Tuesday, May 18, 2004

The Price of Oil: How much do we really have?

REGIONAL INSTABILITY OVER OR UNDER PLAYED

The price of oil really is determined by three factors: supply, demand, and the strength of the purchasing currency. Today I'm going to focus on supply issues. Predicting supply however isn't just a matter of the fundamentals of the oil market - the number of rigs drilled, the kind of crude brought up, etc. It has a number of other factors, such as security.

Right now the world-wide price premium on sweet light crude seems to be about $5-$6 US pb. That means we're paying about five or six dollars more than the what the fundamental supply-demand equation of oil would dictate in an ideal marketplace. As Sterling Newberry at BOP-news reminds us, the price of oil is highly determined by regional stability. This is because oil infrastructure is both costly, easy to sabotage, and distributed widely geographically. This makes a sort of ideal saboteur's situation.

However while many commentator's are ignoring the role of the currency depreciation while playing up regional instability as a cause (The Economist), this is a story that I've chronicled before in the rise of the price of oil and we'll be focusing on true market fundamentals in the oil supply business today.

The reason why I'm ignoring it is that it's a political question and therefore not predictable by means of economic analysis. Let me give you an example. Suppose that the Middle-east is not destabilized and the supply of oil remains secure. Then clearly the market premium for oil supplies is an over-charge. We should keep it in mind and the direction it's headed, but otherwise ignore it. Suppose the Middle-east is about to go up in flames and regimes from Morocco to Jordan to Saudi Arabia are about to fall to populist Wahabbi revolutions or widespread civil wars that disrupt the oil supply. Then no amount of premium currently factored into the market will be an appropriate "insurance" against such risk. The price of oil would have to about triple to compensate. So we should keep an eye on the political situation, but otherwise not pay too much attention to it, simply because there's nothing we can do and we can't really tell what is going to happen beforehand.

Yes, there is unrest in regimes from Egypt to Pakistan, but the problem is that there has been such unrest before. Even experts on these cultures can't predict at this time whether or not they'll remain stable, though they should be able to spot the first signs of true instability fairly well.

So what's left to analyze and predict? The real market fundamentals of the supply of oil, both short and long term, which is to borrow a phrase "knowable".

WORLD OIL RESERVES

Some people claim that there is a coming oil shortage. The matter of fact is that they're correct - in the sense that there will be a permanent shortage situation. The only question is when, and that depends on any number of things. Certainly the increase in the development of the third world especially China and India and the increase in their fossil fuel energy consumption (MSNBC) has moved the date forward of "Hubbert's peak". Reality is of course never quite as simple as a model and Hubbert's Peak has never been directly observed - for instance because of increased fuel conservation measures. (Wikipedia)

But what about absolute supply? Well absolute supply will probably peak in 2010-2020, with current estimates tending toward 2010 (CNN). The good news? The worst of the global warming scenarios may never come to pass because we run out of fossil fuels before that time. While I think they may be neglecting the problem of coal ... but let's just go with it.

Remember also that recently that some companies have been caught overstating oil reserves by over 40%! (Jane's)

The oil industry has been gripped by scandal since Royal Dutch/Shell twice this year downgraded its proven oil reserves by 20 per cent, or nearly 4bn barrels. Shell may not be alone.

Other companies and even governments have hyped up the estimates of how much oil they have, which is a vital factor in measuring their economic health. If exaggeration proves to be widespread, it would have an immense impact on the Middle East, whose economic weight is almost totally dependent on oil and natural gas.

Geologists and analysts have been saying for some time that estimates of global oil reserves may be dangerously exaggerated. If you take oil prices currently at around US$37 a barrel, the highest for nearly 15 years, US petrol prices at record levels and you add terrorist attacks and diminishing supplies, you have a recipe for inflation and economic slowdown. The question of reserves becomes a much more important factor.

Earlier this month, The New York Times reported that internal documents and other data indicated that Shell had over estimated its proven oil reserves in Oman by as much as 40 per cent. But that seems to have been done because everyone hoped that the latest drilling techniques would reach more deposits than in the past and merit upgrading the estimates of reserves.

The Oman estimates were based on assessments made in May 2000 by a senior Shell executive who was subsequently fired. He was among several executives who were said to have known about the unrealistic estimates of reserves and to have done nothing about it.

If the exaggeration is confirmed, the estimate of recoverable oil will have to be lowered. That is bad news for Oman, which claims reserves of 5.4bn barrels and is heavily dependent on oil and gas exports but it is also bad news for the world as a whole.

As the world's natural resources shrink and global warming changes the environment, competition for unimpeded access to them has intensified and will continue to do so. About four-fifths of the world's known oil reserves lie in politically unstable or contested regions.


So while we have more oil reserves and there are untapped areas - such as Antartica - but basically the story is not about global warming but that oil is indeed going to start "running out".

HOW WILL THE MARKETS BE IMPACTED?

Of course, we won't really run out - it'll just get much more expensive. What is relevant is that the lowest available price is going to move up. When can we expect it to start moving up due to irreversible supply-demand factors right-now.

Of course it won't move up in a straight line. What will likely happen is that the current price of oil will hit a peak and then back off. If the Chinese economy noticeably cools off and the American currency doesn't depreciate then the price could drop back to about $32 pb - temporarily. That would be the "buying" point or entry point to the market. The price of oil might go beneath that for people who really want to maximize buy-low, sell-high but within a year it should be close to $40 again.

In the short term, the price of oil could easily hit $45 and for real speculators might go all the way to $50 if there's some sort of international crisis this summer. However the safe bet is about $45 pb sweet light crude.

The prices in markets run in a general "S"-curved zig-zag. They rarely except in supply-shock or demand-shock situations run in a smooth curve or line.

The real movement in the price of oil in the short term will occur if the US-debt situation and the currency stability "compact" between the Fed and the People's Bank of China becomes unraveled by market forces. In order to examine that, we need to understand hard currency and foreign reserves.

For my next post I'll be discussing the Chinese situation, the influx of "hot" or "black" money as capital - much of it trying to capitalize on a repegging or depegging of the renmimbi versus the dollar. If the People's Bank of China is successfully able to fight them off and America's economic transition is relatively smooth, then the "worst" that will happen is that China will have a hard landing and there will be a slump in the price of oil temporarily as the country has a capital liquidation phase.

Of course all the speculators right now are betting otherwise, and it's an open question whether or not China will be able to maintain such a situation for long.

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