a barrel in 2009.

And for relief, we do not have to count on increasing capacity any time soon, as argued above. Extra energy capacity will have to come from new sources outside OPEC and those countries still willing to invest substantial amounts in developing new resources.

We didn’t set out to write with the following purpose in mind, but this actually underpins nicely two of the companies we feature here on this site, Trina Solar and InterOil.

Tags: The Markets

3 responses so far ↓

  • 1 Jim Tate // Jul 31, 2008 at 4:43 pm

    This article I agree with 100%. Oil may be in the $140 as soon as this fall and NG in the $13 in the US this fall, All per GS which I agree with. I think your picks are right on and I have invested accordingly. Well that is I continue my commodity loaded investments for the last 5 years…Even use margin sometimes to play this better. Good Stuff STP..

  • 2 Jan Tort // Jul 31, 2008 at 4:59 pm

    Indeed, I follow ur picks and never a bad trade. You are the man!

  • 3 High energy prices are here to stay // Sep 5, 2008 at 5:59 pm

    […] These are uncomfortable stylized facts about the energy markets and they will virtually guarantee that whatever correction we now have on the basis of weakening economies, it won’t last. High energy prices are here to stay. (We had an earlier entry on the topic, you can read here) […]