Energy Views

While attending meetings this week in San Francisco, I stopped by MarketWatch’s offices to be interviewed for a short video.  Their reporters talk with me all the time so it was good to drop by and chat in person.

You can view it here:

http://www.marketwatch.com/video/asset/54155930-AC84-4383-BD38-8C65E43F3FED

We saw crude oil start the year 2008 at about $98 per bbl. for the Cushing WTI weekly average spot price. From that point, the price dropped to a little below $90 per bbl, and then rose to the current $127 per bbl. in May 2008. This all time high for crude oil is at, or near its peak. There are other factors coming in to play as described below, which I feel will soon cause a decline in crude oil prices..

Of course the question now is where does the price go from here. To try to predict this, one should examine the factors that might influence the price of oil. Many now refer to crude as the new commodity that replaces gold as a commodity in which to hedge the value of the dollar. We do know that the number of crude oil future contracts have increased dramatically since Jan. 1, 2008, from 5 million contracts per day to 20 to 30 million contracts per day (see Crude Oil Lt Sweet Pit (Nymex) June , 2008).

This might indicate that the speculators (hedge funds and institutional investors) have migrated to the crude oil market from other markets. However, in a March 31, 2008 teleconference, President Red Cavaney of the American Petroleum Institute questioned whether institutional investors are driving oil prices higher. He quoted Alan Greenspan as saying, “When people buy oil for non-commercial accounts, they provide liquidity for the markets.” While this may be true, when more and more purchasers start buying a limited amount of a commodity, common sense will suggest that this has to drive the commodity price up to some degree. It is my opinion that these type investors who are now investing in oil future contracts will exert an upward pressure on the market, but may be only one of several upward pressures being exerted.

Another pressure might be in the fundamentals – how much supply is available, and how much demand there is. In a normal market, an increase in demand for a finite amount of a commodity (which would result in a decrease in inventories) would cause the price to rise. But not so with crude oil: since January 1, 2008, the spot price for crude oil has been rising in spite of an increase in crude oil inventories. See the following graph. (As seen in this graph, as the inventory rose from 295,000 thousand bbls. to 325,000 thousand bbls., the price increased from approximately $90 to $120 per bbl.)

From the data in this graph, it is apparent that the normal relation of supply vs. price has not been occurring since January 1, 2008. So what else could be impacting the price of oil?

Many analysts attribute at least part of the oil price rise to the decrease in the exchange rate of the dollar. Almost all crude oil world wide is sold for U.S. dollars. So if the exchange rate for the dollar against other currencies falls, it is necessary that the number of dollars required to buy crude oil rises to account for the increased cost to the crude oil seller to keep him whole on other goods he may purchase from other countries. Since the first of the year, the dollar has fallen from $1.00 to buy 0.681 euros (the universal European currency) to $1.00 buying 0.631 euros. A graph of the price of crude oil vs. the exchange rate correlates very well indicating the relationship of a drop in dollar exchange rate will cause a rise in crude oil prices.

See the graph below:

So for the $64,000 question of which way oil prices will go, that depends on several factors:

1. With respect to supply, world wide consumption of crude oil has been climbing rapidly, but there are indications that the increase in crude oil prices is causing demand to taper off somewhat, in the U.S. as well as other net importing countries (including China and India.) This week, the IEA reduced their forecast for demand of crude oil, and indicated that they may drop it again in the near future. If demand does indeed decline, this will cause the price to drop somewhat. But there is the cause/effect: a decline in prices will again stimulate consumption.

2. For the U.S., a strong dollar would cause a decline in prices for the U.S. For other countries, the change in price would be minimal since after exchange for dollars, there would be little change in their costs based on their currency. So what are the chances of this happening? As of right now the Bush Administration and the Federal Reserve are attempting to hold a weak dollar, presumably to aid export sales, and to decrease imports. This may change with a new administration, but chances are it will take a change in Federal Reserves policies. So it does not appear likely this will happen soon; in fact, we may see additional declines in the exchange rate on the dollar which will cause the price of crude to rise some more.

3. What about the impact of institutional investors trading in crude oil futures? Institutional traders move from one investment to another, depending on what appears to be the best investment. With the crash in real estate values, I would not be surprised for them to soon start “bottom fishing” in real estate and move some of their money from oil futures to real estate. So I expect to see the number of contracts traded to decline during 2008 because of the institutional investors moving on to other markets, and this will remove some upward pressure on crude oil prices.

