Crude Oil $130 and Beyond
Commodities / Crude Oil May 28, 2008 - 07:50 PM GMTBy: Roger_Conrad
Markets have a way of humbling even the most prescient prognosticator. That's definitely been the case for oil this decade.
There have been perfectly good reasons why oil prices couldn't break, let alone hold, every perceived milestone it's hit and passed in recent years—from the $20 level taken out in the run-up to the Iraq war to the $100 mark burst through this year. But even with a lot of very smart people betting against it, black gold has pushed on through, and the next impassible point has been shoved higher still.
One of the early bear arguments against oil was its potential to slow the US economy. Some expected every upward burst earlier this decade to sow the seeds of its own reversal by slowing the US economy.
As it turned out, oil's strength had a wholly unexpected impact. In 2003, 2004, 2005, 2006 and again in 2007, interest rates spiked higher in the spring and summer months only to come down hard in the fall. Each time, the action was more volatile and dramatic.
Last year, the 10-year Treasury note yield—off of which virtually all income investments benchmark—reached its highest level yet for this cycle, moving above 5.3 percent. And its drop over the past nine months has been equally dramatic, falling to its lowest level for the decade well under 3.5 percent.
Rising market interest rates, of course, have historically cooled off overheated economic growth. As the decade has progressed, however, each spike has come with oil prices at a successively higher level.
Rising oil prices also depress economic growth because they prevent consumers from spending on other things and jack up costs on businesses. The result is double jeopardy for the economy and a much greater impact on growth because oil has reached a higher benchmark price.
Up until 1950, America produced all the oil it needed within its own borders. That was a decisive advantage in World War II, when Nazi Germany was forced to invade oil fields far to its east to keep its war machine going. Imports moved steadily higher in subsequent decades. But even during the oil embargoes of the 1970s, the US had a secret weapon: We were the major global market for oil.
No matter what was happening on the geopolitical scene, it was in the producer nations' interest to keep the US economy healthy and using oil. There were always the bomb throwers among the Organization of the Petroleum Exporting Countries (OPEC) nations, who wanted to push up oil prices high enough to really cripple the US and, to a lesser extent, Europe. The Saudis and their allies, however, always acted to prevent that from happening, understanding that doing so meant mutually assured destruction and the end of the gravy train.
Eventually, as is the case in every commodity cycle, the consumer nations (mainly the US) changed their behavior in the face of high prices. That resulted in permanent demand destruction in the late '70s and early '80s through a switch to alternatives and simple conservation by driving smaller cars. And high prices also encouraged investment to boost production, which paid off with the development of the North Sea.
Permanent demand destruction and new production will ultimately be the case with this oil market cycle. What's different this time around, however, is permanent demand destruction in the US is no longer enough. The US is still the most important market for oil. But it's no longer the only one, and it's becoming progressively less important every day in setting global prices.
Already this decade, we've seen China and the US reverse roles in copper demand. As recently as 2002, the US made up more than a quarter of global demand for the red metal, with China coming in at about 12 percent. Today, China consumes close to 27 percent and the US is only around 12 percent.
That dramatic switch isn't due to significant changes in the US. Demand has dropped some as housing starts have fallen off over the past year, but copper remains an essential material in many areas of industry. Rather, it's due to massive demand growth in China, which continues as that country upgrades infrastructure and deals with unprecedented migration of tens of millions to already infrastructure-challenged cities.
The same dramatic upturn in demand is happening for a wide range of other vital resources. Oil will take longer to turn because of the size of the market and the huge amount we use in the US. But unless there's a major break with current trends, sometime in the next 10 to 15 years, China will begin to consume more oil than we do.
When the US was the world's dominant copper consumer, our level of economic growth basically set the price. The red metal earned the moniker “Dr. Copper, the only metal with a PhD” because its price moves tended to presage the level of US economic growth. Higher prices meant faster growth, while lower prices forecasted slowdowns.
When the US economy began to slow in mid-2007, many mistakenly assumed that copper prices (and copper stocks) were going to head lower in a big way. One of the biggest shocks of recent months has been they haven't. In fact, global demand for the red metal has remained solid, and many copper mining stocks, such as FREEPORT MCMORAN COPPER & GOLD, have recently made new highs.
The upshot: The US is no longer the world's major market for copper, and therefore, it no longer sets the global price. And as the global demand profile for other vital commodities—including oil—inevitably shifts that way, their prices will also be increasingly set somewhere else.
