Insightful analysis and commentary for the US and global equity investor
Contributors: Douglas McIntyre Jon C. Ogg

Previous Posts

Wednesday, August 02, 2006

No Conspiracies Needed

By William Trent, CFA of Stock Market Beat

It can only be expected that people grumble about oil prices when they are high. The latest example comes in this CNN story:

Now, as budgets in oil producing countries grow fat off windfall profits and worldwide demand remains unabated, some are saying that OPEC won’t, at least in the short term, let the price of crude fall any lower than $60.

But the cartel, which like the provider of any good must balance desire for profit against the need to keep its product popular, must watch both prices and demand as the cost of oil heads toward uncharted territory.

This story, like many others we have seen, makes the erroneous assumption that OPEC still has sway over oil prices. The fact is, they don’t. When oil got slammed a few years ago to $10, the stories were about Oil Gloom in the Gulf. If OPEC had the control people believe they have, why didn’t they do anything about it then?

The fact is, oil and other commodities tend to have fairly stable demand increases. Supply, however, is another story. A large new oil field discovery or new technologies to access existing sources will quickly sate several years worth of demand, bringing prices down in a hurry. The problem, as Jeff Matthews recently pointed out, is that after years of low prices, environmental opposition to new refineries, and little love for the stocks the energy companies are still overly cautious toward new exploration.

The Investors Relations person of British So-Called Petroleum told a group of investors back then that it made no sense to plan its exploration spending based on $65 a barrel crude oil when everybody knows crude oil prices fluctuate—so BP was using a more conservative oil forecast when calculating where and how to invest its unstoppable cash flow.

How conservative? If you guessed $50 a barrel, you would be wrong. If you guessed $40 a barrel, you would also be wrong. Not even $35 a barrel would have been close.

No, the crude oil forecast British So-Called Petroleum was using in its forecasts was $20 to $25 a barrel.

The other problem is that oil tends to be in places that are politically unstable. In part it is a vicious cycle: governments dependent upon volatile commodity prices end up being volatile. In part it is location, location, location. But if you are Exxon and faced with the following choices, which would you choose:

Give $8 billion to your shareholders as dividends?
Invest $8 billion in oil-rich Venezuela where there is the risk it will be confiscated by a populist government?
Invest $8 billion in oil-rich Russia, where the largest oil company was already confiscated by the government?
Invest $8 billion in Iraq, where insurgents tend to kidnap and behead foreign workers?
Invest $8 billion in newly-opened Libya, still headed by Qadaffi?
Invest in new refineries in the US, fighting legal battles against environmentalists all the way?
Personally I would choose option 1, which coincidentally is what Exxon has done. After a year or so, when things settle down politically in some of these places and high oil prices stick around, the oil companies will start seeking out new oil sources. In the meantime, consumers around the world will have made the gradual (you don’t trade in your brand new SUV for a Prius after one year of high oil prices) shift to more fuel efficient cars, thus slowing the growth of demand. Finally, the high oil prices and march of technological development will have brought some alternative energy sources to market at competitive prices.

The thing is, when the newly discovered oil starts pumping to serve more fuel-conscious consumers just after they have installed solar panels or fuel cells on their home, there will be too damn much oil again and prices will plummet. CNN will write a story about how OPEC is losing its iron grip on pricing at last.

Only they already lost it, sometime around 1980. Today, they are spectators like the rest of us. They just happen to be enjoying the show more.

The author may hold a position in the securities discussed.

Powered by Blogger