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Oil Prices are Wrong--Very Wrong

And the Buying Opportunity of a Lifetime is Soon

Written by Brian Hicks
Posted December 24, 2008

Everybody seems to have the same question for me lately: What's the deal with gasoline prices?

How could it go from $2 a gallon to over $4 and then back to $1.66 in a single year? Was it speculators? The evil machinations of OPEC? Badly-timed fills and draws of the Strategic Petroleum Reserve (SPR)? A financial calamity engineered by the masterminds of a shadowy wealth conspiracy?

It's never an easy question to answer, but I can easily say "none of the above."

The price of oil and gasoline is set daily and globally by a complex interaction of many factors, including the relative valuations of currency, speculation in oil futures, the fact that oil is "priced at the margins," delayed supply and demand feedback to the market, economic growth rates, money flows of hedge funds and big institutional investors, geological factors, geopolitics, and many more.

Oil shot to $147 this year because of a particular highly-leveraged alchemy of those factors, and it fell as the leverage unwound. It's down now because the world is heading into a major recession and traders are, as usual, overdoing their bearish reaction.

OPEC's responses this year have been mostly late to the game, so they were regularly ignored by the market. Last week's production cuts by the cartel, and the subsequent sell-off in oil, was a fine example of this.

Filling the SPR is too negligible to move the markets either. In May, the debate over filling the SPR raged on with hardly anyone seeming to realize that its 68,000 barrels per day of demand is a mere blip against the US consumption of 21 million barrels per day. Traders ignored it.

Much more to the point is an analysis of over 100 studies on gasoline price elasticity by the trade magazine Energy Journal, which found when gas prices increase 10%, they cut demand by 2.6%. When prices fall, consumption picks back up.

Anatomy of a Frenzy

Oil and other commodities shot up in the first part of the year as investors sought a safe haven against the financial calamity stemming from the subprime meltdown and levered up their bets with wild abandon.

That trend reversed course in June as the world's central banks began cutting interest rates and the US flooded the markets with dollars. The global deleveraging that ensued caused a rout in the commodity markets, and absolutely everything was sold indiscriminately as money managers scrambled to meet redemption calls and raise cash.

The progressively worsening news about the health of the global economy has only fed the selling frenzy, pushing down oil prices further still. It's now more profitable to store oil than to sell it immediately, and OPEC has made yet another belated and ineffectual move to curb a supply glut.

The Asian tigers that were widely expected to support demand, even as OECD demand fell, have reported extremely bearish numbers in the last week as their economic growth stalls.

Oil consumption is off 3.2% from a year ago in China, the world's second-largest consumer of oil, and its crude imports are now at their lowest levels this year.

Japan's oil exports fell to record lows in the sharpest monthly decline since such records have been kept; meanwhile, imports to the world's third-largest oil consumer are down 17% year over year. South Korea's oil imports are also down 6.5% year over year.

Oil consumption by the world's top oil consumer, the US, has led the global decline with an expected 1.2 million barrels per day decline from past levels through 2009, according to the latest EIA report.

And voila: after thirteen straight weeks of price declines, gasoline is back to $1.66 a gallon.

Some have even suggested that oil in the $40s, and the current glut of oil supply, is proof that fears about peak oil supply were wrong.

Nothing could be further from the truth.

A False Sense of Complacency

A sub-$40 fill-up only lulls us into a false sense of complacency. As I have written repeatedly in recent weeks, we are setting ourselves up for a serious supply problem in the future with oil prices now below their replacement costs.

The facts are sobering:

  • Current petroleum stocks in the US are still within the average range for this time of year, according to EIA. They're now about 8% higher than this time last year, but that's really nothing to write home about, and it's not much of a "glut."

  • In a recent interview with Jim Puplava, energy analyst Robert Hirsch commented that a 1 million barrels per day decline in world demand would only move back the global peak of oil production by one month. By that metric, the allegedly huge cutback in oil consumption has bought the world about one month more before we peak—whoop-de-do.

  • Oil production in Canada, the US's top source of crude imports, is faltering as prices are now too low to justify new projects that tap its large-but-costly and difficult reserves in tar sands and heavy oil.

  • Our number-three source of imports, Mexico, is in serious trouble. Crude output from our southern neighbor has fallen 7% over last year, and exports are falling much faster, at a 20% decline, according to Pemex. (As I wrote back in June, exports fall faster than overall production. See "The Impending Oil Export Crisis.") Production from its largest field, Cantarell, one of the four "supergiant" oil fields in the world, is crashing at the rate of 33% per year. At the current rate, Mexico's oil exports will cease altogether in just seven years.

  • Experts at the ASPO and elsewhere believe that, within the next two years, world oil production will go into permanent decline, with depletion removing 2.5 million barrels per day from the world market— that's roughly equivalent to the total oil imports of Germany. There are no oil projects that can overcome a decline rate like that. And yet, no major economy is even preparing for this inevitability.

  • Saudi oil minister Ali al-Naimi has warned that the world needs $75 oil to ensure future supply, and that current prices "are wreaking havoc on the industry and threatening current and planned investments."

  • With gasoline now well below $2 a gallon, hybrids and other higher-efficiency cars are staying on the dealer lots. According to an analyst at Edmunds.com, a new hybrid would pay for itself in gasoline savings in two or three years with gasoline at $4 a gallon; but, below $2 a gallon, it's more like seven to eight years. Less than a year ago, you had to get on a waiting list and pay a premium over sticker to buy a new Prius. Now dealers have lots full of them, and Toyota has experienced such a sharp decline in sales that it posted its first operating loss in 70 years. Hopes that we will quickly replace a large percentage of our rolling stock with higher efficiency vehicles are now on hold, along with the hopes for a massive campaign of drilling shale formations and deepwater reservoirs.

  • A steep contango condition in oil futures is still in place, reflecting the market's near-term oversupply and long-term uncertainty.

Given the evidence, the price of oil is wrong. Very wrong. Crude for under $65 a barrel is a bargain, and crude in the low $40s is a steal. I would not be at all surprised to see a sudden and violent move back up for oil prices within the next year, once the current extreme market conditions revert to the mean.

I am still long oil (United States Oil Fund LP ETF, NYSE:USO) and will add to my position if it goes lower. My expectation is to hold it for a year, in case it further overshoots to the downside before recovering.

I'm also on the hunt for top-notch oil companies with low production costs, sizable reserves, and balance sheets healthy enough to let them acquire smaller competitors at basement prices.

I know it's been a tough year for most investors; but, we're nearly done with this turkey, and I'm setting my sights on profits for 2009. The buying opportunity of a lifetime is upon us. All we have to do now is wait for the right moment to pull the trigger.

Here's to a restful and joyous holiday!

Until next time,

Chris

Energy and Capital

P.S. Although oil prices may not have bottomed yet, that doesn't mean investors should sit back and be lazy. The problem is that the window for finding those up-and-coming energy stocks is running out. Many of your fellow Energy and Capital readers have already begun to prepare their portfolio for oil's comeback. Perhaps it's time you joined them. Click here to learn more about the $20 Trillion Report.

 

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