Sunday, May 16, 2004

The Price of Oil ... Crude Cents

As I stated in my previous post, I will be exploring the rammifications and dimensions of the market correction activity about to take place. What I should have also added is the idea of being ahead or behind the curve. As Brad Delong notes, The Economist has suggested that according the Fed Statements that it is deliberately trying to avoid the situation of 1994 when it raised rates quickly and was ahead of the curve. However the real truth is that now that the imbalance in the system unless structural changes take place, the only real choice is which poison is preferable. A sharp rise in interest rates would lead to a currency stabilization:

The Chinese authorities are attempting to restrain and redirect the flow of credit by fiat, because they are reluctant to raise its price. Some media reports had suggested that they might raise interest rates for the first time in nine years as soon as the Golden Week holiday ended last week. But raising rates could break China’s brittle state enterprises and lure in more speculative capital from abroad, exacerbating the overheating problem. China’s monetary policy must also be guided by the need to maintain the yuan’s peg to the dollar. Until Mr Greenspan raises interest rates, China’s monetary authorities will find it difficult to do so. His stately calm, then, is one reason for their frantic hyperactivity. [emphasis added]

As I've suggested, China must choose between maintaining its currency peg or tightening its monetary supply. So long as the Fed delays, then the Chinese must be forced into this dilemma between overheating and maintaining their currency play. Given the sentiments in both nation's banking circles, the result is likely to be that the Fed refuses to move out from behind the curve and China will refuse to give up it's peg and the likely result will be inflation - overheating from the Chinese economy bleeding over as it's already starting to.

The results could be a 8-9% increase in world-wide inflation prices if the central banks of the world are able to keep their grip on affairs and survive the various bond market implosions.

If that is the case we could see a 15% rise - roughly double - in the valuation of gold and oil. If the currency collapse and market debt crisis option were to arise, we could see that the valuations rise 25% or more. However assuming the discipline of central banks, we'll go with a prediction of the 15% rise scenario.

This NYT article will be an intro to kick off the general discussion of the fundamentals of the oil business with "Why prices won't fall".

Two dollars for a gallon of gas? Get used to it. High fuel prices are here to stay, at least for the near future, because no relief is in sight for tight oil supplies.

Most oil-producing countries and the major oil companies already produce all they can. Smaller companies and wildcatters are reopening some mothballed wells, but their combined output is not nearly enough to affect the global supply. What little spare capacity there is is almost entirely in Saudi Arabia, which is willing to pump more — but the extra oil it could produce quickly is too heavy in sulfur for the main consuming nations.

The world economy has learned to roll with oil price spikes, so long as they are short-lived. But sustained high fuel costs will strain its ability to cope, experts say, and the current run-up is already starting to bite.

Wal-Mart Stores, for example, said last week that higher gasoline prices in the United States had taken an average of $7 a week out of the pockets of its customers, leaving them less to spend on other goods. Sales of some of the largest and most gas-hungry sport utility vehicles were down last month, compared with a year earlier. The nation's trade deficit widened to $46 billion in March, largely because of oil imports. And in Britain, the government is making contingency plans in case of mass protests against high fuel prices, the trade journal Platts Oilgram News reported Friday.

The oil industry is constantly looking for new supplies, and with crude oil closing at a record high of $41.38 a barrel in New York on Friday, producers have plenty of economic incentive to step up output. But developing a new oil field takes time, and energy companies can do little to rush projects, industry experts said.

Marathon Oil, a large independent company based in Houston, is pumping its fields flat out — the equivalent of 365,000 barrels a day, counting crude oil and natural gas. That includes new fields in Russia that produce 15,000 barrels a day. Those fields have the potential to yield an additional 45,000 barrels, but only after five more years of investment and work, said Paul Weeditz, a company spokesman. Marathon's new projects in West Africa will take even longer.

