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The Impending Mother of all Oil Shocks

Commodities / Crude Oil Apr 26, 2009 - 08:47 AM GMT

By: Andrew_Butter

Commodities

Diamond Rated - Best Financial Markets Analysis ArticleThe other day I had an interesting conversation with someone who decides how much a small but significant portion of the world's oil reserves gets pumped.

I asked a question, "So long as the revenue from the oil that you pump is enough to meet the immediate needs of your country, why pump more?"


My point was that as the prospect of running out of easy-to-extract oil starts to hit the collective consciousness, and as demand creeps up (as it will), oil will spike again, and again. So why not just wait?

And yes - sure there are new sources, such as oil shale in Canada and deep oil off Brazil, but in any quantity sufficient to make a difference that stuff costs easily $70 a barrel to get out...and then? There are plenty of people that acknowledge that there is a serious problem for example http://en.wikipedia.org/wiki/Hirsch_report and http://en.wikipedia.org/wiki/Colin_Campbell.. but little is being done apart from denial, except that soon radical action may be necessary – just no one knows when, and when that’s known for sure, it could be too late, for some…and bonanza for others.

It could be sooner than later, this financial crisis is bigger than the Asian Crisis which drove the price of oil down close to $10 (less than $15 in today's prices), yet this time prices only went down to $40 and now in the darkest hour (perhaps), they are back at $50; that says something.

There is no question that long term oil prices relative to price of just about anything else will go up until a sustained price that allows viable alternatives to be developed is reached; and although there are viable alternatives to make electricity, nothing has been discovered yet that comes close to oil for powering transportation.

And a lot of things depend on transport, fishing is measured by catch per gallon of diesel, gold prices (possibly) depend on the replacement cost which is about the cost of hauling rock around; and recently a French study concluded that anywhere below $200, electric cars, well..."ca c'est interessant, mais c'est fou!"

This chart illustrates what a dollar of oil that stayed in the ground would be worth today - instead of being pumped and invested1

 

Sure if you had bought gold in 1972, sold it in 1981, then got into treasuries, then into stocks in 1990 or so; sold just before the peak in 2000, then got back into gold, you would have done better than sitting on oil (so long as you controlled the management fees). And perhaps if you had a genius investment guru that smart you might have also bought shares in Citi in June 2008, and then you would have lost a lot.

And if you had gone for a "spread" you could have done much worse, and that's what "sensible" investors do, they go for a spread.

The answer I got surprised me:

"Of course we know that if we keep surplus oil in the ground it will be worth more than we can earn from even the most brilliant investment strategy... but it's not completely up to us".

 Take Two: Genius investment advisor sits paralyzed with mouth wide-open for one full minute.

 I'd never thought of it like that, but on reflection it makes perfect sense.

The world is heating up, sources of new oil are drying up, yet alleviating the short term pain of expensive oil is of course much more important than guarding against the potential long term pain of global warming and oil spikes...followed by no oil. After all...  everyone wants to be a responsible citizen of the world - RIGHT? That means that "responsible" producers pump as much oil as they can  (at cheap prices).

The reasons that there are more incentives to pump the oil and invest any money that is surplus to immediate requirements, are as follows.

1: The structure of concessions

In most countries where oil was discovered the country was dirt-poor (then), they had neither the financing nor the infrastructure to develop oil. So they signed concessions, most of these concessions allow the company that took the risk to pump as much as they found, and it was massively in their self-interest to do this.

2: The lure of money now rather than money later

 Many of the countries where oil was found were ruled by a clique who were more interested in what they could get personally than the needs of the country they controlled; or if not then a clique soon took power.

And the cliques knew that (a) the more oil they pumped the more they could steal and hide away in discrete foreign bank accounts (case-study Nigeria where perhaps 70% of the oil money never came anywhere near Nigeria), and (b) that even with the implicit and sometimes explicit support of their "mentors", the "franchises" were fundamentally unstable (case study the Shah of Iran), so "get it while you can".

That sadly is the story of what happened (and still happens) to a lot of the oil money, and explains why people living in the Niger Delta, which is one of the richest oil fields in the world, scratch a living from the horrendously dangerous job of tapping into pipelines to carry stolen petrol away in jerry-cans (and regularly get burnt to death - if they don’t get shot first). The "mentors" were traditionally happy with the deal; the surplus cash got invested in their own country and if they were smart they could tie up contracts from the oil that got spent in the source country.

There were exceptions of which the most notable is probably Dubai where the Rulers put every cent of the oil money back into the local economy. But still Dubai pumped as fast as it could (and for all practical purposes they ran out five years ago).