4. As for inventory, the cost of carrying inventory is expensive at the price of crude oil now. So I expect the U.S. users of crude oil to soon start decreasing their import purchases, and cause their inventories to level out. This will cause a downward pressure on prices, unless the rest of the world can absorb all oil not taken by the U.S., (but I do not think this likely: other countries will be reducing their demand at the same time.)

If we combine the above four items, I expect that Nos. 1,3,and 4 will exert some downward pressure on crude oil during the next 6 months, and No. 2 will exert some upward pressure. The results will be the price is near its near term peak now, but is not likely to decline below $100 in the next 6 months. Then long term, the price will rise due to increasing demand and limited supply.

And all of this assumes no major war or other major geopolitical event.

Once again Myra Saefong hit me up for some comments for an energy article

Crude futures have fallen almost 9% since the start of the year, but have prices weakened for all the right reasons?

Link: Oil’s sell-off defies the usual reasoning

My first-ever article was posted on MarketWatch.com today, titled The oil boom is here again

Well, well, well! The price of crude oil slipped to the high $50’s this morning. It appears that our forecast for the next 1 to 2 months, in “Down, Down, Down Goes Crude Oil,” posted on September 15, 2006, has already occurred. But we have not seen the bottom yet. We still think that we will see a bottom in the “high $50’s” (above $55) in the next month, plus or minus.

Fundamental’s behind this price decline include many factors. One is the time of year when we see demand for products decline, and inventories rise. Another major factor is that Iranian President Amadinejad has been amazingly quiet since he visited the UN and the United States - no threatening speeches. And yesterday, Venzuela announced a cut in crude oil production of 50,000 bbl./day, and Nigeria announced a cut of 5%. Both of these cuts are symbolic only, and will hurt those two producing countries far worse than it will impact the crude oil market. But the next big impact will be US gasoline consumption. With Gasoline now near $2.00 per gallon, here come the SUV’s again, and away goes conservation. Again, Economics 101: cheap gas, consumption goes up. This will ultimately put the brakes on crude oil price decline.

The internet is buzzing with rumors that the Bush Administration is causing this price decline in order to impact the November elections, and as soon as the elections are over, it will let the prices rise again. Frankly, we wonder what those proponents of this theory have been smoking. In our opinion, the Bush Administration couldn’t manipulate gasoline prices if they wanted to. With all the deregulation that has occurred over the past few years, the petroleum market is indeed a free market. Prices are moved ultimately by supply and demand, although short term, they are frequently impacted by traders in the futures markets. If petroleum prices were subject to price controls (as urged by some,) then the government could exert some control over prices. But all our observations are that current prices are being determined by willing buyers and willing sellers.

Tomorrow, the DOE will post crude oil and petroleum product inventories, and we think that we can expect some modest increases. However, the traders have already discounted this rise in inventories, so the impact on prices should be minimal.

It now appears that world oil traders have finally realized that the world is not short of oil, at least for the short term . The price of crude has declined steadily for the past 40 days, declining a total of over $15 from $78 plus in early August to around $62.50 today. So how much lower will crude go? Of course no one knows, but Economics 101 teaches students that when supply exceeds demand, the price will go down. And that is where we are today.

It is clear that recent high crude prices did reduce demand somewhat. This has been hard for traders to understand — demand for crude oil is not fixed, and it will fluctuate with the price of crude oil. However, listening to news media interviews today, drivers already are thinking about driving more now that gas prices have declined. So as consumption picks up, this will put the brakes on the crude price decline, and we may even see a slight rise. My guess is we will see more crude price decline for 1 to 2 months before it bottoms out. I expect it to get into the high $50’s at the bottom.

OPEC members have indicated they intend to take action (curtail shipments) and attempt to hold the price above $60 per bbl. I am skeptical that OPEC can have any great effect on crude prices. OPEC production is now less than 30% of world production, and some OPEC members have let their production decline in the past few years. However, certain OPEC members can “scare” the price up with their saber rattling and threats. Higher oil prices are so important to them, that I think we can anticipate that some threats will occur, and it may be enough to raise the price a few dollars per bbl.

So hang on for the ride, but make plans to be prepared for the next rise in crude oil prices, probably starting in late 2006 or early 2007. And make no mistake about it: long term, crude oil prices will rise. Again, Economics 101: we are faced with rising demand, and reduced supplies.

OPEC meetings have become non-events. This is because they no longer have a huge surplus of oil available. (In fact, Venezuela and Iran have seen significant declines in their production.) OPEC member’s need for cash no longer gives them the ability to withhold oil from the market. So the most we can expect is some discussions about maintaining prices as high as possible for crude oil.

