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Saudi's Say Crude Oil $75 is Fair: Parasite Economics Explained

Commodities / Crude Oil May 31, 2009 - 12:57 PM GMT

By: Andrew_Butter

Commodities

Diamond Rated - Best Financial Markets Analysis ArticleThere is a rumor that demand for oil is a function of GDP, therefore when the world economy recovers, demand will go up, so divide that by supply and you get to price.There is only one small little thing wrong with that theory; historically it doesn't work very well.

Rather the other way around, sort of like a 300% increase in price might cause a 5% decrease in demand with a four or five year lag and a 60% decrease in price might give a 10% increase in demand with a four or five year lag.


Short term OK; and demand is quite easy to predict short-term, but the reality of supply is more difficult (it's human nature to lie and to cheat, just as there is a predilection in all of us for self-delusion).

Both supply and demand are harder to predict medium and long term; particularly since (a) demand sort of depends on price, (b) price might or might not depend on supply divided by demand, and (c) supply might depend on whether on not Ali got his conjugal rights last night. The recent price of $147 was rumored to have been due to supply constraints, other theories blame hedge funds; the Saudi's said it was a Zionist plot...it's complex!

Since 1974 when the Arab States imposed an embargo, there were two distinct types of market for oil, buyers markets and seller's markets. Their dynamics are different.

The 1974 embargo was followed a few years later by a blockade by Iran; prices jumped from an average of about $2 a barrel in 1970 to an average of about $35 in ten years. That was a "Seller's Market".

Then the high price of oil spurned exploration, but it took ten years before there was enough new oil to bust the cartel (that happened in late 1986). Then there was a buyer's market for fifteen years, and in that sort of market demand/supply = price. That's Adam Smith (or someone), but that only works when the buyer can say "no thanks".

Oil prices were pretty steady around $20 in the 1990's, so if they rose from that base-line by the same extent they did in the last "transition" in 1974, i.e. fully from a Buyer's Market to a Seller's Market, they could perhaps go to $350 if that piece of history repeated, in which case expect a 5% drop in demand by 2015. That's of course assuming, that the Arab Nations can all agree on something; and the last time that happened was 1974.

In about 2000 the market dynamic started to change, for a number of reasons (1) there started to be talk about a long-term supply shortage, that may be baloney and it may not, (personally I'm inclined to believe it's not), but talk is talk.

(2) Right now some existing producers are running out of oil or passing their Peak Oil point, particularly Mexico and Saudi, the mindset is changing and questions are being asked - "now that we paid back the capex (and some) how do we maximize our returns on this dwindling resource?" 

 (3) In 1986 the oil producers needed the money (many had to pay for wells that had been developed in anticipation of $30+ oil). Now many don't, they have an option, they can afford to wait for the price and live off accumulated financial reserves in the "lean years", none are doing that yet.

At least not obviously; although the people storing the oil in tankers picked up on that ploy real quick, which is pretty cheeky actually, it's like standing outside a pub selling beer but not paying tax.

I wonder how long it's going to take the oil producers to figure out that if they held onto the oil until the price went up and then sold it, they would make more money. Smarts is perhaps not a core competence in the Sales and Marketing Departments of some of the producers - or perhaps the problem is in the Internal Audit, and uh...well perhaps they got a scam running? Whenever oil starts peaking you start running into shady characters with "connections".

Either way, the renewed resolve of OPEC possibly demonstrates the prospect that at some point, well...the penny might drop.

It took ten years to "transition" from Seller's market to Buyer's market after the first oil-shock, there is no good reason to believe that if oil prices spike again it won't take another ten this time; and that's if they find enough. They might, but that's not certain.

And although starting in 1974 there was talk of new technology to replace oil as a transport energy source, in over 30 years, that hasn't happened. A recent study by the French concluded that the electric car was just a pipe dream even at $150; ethanol is a nice idea, but capacity is constrained by demand for food (well meat actually).