The money from the oil was used to build a self-sustaining city from scratch that now runs without the crux of oil. In 1990 the Dubai "non-oil" economy was 15% the size of Singapore, now it's 40%; the economy in 2008 was sixteen times the size it was in 1990; proof about what can happen if the oil-money stays in the country that produced it, and is invested wisely. Sure you hear a lot in the press these days about the bad investments that were made, but there were a lot more good ones than bad ones, and if President Obama's Stimulus Plan is that effective, well the US economy might just double in size in the next five years. But then Dubai is a rare exception to a dirty little open-secret.

3: The temptation to be responsible citizens of the world

One thing that always works is flattery, and what could be more flattering than being regarded as a "responsible citizen of the world". The countries that couldn't be "bought" and that didn't want to pump whatever they had as fast as they could, were persuaded that in the interests of "stability" they should try and keep the oil price "within limits". Various arguments support that strategy, of which the most common is that the buyers of oil are "customers" and if oil prices rise too high the "customers" will find other sources of supply, (or might just engineer a regime change to a clique who is more "responsible"). 

That was the stick, the carrot was that the oil producers could invest the extra money, which they couldn't possibly spend efficiently to develop their own country in the country of their customers.

And so when/if the oil ran out (and oil does run out, as UK is finding out), or whenever a viable alternative was found ("just around the corner - hey if we can put a man on the moon, well, any day now")...then there would be a nice pension scheme to fall back on.

That's nice isn't it, the "mentors" always thinking responsibly and taking the best interests of those less fortunate into consideration!

So how did that play out?

Look at the chart; in 1973 the price of oil suddenly went up by 400% due to the Arab Oil Embargo, by 1983 (after Iran started blockading oil tankers), it was 700% up on ten years earlier. And, this is the thing...the world paid that price.

What happened next was that the huge increase in price spurred a massive explosion of exploration; then as the new supply came on line, prices came under pressure. For a while Saudi Arabia tried to defend the price, in 1985 it was exporting just 22% of it's capacity2, yet everyone else just went on pumping - "get it while you can". 

Then Saudi decided they couldn't afford that anymore, and the implicit and explicit cartel collapsed. For the next fifteen years the price bumbled along generally in the range $20 to $30, as the new supply was pumped as fast as it could be sold to happy customers, interrupted now and then only by wars and temporary interruptions of supply, and now and then by an occasional fall-off in demand like the Asian Crisis.

Then in 2000 when the amount of spare capacity to pump started to run out, OPEC had a go at pushing the price back up, it worked, until 9/11 cooled things down. But they needn't have bothered because by 2004 there was a genuine shortage of supply. This was the first natural shortage (i.e. not created by war or a political decision)...ever.

The point?

There are two; first, the common perception of Americans that oil producers have been holding the world to ransom, and that OPEC can control the amount of oil that is pumped, is completely false. The only times oil has spiked much above it's average marginal cost of production is when there was a war that constrained supply, until now.

Second; with the price of oil where it is now and where it is likely to go, the number of countries that can afford to ask the question - "is it better to leave the oil in the ground and wait, than to pump? will go up, a few oil exporters were happily balancing their budgets at $20 oil, as the price goes up the number of countries in that situation will rise.

Since the exception of the 1973 Arab Oil Embargo, oil producers have never held the world to ransom, but now the most obvious and logical step for many of them to take, is to do just that.

For many years at least one oil producer has had more money flowing in from oil than it could possibly spend, some producers that were heavily in debt ten years ago, are now debt-free, there are now at least seven counties who can easily afford to ask that question, in aggregate these seven account for 40% of the worlds oil reserves. Theoretically they could shut off the taps for five years and go to sleep, and they would not suffer in the least.

In 1973 these countries were dirt-poor, the oil-embargo was about principles, the 400% price rise was a surprise; now they have better infrastructure (paid for by oil), excellent social services, and in many ways better government, than the West; they do not need the money now, they can afford to wait until the money is worth much more tomorrow.

So what should they do?

OPTION A:  Encourage facilitate and contribute to the destruction of the planet and Global Warming and the risk of a catastrophic shortfall, by selling oil too cheap, and invest the money in toxic assets in USA or in not so well regulated shares in China?

OPTION B: Be "be responsible" and cut back, and force the world to live up to it's stated goals on Global Warming, and mitigate the risk of a catastrophic shortfall?

Or perhaps Option A is being "responsible" and Option B might be construed as well, something akin to terrorism?  Hard to tell who is a terrorist and who isn't, these days!

$100 oil today (if you believe the US CPI numbers) is the same price (in America) as the world swallowed at the height of the Iran embargo of Iraq, this represents in real terms the maximum the world ever paid for oil, until last year.