MarketWatch quoted me again in this story about the topic:

Oil’s volatility has made OPEC unusually silent

The Simple Answer: For the long term future, the answer is “Up.”

Consider the following:

1. There is a finite amount of oil reserves left in the world, and at the end of each year the amount has diminished by the amount produced for that year.

2. The demand for crude oil is rising rapidly, particularly in developing countries. Increases in demand for crude oil has been rising at double digit rates in China and India before 2005.

3. In developed countries, the demand for crude oil is also rising but at a slower pace that in the developing countries.

Any freshman economics student can tell you that with a decreasing supply and increasing demand, prices are going up.

Mitigating Factors: The good news is that there are mitigating factors that will include:

1. Reducing the rise in demand for crude oil, and thus will slow the rise in prices;

2. Increasing the amount of crude oil reserves available, which will also slow the rise in prices; and,

3. Development of non-petroleum fuels, while not cheap, will nevertheless reduce demand for crude oil.

All of this simply means that the existing reserves of crude oil will last much longer than the conventional Laffler curves would indicate.

First, the increased prices for crude oil (and products made from crude oil) will cause a reduction in the use of these oil based products over time. For example, higher gasoline prices will cause consumers to buy more fuel efficient cars, reduce driving, and use mass transit (and mass transit will develop with increased demand.) Our government can talk about, and spend money on programs to promote conservation, but it simply will not happen until higher gasoline prices forces it to occur. This means consumers will use less gasoline (and crude oil), and with this reduced demand, we will see prices rise much slower than they would otherwise.

Second, it is a well known fact among oil industry professionals that higher crude oil prices make marginal reserves economically attractive to develop. Without these higher prices, these marginal reserves would never be developed. Therefore, it is safe to assume that as crude oil prices rise, the recoverable oil reserves worldwide will increase, making more supplies available, and thus also slowing the rise in crude oil prices.

Third, higher prices for fuels make alternate synthetic fuels economically attractive. To whatever extent such fuels are developed, it will reduce a like amount of demand for oil base products, which ultimately reduces demand for crude oil.

Alternate Fuels: Only a Small Factor
One must always keep in mind that alternate fuels (ethanol, bio-diesel, hydrogen, et cetera) with present and foreseeable technology, can furnish only a very small part of the overall demand for fuels. Those who envision these alternate fuels furnishing a major part of our fuel supply are not being realistic. There simply are not enough raw materials available to make these fuels. And agricultural experts are already warning the U.S. cannot count on corn being a long term raw material for ethanol because the world population growth will cause the corn to be needed for food.

Price Manipulation
Politicians and the public have long been suspicious of manipulations of the price of crude oil. It is our opinion that the price has indeed been manipulated, but not by anyone in the U.S.

Oil is a worldwide commodity. The U.S. consumes about 18 million barrels a day out of the worldwide market of about 83 million barrels per day. In other words, the U.S. uses a little over 20% of the worldwide crude oil market. Although this is a significant amount, it is hardly enough to control a global market. In fact, there is no one in the US (not even major oil companies or Wall Street traders) is able to control this worldwide crude oil market. Crude prices are set by willing buyers and willing sellers on the NYMEX and the London Stock Exchange where traders buy and sell future contracts in volumes far in excess of the physical amount of oil being produced. What influences the traders as to what they are willing to pay (or sell) future oil sales contracts? The answer is anything that may influence oil availability or oil demand. The traders have become very sensitive to how hurricanes may affect oil supply after Rita and Katrina.

However, beginning in the fall of 2005, another factor emerged that appears to have impacted oil prices, perhaps more than they should have been influenced. Their names are Mahmoud Ahmadinejad, President of Iran, and the Ayatollah Ali Khamenei, the Supreme Leader of Iran.

They have learned that a speech containing veiled threats of disruption of Middle East oil exports generally moves the futures market up between $1.00 to $4.00 per barrel. Iran exports about 2.7 million barrels per day, so a $1.00 increase in oil prices makes Iran almost an additional $1 billion dollars per year! Iran is now running about a $10 billion per year budget deficit, so a few choice threatening words will cover this deficit.

Make no mistake; Ahmadinejad and the Ayatollah know this and they play the oil futures market like a fiddle. The traders on the NYMEX and the London Exchange either do not realize how they are being manipulated, or else they are making so much money trading oil futures that they do not care.