Also there are risks looking for oil in anticipation of a sustained price increase, anyone who brought on new supply in 1985 in anticipation of $35+ oil, had to endure fifteen years at $10 to $20 with only a small "relief" provided by the First Gulf War. Oil wells or infrastructure to process bitumen are not cheap, particularly today, that's up-front cost, and the reality of the capacity of oil sands (and marginal cost of extraction in any quantity) is not certain. I hear they are talking about building nuclear power plants to generate the steam, now that's real up-front costs, you don't want to be doing that if oil falls back to $20.

Demand drivers in a "seller's market": Parasite Economics. 

The market for oil is a monopoly, there are not many suppliers and they collude, some of the time, sometimes they are effective, sometimes they are not.

A monopoly is like the relationship a parasite has with its host, it tries to figure out how much blood it can suck without killing the host.

That's not a market with "willing buyers and sellers acting rationally and in their own best interests, without compulsion", that's like the decision that Microsoft makes every year when it decides the pricing of Windows and MS Office; sure there are "alternatives", try an abacus.

And sure they always run the risk that someone will invent a better mousetrap next year, and they know that demand is somewhat elastic, tough call, meanwhile “has anyone got another bag I can put a billion dollars in”.

So how much can America, the world's largest consumer, "bleed" before there is "harm"?

Oil is used to create economic value added (GDP), or put that another way; in modern economies it is an essential component of that. It follows that the value added created can "bear" a certain slice of the pie (i.e. you can bleed a bit without radically affecting the outcome, like the way the Maasai   bleed their cattle (where the USA is the cow)).

So how about using GDP per household as a marker? There are other markers but that's one I like because households are functioning economic units, and they are the major users of the one thing about oil that is hard to substitute, gasoline, so if a household spends $100,000 a year - how much can you suck out of the "cash-cow" before it squeals...$5,000, $10,000, $30,000?

Here is a plot of the oil price compared to nominal GDP per household in USA.

I have three points, first GDP per housing unit looks like it might be a reasonable marker for price for if the scenarios are treated differently (either when supply is constrained - (by accident or design), or when supply is significantly more than demand).

Second, if you believe it's still a buyer's market and price = demand/supply well the oil is going down to $30. That's good news, you can go back to sleep!

But if you believe in Big Bad Wolves, then from the point in time that OPEC started to re-assert it's influence in 2000 it looks like the market started to transition from a buyer's market to a seller's market; in that context the Saudi target of $75 looks cheap - that's their estimate of how much the "customer" (the cash-cow) can be made to "squeal" without causing itself serious damage.

Everyone thinks the Saudis are the bad guys in this equation, little do they know that a big part of the quality of the lifestyle of average Americans has been subsidized by the Saudi's for the past fifteen years, the question now, is since there appears to be a genuine prospect they are running out of oil in the foreseeable future, will they wake up?

The 78% drop to $32 in early 2009 was a significant drop from $147, it was a bigger drop than the 60% drop when the oil cartel broke in 1986. But it didn't get anywhere close to the $10 it hit at the bottom of the Asian Crisis in 1999.

In fact it was higher than at any point since 1986 except for the transitory spike after Iraq's invasion of Kuwait. What does that say? That says that the longer an addict waits for a fix the more he will pay.

And $147, speculators or not, that was the price that the market paid.

There is a theory that floats around in the air like "The Big Bad Wolf", but when the time comes for that bed-time-story the sweet fantasy of denial creeps into the dreams of the addict who is so dependent on that "fix". And addicts love their pusher really they do, all that talk about Ahmadinejad and Hugo Rafael Chávez Frías that’s just love!

And the theory to deny is that the trigger for the bust in the financial system might have had something to do with the rising price of oil; but no one talks about that, because right now America has no practical option, but to pay the price, whatever it is.

Could it go higher?

Once the sellers start to find out that they can control the market again, and once many of them realize that the oil they have in the ground is a finite resource for them (there is no guarantee that the countries that have oil now will be the ones to discover new oil).