But 1981 was an accident, and then there was plenty of oil to be found and the oil producers needed the money. Now there's no spare capacity, and it will take three years at least to put on new pumping capacity (many wells are running dry and you need expensive injection technology to squeeze the last drops out), and five to ten years to bring on stream any significant capacity from oil shale or deep water Brazilian Oil. But they don't need the money now, they can afford to wait.

That's the "nightmare" to look forward too, when the oil producers go "Green", and say they want to help "Save the World".

So where will oil go after the recession fades away? Well forget about "market economics" the decision on where it will go will be taken by about five people. Most likely it will go to more than $120 a barrel, after the Asian Crisis with a little help from OPEC it tripled from $10 to $30 so this time it hit $40 x 3 = $120. Whether it goes to $200 or more will depend on the decisions those five people make.

The Structure of demand

That's the supply part of the equation - historically it's hardly what Adam Smith would call a "market" where people as a whole (rather than as a clique) acted in their own best long-term interests, but that's the reality. On the demand side until China and India started to buy oil, there was an assumption that the "arrangements" were solid.

There were a few "hiccups"; the first oil shock in 1973 provided the producers with a clue about what the real "fair-value" of oil actually was, and the Iran Iraq War confirmed that the customers would pay a lot more if push came to shove, but happily after the initial period of angst the producers were persuaded to "be more responsible" (i.e. pump more oil at rock bottom prices).

The Architecture of America's Demand

America consumes 24% of the world's oil; China currently consumes 9%3, but for the Chinese the decision is whether to cycle to work or drive, for many Americans the decision is whether to drive to work, or not work.

Few Americans realize that the whole architecture of their country was predicated on the assumption that oil would forever be plentiful and cheap, (a good account of this can be found in Intown Living - A Different American Dream4).

In 1956 the Interstate Highways Act was passed, the effect was that 90% of the cost of major roads in USA was financed by the Federal Government. This piece of legislation was heavily influenced by the auto manufacturers and their lobbyists, the "carrot" was that the subdivisions in the suburbs was where the American Dream could be found, and the kicker - every American family could own two or three cars and keep them in nice big garages. So roads were built to transport people from the suburbs to the cities, and the suburbs exploded.

The shift to the suburbs was further encouraged by The Federal Housing Administration and Veterans Administration brought in after World War II which only underwrote new houses meaning that the rehabilitation of older city property could not benefit from the same financing.

And tax codes meant that city residents paid the same for utilities whereas the cost of providing these is much higher in the suburbs - so city dwellers subsidized the suburbs. Soon the rush to the "countryside" started to hollow out the cities, and as revenues available in the cities dropped, the funds for supporting public transport and security dropped too; then riots, crime and drugs took over.

I lost the reference, but once I read a tragic book about how a mother tried to stop a crack-cocaine epidemic in her neighborhood, but she was black, and the police did nothing. Black kids killing black kids - who cares? The level of security you get in USA depends on where you live and how much taxes you pay; it's a free market economy.

The Interstate Highways Act favored roads, big ones - freeways cutting through the old surplus-to-requirement neighborhoods, not public transport, which received no Federal subsidies.

And the destruction of public transport was helped along by stealth, for example a consortium led by General Motors called "National City Lines" bought up streetcar lines, to dismantle them5. Zoning also played a part splitting the work-place from residential, today in Chicago and Detroit, 60% of the working population live more than ten miles from their workplace4.

Thus the heart of many American cities died, and was replaced by suburbs, in the most extraordinary piece of social engineering in the history of mankind.

Much of Europe was spared from this bizarre Brave New World, if you are an ordinary person and you live in Paris, Lyon, London, Berlin, Amsterdam or Rome, you live in an apartment, or a terrace house, and you can walk and take public transport. And you don't (generally) get mugged; and your kids can walk to their friend's houses and play in public parks. It is perfectly possible to live without cars, but only if the architecture works.

The architecture of American cities, with a few exceptions is not designed for that, Americans spend 10% of their time walking or cycling (for transportation), Italians spend 50%4; no wonder Americans are fat.

And no wonder the first oil-shock when prices went from $10 to $50 was perceived in USA as an attack on the very core of the American Dream. No wonder either that when Europe decided to put a tax on petrol and subsidize energy efficiency, increasing the pain, America just brazened it out.

The politics of raising fuel costs in USA are hugely more sensitive than in Europe, for many Americans a doubling or quadrupling of the cost of fuel would have a huge impact on their pockets. According to one study, in 1999 on average residents of Atlanta and Houston spent 22% of their income on transportation4; and that was when oil was $16 a barrel, and it's the poor people who suffer, an American worker probably spends about as much on transport as it costs to employ three Chinese - and that's "progress"?