Since last fall, both have made statements with veiled threats to (1) block the Straight of Hormuz, or (2) stop Iranian oil exports, and (3) “wipe Isreal off of the face of the Earth.” There has been at least a $1.00 upward movement in the price of crude oil after each of these speeches. It is reasonable to assume that whenever the spot price for crude oil starts to decline below $70 per barrel, one should expect to hear that Ahmadinejad or the Ayatollah have made another speech which hints at the disruption of oil from the Middle East.

Many experts believe crude prices now carry about a $20 per barrel premium for hysteria and uncertainty regarding the political situation in the Middle East, primarily based on what Iran may do. We believe that this is an accurate estimate.

A comparison of crude oil to natural gas prices shown in Figure 1 for the past 12 months. shows the difference between gas and oil prices (converted to MMBtus) has been widening. Notice that natural gas prices peaked in the summer through September 2005 in response to loss of gas production due to hurricanes Katrina and Rita. Natural gas prices also peaked in December 2005, which is normal in the middle of the winter.

Other than these explainable peaks, gas prices have been declining since 12/10/05, while oil prices have been climbing. Keep in mind that the Iranian rhetoric has no influence on US natural gas prices. Thus it appears that crude oil prices should have declined after the impact of hurricanes Katrina and Rita were over. Instead, due to concerns over Iran
withholding oil from the world markets, the crude oil prices kept rising.

As to the Future
The big question everyone always asks is where will oil prices go in the future. This is anyone’s guess, because there are so many external factors that have an influence on oil prices. It would be easy to make an accurate forecast if there were no external influences on the price of oil (like Ahmadinejad’s speeches.) But in a real world, these external factors always exist. So the only good advice when oil prices impact business, is to be prepared to adjust for these external factors.

In Figure 2 below, the price of crude oil (WTI at Cushing) is plotted, along with a trendline indicating the average price. This trendline is projected through the summer of 2006, and it indicates a decline of crude prices into the $50 range. But will this occur? It all depends on those external factors, such as how many inflammatory speeches will the Iranians make during the summer, and the level of hurricane activity in the Gulf of Mexico.

The bottom line is we will probably see crude oil prices decline to the low $60’s or even into the $50’s by the end of the summer, PROVIDED there is no hysteria from what Iran may, or may not do, and there is minimal hurricane damage in the Gulf of Mexico. There is really no reason for crude prices to be as high as they are now other than hysteria and uncertainty. Keep in mind, oil traders thrive on hysteria and volatility, and the market hates uncertainty. With a stable market, the traders could not make money trading oil future contracts, and they would move on to other commodity contracts that do have volatility. But the big problem is Iran’s economy. Most consumer goods in Iran are subsidized by the Iranian government (their gasoline price is fixed at $0.40 per gallon.) So Iran’s economy will become a basket case if oil prices fall very far. So expect Ahmadinejad, the Ayatollah, and the Iranian government to take steps to maintain the oil price as near to $70 per bbl. as possible.

NATURAL DISASTERS MAY TRIGGER WHAT WAS COMING ANYWAY:

Although some may feel that Katrina and Rita caused all the trouble in oil refining capacity, the United States has been on the ragged edge of running short of capacity for more than five years (see: Oil Crisis? How About the Refinery Crisis?, and many other papers describing the problems in expanding our refining industry). In spite of many older and smaller refineries being closed, the industry has managed to keep its total capacity up by a band-aid approach of “debottlenecking.” Another problem is that the world demand for crude oil is rising rapidly while world oil production is not. The worldwide outlook for crude oil will be the subject of a future article.

A LESSON IN ECONOMICS 101:

So as always happens in a free economy, a shortage of supply has caused the price to rise rapidly, (just as a surplus in supply would have caused the price to fall.) In a true free economy, there is never a shortage of supply – prices rise and demand falls until supply equals demand. Preliminary indications are that with the run up in gasoline prices after Katrina, (which caused about 12% of the U.S. refining capacity to be shut down at least temporarily), conservation has kicked in, and we are now using less gas.

Then along comes Rita, and supposedly there is already a short supply of gasoline.

With Rita, we saw another 22% of the refinery capacity shut down temporarily. But other than spot shortages along the evacuation routes for Rita, we still have not seen any gasoline shortages in the U.S. Now, 2 days after Rita hit, there is plentiful gasoline all over the country with only a few reports of tight supplies.