And unless and until all the talk about new fields and new inventions starts to turn into reality, it seems quite possible that oil will go back to where it was in 2008, i.e. to an average of $125 and quite possibly all the way back to $147, you can say what you like about speculators, but the useful function they play is price discovery.

The big uncertainty is what happens next, if solutions start to be found then that will bring down the price. Time will tell, there are too many "ifs" to know for sure, although it looks highly likely that after fifteen years of a "buyers market" there could be ten years of a "seller's market" that started in earnest in about 2004. And if the "talk" of huge new oil discoveries and genius inventions does not turn to reality, perhaps more...try twenty?

If so then $350 oil might well be a possibility, if that happens then the economic success of a country will start to be measured in how efficiently it can turn the input of oil, into economic value added.

In that regard USA (and to some extent China) are at a disadvantage, both have "coasted" on cheap oil for a long time. In particular the architecture of America is not designed for expensive oil; people live in the suburbs and drive to work, that business model may start to be tested sooner than many Americans think, but hey, that won't be inflation - "core inflation" doesn't count oil, or should that be called "cow inflation".

The 1974 oil shock affected USA less than other developed countries, because then it imported only 40% of it's oil (up from 15% in 1964); and by 1984 that had reduced to 30% so the price did not add greatly to the current account deficit, that's why they didn't ramp up taxation on gasoline like the Europeans did.

Now America imports 70% of its oil, a question that might be worth asking is can America actually "work" at a sustained long-term price of $150 or more?

Strategy for America

James Quinn came up with an interesting conspiracy theory that I never heard before (http://www.marketoracle.co.uk/Article9913.html), which was that Kennedy was assassinated because he wanted to reduce the US dependence on imported oil, and put up petrol prices. Perhaps the Ewing  family had a part in that, after all it was Dallas?

Be that as it may, one thing is for sure, if Kennedy had started that job then America would be a very different place.

More people would live downtown and walk or take public transport to work; the deficit would be a lot less, and the logic of going to war to "protect oil supplies" would be seen as madness rather than simply foolish, "don't worry Daisy, they won't cut you off, just so long as you keep producing that nice sweet milk".

The logic of that theory in the case of Iraq is even less credible than the WMD theory (Saddam Hussein would have happily sold oil to anyone), and it's only marginally less credible than the idea that the $1 trillion that the war will end up costing, was about ridding the world of a lunatic psychopath (if so then why not Mugabe or that evil midget in North Korea)?

The cold-hard reality is that if Kennedy had had his way, the number of really nasty people that are treating USA as their cash cow, would be a lot less.

It's never too late to start; but I suspect this whole thing is a mite more complicated than short-term demand/supply. Perhaps now really is a good time for America to start to implement the policies that Kennedy wanted to implement?

One strategy might be to guarantee minimum prices for "Made in America" energy sources for transportation, so that capex can be invested with a higher degree of certainty in anticipation of what is starting to look increasingly like an evens'-chance of being inevitable.

One way to finance that might be to increase the tax on gasoline. That would at least help find some more "spare" trillions to throw at the clowns...but would it be popular?

Taxation is Parasite Economics; the choice looks like one between who gets to spend the money that can be "bled", the speculators, lunatic midgets with nuclear ambitions, or the Federal or State Governments perhaps for a bit of "de-leveraging"?

Take your pick, plenty of time. 

In the meantime why not throw a couple of hundred billion at T. Boone Pickens so he can build his crazy windmills, just on the off chance.

Here's another idea "Daisy", in exchange for raising the tax on gasoline by $10, every year offer 10 million Americans a brand new Fiat-Chrysler Panda for free in exchange for their gas-guzzler, that would “only” cost $100 billion a year after a volume discount, at $150 oil think of how much that would cut the current account deficit and how many jobs that would save (you could ship the gas guzzlers to China in part payment of interest) , compared to the money you are throwing at the clowns, that could be a steal.

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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