When the US was the dominant market for commodities of all stripes, our level of growth was a natural check on resource prices. When commodity prices spiked up, our growth slowed. This, in turn, brought down demand for commodities and finally prices, which gave the economy a shot in the arm.
That relationship no longer exists for copper, and it's increasingly weaker for oil as well. What that boils down to is that sluggish economic growth in the US is no longer a major threat to oil prices, unless it spreads elsewhere.
The oil market is going to continue reacting to every indication that the US economy is or isn't slowing. But until or unless that same weakness starts to show up abroad, it will be just a lot of splashing around. And oil prices will continue to hold up and probably go higher.
THE DOLLAR, SUPPLY AND OTHER ISSUES
In today's Wall Street Journal, there's an editorial basically blaming oil prices' rise on US government policy promoting a weaker dollar. Oil is still priced globally in US dollars. But the quadrupling of its price in euros this decade is less dramatic that the sixfold or so increase in the US dollar price.
By this rationale, oil prices could be reduced considerably simply by a coordinated US government policy to strengthen the long-suffering greenback. And black gold's weakness at certain times in recent months when the dollar has strengthened seems to back this up.
Ultimately, however, engineering this kind of turnaround in the dollar would require some considerable boosts in interest rates to make US bonds—for example—more attractive to foreigners. Such a policy was one of the reasons for the dollar's dramatic strengthening in the early '80s. It came at the price, however, of the worst recession since the Great Depression, not only in the US but around the world.
There's also a very real question about whether such a policy would have any permanent impact on either oil demand or prices. When then-Federal Reserve Chairman Paul Volcker jacked up US interest rates in the late '70s and early '80s, the US was by far the most important market for almost every major vital resource, particularly oil. There was no other major driver of demand. In fact, demand collapsed almost everywhere else because of the combination of a global recession and a sharply higher price for oil in US dollars.
Even then, though, it took until 1985 for the Saudis to abandon their role as swing producer of oil, sending prices meaningfully lower at last. Moreover, even in the depths of the early '80s global recession, Chinese demand continued to rise.
The bottom line: A high US dollar policy to bring down oil prices would likely bring even worse consequences to the economy at large. Rather, a weak buck is likely to remain part and parcel of this commodity bull market as long as it lasts, just as was the case during the '70s.
The discovery and exploitation of new sources of supply is a necessary element of ending every commodity bull market. And bringing oil's rise to a close this time around will definitely require major moves on this front.
Unfortunately, it's increasingly looking like this is going to be an even bigger challenge this time around than it was in the '70s. This week, the Energy Information Administration (EIA) revised its estimates for future global oil production dramatically downward based on a wide range of factors. The upshot was to raise serious doubts about whether producers could continue to cover current demand, let alone projected increases as countries such as China boost their per-capita consumption closer toward developed world levels.
I'm basically ambivalent when it comes to theories about “peak oil.” We heard much of the same during the '70s from organizations such as the Club of Rome, forecasting the world would run out of certain vital resources with disastrous consequences.
There's no doubt there's been a worrisome decline in output at some of the world's most-important fields, notably Mexico's Cantarell. And there's considerable doubt whether secretive nations such as Saudi Arabia really have the capacity to boost output meaningfully in coming years.
It's also true, however, that there are still significant new sources of hydrocarbons in areas that were uneconomic to exploit just a few years ago. The massive development of Canada's oil sands this decade is one example. So is the Tupi Field off the coast of Brazil. And there are numerous potential reserve finds off the coast of Africa, in Asia and even in the continental US, as shale formations are explored and technology makes it possible to tap them with fewer environmental consequences than in the past.
The common element of all these new sources, however, is they're far more expensive than the reserves the world has been using to date. That means they're only going to be tapped into if oil and natural gas prices are at very high levels.
The Syncrude partnership, for example, is Canada's biggest oil sands producer today, and there are plans to boost output significantly in coming years. The Super Oils that developed it, though, were only willing to make the investment as a group, which limited the financial risk for each partner. And that's generally their current position, particularly as costs have basically risen with output.
PETROBRAS, developer of the Tupi Field, must drill through a mile of salt, after first going well below the ocean floor, before it can get one barrel of oil out of this potentially extremely prolific find. Fortunately for the company, it has full backing from the Brazilian government and some pretty strong partners in CHEVRON CORP and others. It's going to need a lot of that support if this find is going to produce to its promise.