Inventory reports as of September 20 indicated gasoline inventories had risen an amazing 3.4 million barrels for the week ending September 19. Inventories of gasoline had also risen the two previous weeks. In fact, demand has declined to a point where we have actually encountered no widespread shortages of gas anywhere in the U.S., in spite of the loss of about 1.5 million barrels per day in refining capacity

So let’s face reality: the only way the American people will conserve gasoline is if the price is high enough to cause them to cut out unnecessary trips, to acquire more fuel efficient vehicles, to form car pools, and to use mass transportation. This was proven back in the ‘70’s when disastrous price controls were implemented by the Federal Government to keep gasoline prices low. With low costs for fuel, there were no significant efforts by drivers to conserve, and we quickly ran out of gasoline. Do you remember having to go to several stations and if you were lucky, you might find one with gasoline for sale. Politicians seem to have the impression that every American is entitled to life, liberty, the pursuit of happiness, and cheap gasoline for their SUV’s.

THE RELATIONSHIP OF PRICE AND DEMAND:

Data from the developed countries dramatically show that gasoline consumption per capita is directly related to the price the consumer pays for gas. (See Figure 1 and Table 1.) Of course everyone says that is to be expected, but one look at Figure 1 shows how dramatic this relationship is. European countries and Japan have for years maintained high gasoline prices with taxes on fuel. This was done primarily due to the fact that these countries had little production of oil within their countries, and they needed to minimize the cost of oil imports. The U.S. consumption has been running about 450 gallons of gasoline per capita per year, but other developed countries consume only 100 to 200 gallons of gasoline per capita per year – or less than half of what the U.S. consumes. It would be overly optimistic to expect the U.S. to match these consumption figures, but certainly 350, or maybe even 300 gallons per person per year should be achievable. Figure 1 indicates that with $3 plus gasoline, the U.S. per capita demand will fall to about 300 gallons per year – a 33.3% reduction which will occur in time, after everyone takes steps to reduce their use of gasoline, and the U.S. has time to develop more mass transit. With high fuel costs for many years, these other developed countries have developed efficient mass transportation, and it has been heavily utilized because it is much more economical than driving one’s car. So it is reasonable to expect that over a period of time, mass transit systems in the U.S. would be much more fully developed if gasoline prices remain high.

Sources:
CNN/Money: Gasoline Price/Gal U.S.$
California Energy Commission: Gasoline Consumption MM Gals.
Click Z Networks: Population MM People

WHAT IS THE CAUSE, AND WHERE WILL IT END?

Now, let’s get back to the root of the problem. World demand for crude oil is growing rapidly, with much of the growth in Asia, primarily in China and India. At the same time, the vast majority of our oil worldwide is produced from old “Giant” fields. These fields are now mature, and some have begun to decline. It even appears that Saudi Arabia production is at, or near its peak production (see Twilight in the Desert, by Matthew R. Simmons.) While new oil is being discovered, it is in smaller fields, sometimes remote, and it takes many of the new, smaller fields to replace one of the old “Giants.”

So what this means is we are running out of oil worldwide, and we have already run out of cheap oil. But this does not mean that we will have oil one day and it will all be gone the next day. Instead, the amount of oil produced in the world will plateau, and then slowly decrease. As this occurs, the price will rise until the demand starts to decrease. (Remember in a true economy, the price of a commodity will increase and/or decrease until demand and supply are equal.)

WHAT ABOUT ALTERNATIVES?

Much has been said about alternate fuels, particularly by politicians. Ethanol, biomass fuels, and maybe even hydrogen are potential alternate fuels, (and certainly should be developed wherever possible – before this is over, we will need every source of energy available to us.) These alternate fuels are expensive to make, and they become attractive economically when gasoline prices are high. However, they never can be made in quantities sufficient to replace the gasoline we use today, and will always be supplemental to our main energy supply. For someone to expect these alternate fuels to eventually replace gasoline, they are simply daydreaming.

Another potential source of a type of crude oil is shale oil. The U.S. reportedly has more shale oil reserves than Saudi Arabia has crude oil reserves. But shale oil requires huge capital investments, and will take many years to bring it into production. Once that is done, we will have another source of high cost oil.

THE BOTTOM LINE:

When you put all of these factors together, one can readily realize that the days of low cost gasoline are over. We Americans need to bite the bullet, and start rearranging our lives and our infrastructure to be able to live with, and make our economy progress with, high cost gasoline. The sooner we get started, the sooner we can get our lives adjusted.


Charles R. Perry is President and CEO of Perry Management, Inc., a consulting firm in Midland, TX. He is a Registered Professional Chemical Engineer in Texas, and has had over 50 years experience in the oil, gas, and electric power industries. He is the holder of numerous patents, and the author of many technical papers, and his background includes both top management and technical development in energy businesses.