"Companies are always under pressure to grow production, so they are always trying to bring new wells on," Mr Weeditz said. "Many people may think it's a matter of turning the tap on and off, and that there's excess capacity, but that's just not the case."

Major oil producing areas like the North Sea and Nigeria, which produce the most desirable type of oil, known as light sweet crude for its low sulfur content, are operating at capacity. So are many of the refineries that turn the oil into usable fuels.

United States refineries were running at 96 percent of maximum output in April, the Energy Department said. As a result, wholesale gasprices reached record highs last week, and those prices are quickly passed along to consumers at the pump.

"The worrying part is that no end is in sight for the oil price rally," said Jan Stuart, director of energy research at Fimat USA, the brokerage unit of Société Générale. "Whatever is driving this upward, those factors are not changing: high demand, lower inventories, supply that is constrained, and only in part by OPEC decisions, and turmoil in the Middle East." [emphasis added]

Now remember the market factors are separate and additive to the fundamental factors. If Oil remains at about $40 pb light crude then a 15% price rise over a year due to inflationary factors would mean $46 pb light crude by the end of 2005 - nicely right around my earlier estimate of $45 pb in light crude futures. If the 25% option hit with maximum "perfect storm" market correction then we could see $50 pb light crude by the end of 2005.

Why only 15% if there's a collapse? As The Economist notes:

Some fear that China is destined for a hard landing. The growth in credit is unsustainable. Either it slows at the behest of China’s authorities, or it will collapse of its own accord. Given that China accounted for about a third of the growth in the world economy over the past three years (in purchasing power terms), a credit crunch in the Middle Kingdom could also spell trouble for lands to the east and west. Still, if China’s growth does sputter and stall, it will at least take the pressure off the oil price.

However the choice isn't between China getting a hard landing and a sustaining of the current situation. If China get's a hard landing then inflation wins and prices - including that of oil - will go up. As I said, maybe 8-9% world-wide. But the especial problems in the debt market discount for inflation and the problems in the dollar are likely to double the impact on oil. So hence the 15% number, so the real choice is whether oil futures will rise 15% or they'll rise 25% roughly - with all fundamentals staying as currently predicted. You have to remember that all modern economies - and China is becoming a modern economy - are dependent upon oil. During bad times their usage growth slows but it is unlikely to drop in real absolute and historical terms if they're continuing to develop. Even if China's economy were to contract, it is likely that the rural peasants that would be hurt the most and this squeeze would force the Chinese economy to modernize even more. There is no going back for China, and because they're going to continue using more fossil fuels we won't really see a price break even if they take a breather.

If there is a crisis in fundamental supply conditions as well, then prices could match in nominally inflated dollar terms the $60 pb price spike of the oil crisis in the seventies.

In the days to come, we'll go over the deeper fundamentals of the oil business and the likly over-estimation of known reserves, and an estimated date for Hubbert's peak. Of course people aren't going to just stop using oil, it'll just get more expensive. In addition, with the rising price of oil will come rising gasoline and also natural gas - and therefore electricity prices - barring extensive increases in coal-fired or a new generation of nucelar power plants (all many years down the road, so don't look for immediate rescues there). I also expect solar and wind-turbine alternative energy to become more cost competitive as the technology improves and the fossil fuel option becomes increasingly expensive.

I'll also discuss hybrid vehicles and their likely future, since if we could increase fuel efficiency by two or three times then we could also put up with from at least the automotive point of view gasoline that hit $4 or $6 per gallon here in the States. They're not quite ready for prime time, but in a few years both market demand and pressure from oil prices will make them viable and we could see large scale roll-outs. My kid if I ever get around to having one is likely going to get anywhere from 40 to 60 miles per gallon highway driving if you can think of that, and on the outside may 80 miles per gallon.

The problems with Detroit don't lie in the oil-futures market and that's a discussion for another time. But before I delve into all of that, let me for my next post begin the topic of the familiarizing my readers with the gold market and its relevance to what is about to happen on the world scenes ...


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