Good things don't last forever

Everything worked fine when oil prices were low, then the darned Chinese and Indians started wanting to buy a bit of the "good life" (and live in suburbs), and the whole "arrangement" started to unfold.

This coincided with a reduction in the influence that America had as the nation with the big stick, partially thanks to "darn liberals" taking power, partially because of the collapse of the Soviet Union as a world power which made the "big stick" argument less persuasive (and took the wind out of the idea that you had to chose between Communism or the Free World), and partially because of the realization that USA would never use nuclear bombs to effect regime change (and the cost of doing it any other way as George Bush found out in Iraq is prohibitively expensive), so people like Mahmoud Ahmadinejad and Hugo Chavez can snub their noses at the guardian of the big stick,  and get away with it.

Where next?

Whenever the world economy recovers, demand for oil will increase and prices will rise, the best advance warning of this will be when oil production starts to rise; currently demand is down and cutbacks in production are keeping the price up, OPEC only works when production capacity is close to demand; it's only when prices and production rise can the end of the recession be called.

Where the oil price goes from there will depend on whether five men decide they want to subsidize ordinary Americans so they can live out their dream of Revolutionary Road and have barbecues in their yards on weekends, and drive nice big gas guzzling cars.

The opportunity

These days some people are talking about bringing back the Gold Standard so as to prevent governments from creating bubbles, and generally so that they start to behave a little bit more responsibly. Like all "good" ideas (for example PPIP) the debate is how the stuff should be priced, there are two camps (aren't there always).

In 1971 gold was fixed at about $40 an ounce, so if you believe the CPI numbers a reasonable "fair-value" for gold today would be about $200 an ounce, that's one idea. The other idea is the total amount of money in the world should be divided by the total amount of gold, that gives a price of about $9,000 an ounce (if I got my sums right - anyway it's a big number), which gives an idea of how far the world moved along from the Gold Standard idea.

How about an Oil Standard?

Adam Smith's idea for a reserve currency was something that was indestructible, rare to the point of being broadly irreplaceable, and has no major industrial use.

OK, OK...no I'm not losing it here, I do know that oil does have a rather important industrial use and also that it's not indestructible (but thanks for reminding me). But that's not the point, the point is (a) that the world CAN decide a fixed "reserve" price for oil and (b) there are a lot of good reasons why it should.

1: Why can it decide?

It can decide because a significant part of the world's oil reserves are owned by people who would happily trade the extra benefit they could get from playing hardball and making sure that they squeeze the optimum price of the oil they own, in exchange for stability and sustainability. Many have done that for years anyway.

Granted there would have to be an agreement on how much oil nations could sell and policing against under-cutting, and the price would have to be set high enough so that there was an incentive to use it sensibly (just as there need to be rules so that credit is used sensibly, but that's another subject). Agreements like that CAN work if they are properly policed - OPEC works...from time to time, but this agreement would need to be an agreement between the buyers and the sellers (not that the buyers don't already lobby OPEC furiously).

2: Why must it decide?

Until it is clear what the price of oil will be, there is no chance that viable alternatives to oil can be found - and until that happens all the talk about Global Warming is just hot air.

As a kicker to such an agreement, the oil producers should be given the option of investing the money that they can't possibly spend in their own countries, on power-plants in consumer countries that don't create greenhouse gases, with guaranteed off-take agreements. Nuclear is probably the only viable large-scale option right now although wind does appear to be gaining; the agreement could include for oil nations to divert a portion of the considerable sums of money that they give out in aid (no it doesn't go to fund terrorism), by investment in power generation in poorer nations.

And the consuming nations could be forced to commit to phase out power-plants that create greenhouse gasses. The point here is that what kills carbon neutral technology is (a) economies of scale are too small now (b) it is capital intensive; so use the oil in the ground as security.

So what price?

Well I reckon $100 a barrel would do the trick - that's a nice round number.

Notes:

1The chart was started in 1971 because that's when the Gold Standard was abandoned, the line for the DJIA doesn't consider dividend payments (so it's an under-estimate), the line for long bonds considers a 30 year note bought in 1971 with the interest payments re-invested. The chart is not intended to be definitive, it is simply illustrative.

2Saudi Arabian Monetary Agency, Annual Report 1429 H.

3http://www.nationmaster.com/graph/ene_oil_con-energy-oil-consumption

4Intown Living: A Different American Dream by Ann Breen and Dick Rigby; published by "ISLANDPRESS", 2004.

5Cities Back from the Edge: New Life for Downtowns by Roberta Gratz with Norman Mintz; published by John Wiley & Sons, 1998.

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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