The bottom line is none of these resources is going to be developed unless oil and gas prices are at very lofty levels. In the end, today's high prices will drive down energy prices by boosting production from these sources. But it's going to take time and a lot of money before significant new supply comes onto the market.
Finally, there's the question of how much speculation is in this oil market and how vulnerable prices are to its unwinding. This, of course, is one of those imponderables.
For one thing, there's always a lot of speculation when a particular market is moving higher (or lower) in dramatic fashion. Most of the speculators wind up getting burned, regardless of which way they're betting. But that eventuality doesn't dampen the appeal, and the result is a lot of volatility and, therefore, opportunity to speculate.
Some technicians have tried to quantify the impact on oil prices from speculation, and numbers range to as much as $50 a barrel. It's important, however, to realize why such a premium may exist. Basically, a big premium is a bet that something out of the blue will happen with oil supply somewhere in the world that will send oil prices markedly higher.
Even in the '90s, there were events that interrupted supply. One difference today is that producers are being forced to go to ever-more remote locations to boost output, which by definition are more vulnerable to supply interruptions. Another is that supplies are so tight that even the smallest source has an impact on the overall market.
During the '90s, for example, supplies were loose. Interruptions in production because of violence in Nigeria or a strike in Ecuador occasionally had sharp impacts on prices. But they were always short lived and reversed just as dramatically.
Threats to supply today have such a dramatic impact precisely because supplies are stretched. Speculation is an important influence on prices, precisely because of this event risk. But it's not going to simply go away at the wave of someone's magic wand. Rather, it will become less important at the same time supplies loosen up and the commodity bull market ends. Until then, it's going to be popular and create a lot of volatility.
So can $130 oil last? No market moves in a straight line, and the gains we've seen in recent months have been dramatic to say the least. My view is investors should expect some kind of pullback in the coming months.
If and when that occurs, we can expect to hear a lot of cheerleading in the financial press. That will be particularly true if it happens coming into the November elections because of the financial media's strong bias toward a Republican victory. And, coincidence or no, we did see oil prices come down rather significantly in the months before the November 2004 presidential election.
If that does happen, it will be critical for investors to remember one thing: This long-term energy bull market will remain in place until we see real, permanent demand destruction worldwide and significant new supply.
As of May 2008, there are some signs of progress. This week, FORD MOTOR CO announced a major shift in its product line away from trucks and toward cars. That accompanies big moves by other auto companies around the world to roll out hybrid vehicles for popular models.
Electricity production outside of fossil fuels continues to advance globally, as wind and nuclear plants go up worldwide and solar energy supplies get cheaper. And production of unconventional fuels is accelerating.
Consumer nations, however, are still a long way from where they need to be to tilt the global supply/demand balance back to their favor. That's a process that's going to take years and a lot of money. And any near-term drop in oil prices—whether because of government intervention or slower-than-expected global economic growth—is only going to prolong that process.
I'm certainly not averse to taking profits on certain positions that have run. Anyone who is overweighted in any particular stock that's soared is certainly a good candidate for taking some money off the table here. And this is a bad time for Johnny-come-latelys to this bull market to try to make up for lost ground.
The bottom line here is that the long-term underpinnings of this energy bull market still aren't being threatened in a meaningful way. There are plenty of ways to lose money: getting too fancy with leveraged positions, buying into overhyped stocks, making bets that involve the health of less-transparent enterprises, responding to “invest now” solicitations over the phone or in the mail—all the classic loser trades of the last bull market.
Positions in strong companies, however, still look to be heading a lot higher in coming years. That includes Super Oils such as Chevron, Canadian royalty trusts that are only now starting to benefit from higher energy prices as they transition lower-priced for higher-priced selling contracts, rising profile producers such as CHESAPEAKE ENERGY or utility/producers such as MDU RESOURCES.
These are the kind of investments you want to keep hitching your wagon to in the coming months. They're not immune from a near-term drop in oil prices because of ephemeral factors. But they'll hold their own, and that will be the time to pick up more.
Again, this thing will have its ups and downs, and $130 or even $120 oil may not hold for long. But as long as the long-term fundamentals are in place, this has a long way to run. And the real beauty is all you have to do to play is buy-and-hold quality stocks.
By Roger Conrad
KCI Communications
Copyright © 2008 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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