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Trading Lessons

Reverse Bubbleomics: What If OPEC Figures Out Crude Oil’s Fair Price is $150?

Commodities / Crude Oil Nov 11, 2010 - 03:25 AM GMT

By: Andrew_Butter

Commodities

Diamond Rated - Best Financial Markets Analysis ArticleLike one of Victoria’s Dirty Secrets $150 oil is something you don’t joke about. But don’t worry; over a year ago the Saudi’s said that they thought “Fair Value” was above $75, and Lo and Behold, “Above $75” was what happened. Magic Eh!


So how about$150?

The International Energy Agency (IEA) recently announced their 2009 projection of when oil production would peak was changed from 2030 to 2020, although in a bemusing twist they said it would never ever exceed the peak that was reached in 2006 of 70 million barrels per day. Err…just a small point there; perhaps someone can help me out here? Like I’m not very smart, but the way I read that it looked to me like they were saying that “Peak Oil” was in 2006?

http://af.reuters.com/article/energyOilNews/idAFLDE6A70SK20101109

They also predicted $100 oil by 2015 and $200 by 2035 although they don’t say how they calculated that. But if you assume (a) that the share of GDP that will be spent on oil is constant (b) that right now the price of oil is just right (according to the theory of Parasite Economics it is http://www.marketoracle.co.uk/Article10998.html) (c) broadly static production capacity over the next ten to twenty years, and (d) 5.5% global GDP growth (nominal), then you get to those numbers.

Except that oil demand is not elastic.

$147 oil in 2008 proved that, the price went up, demand was hardly affected, and then the players blinked. In that year USA spent $450 billion importing oil; if oil had cost $147 for a whole year they would have spent $750 billion. That makes QE2 look like chump-change.

So what is the “Fair Price” of oil?

These are the IEA numbers put out in the November 2008 World Energy outlook for the all-in costs of producing oil:


 
I don’t think that’s changed much. More likely the price has gone up, and by the way, I don’t think the oil-shale numbers include the cost of cleaning up afterwards. OK these days, jack-ups are chartering for less, but then that’s not where the new oil is, the market is for semi-submersibles, and net-net those prices are up not down, particularly if you self-insure, like BP.

Production costs matter because there are two ways of valuing a resource that, even if its supply is not finite; the cost of bringing in more goes up exponentially. And don’t forget, you have to add royalties to those numbers.

This is the latest chart put out by OEDC/IEA:

Notice how much of the oil that will keep the world ticking over is supposed to be going to come from “fields not yet developed or found”.

Now I wonder, would that be the expensive oil…or the cheap stuff? Perhaps that’s like for hardwood trees, the ones at the edge of the forest near a road are cheap to get out, then the further you go in, the more expensive that gets, and then you have to wait for new ones to grow.

So you pay the generals a kickback to let you pull out the easy stuff, and you leave the stuff on the mountain on the other side of the river, to the peasants. That’s how “fair value” is another word for saying what the value is when there is “fair-weather”.

“Ah nonsense” you say, “the correct, fundamental, fair-market price of oil is what you can get some sucker dumber than you to sell it to you for”. And you are absolutely correct!

That’s the same principle (in reverse) as how they used to value AAA rated synthetic collateralized debt obligations lovingly crafted by Goldman Sacks. In those days on Wall Street the price of that garbage was determined by, “What you can get some dumb sucker to pay you for it”.

That’s what accountants call called “fair-value” or “mark-to-market”; or if you want to be technical and use International Valuation Standards (IVS) that’s called a “Sales Comparison Valuation”.

It helps if you can spread some misinformation around to “oil” those deals; and the misinformation in the oil business is legendary. But look where that method of valuation ended up on Wall Street, as the genius financial engineers who knew the price of everything and the value of nothing, worked their magic!

And the lesson learned from that is?

Manure happens (with a capital “S”), it really does.

The other way to do a valuation if you have a growing demand, plus a nominally finite resource, is to value it at what the buyer will have to pay if you don’t sell him what you got, today.

That’s the same as valuing an oil-rig at depreciated replacement cost, sure you might have spent $100 million to buy it five years ago, but if a new one costs $200 million today, you are not going to sell it for $50 million (unless you are someone’s agent and the buyer slips you a kickback or your bank is calling in its notes).

So say I’m a seller and I don’t have to sell, and you are a buyer. And if I don’t sell to you then you got four options:

Either (a) you hold a gun to my head and steal, or threaten to steal, what I got (b) like if I am an agent for the owner you pay me a kickback, or if I am a despot, you can train my police how to do water-boarding and testicular electric shock treatment (TEST), and in return for your “aid” and “protection”, I will give you a discount, (c) you trade in your Ferrari for a donkey (d) You lend him a shovel and tell him to go out into the real world and dig the stuff up himself.p>

Traditionally in the oil industry the main negotiating strategy was a combination of (a) and (b). But now there is a glimmer in the wind that things might be changing.

The problem with the old “gun to the head” strategy; is that oil has to go a long way from its point of supply to its market. And as the Americans and Tony’s Tommie’s, found out in Iraq (before they ran away the second time), you can spend a trillion dollars AND urinate on the Geneva Convention, and still not stop those darn peasants coming down out of the mountain and blowing up your pipelines, and if you are unlucky, sometimes they blow you up too.

And the problem with the CIA’s idea of “we know he’s a son of a bXXXX, but he is OUR son of a bXXXX” is that (a) fundamentally he IS a son of a bXXXX (b) he might get tossed out. Then you have to start over.

The other thing is this idea of democracy. It was that darned communist Jimmy Carter who opened up that can of worms (read his new book). Before he came along, like for example in South America, the Generals with their connections to US Generals had the whole thing sewn up in a variation of “Option (b)”…banana’s copper, cocaine…you name it. Then Jimmy put a stop to all that and started going with this weird “peace-&-love” idea that the beneficiaries of the resources of a country, should be the people who live in that country, rather than a few Generals, and of course The Free World.

That was the start of the rot.

So let’s say you are Abu Dhabi, or Saudi Arabia, and any other oil exporter that has the independence and the integrity, to decide to put the long-term prospects of its own people ahead of the long-term prospects of the Free World.

You got money in the bank, your infrastructure is built, and the biggest threat you face is people trying to put their hands in your pockets, plus there is the theoretical threat of your neighbour (Iran) invading and stealing your oil (not that that is very likely, but the Free World would have you believe that could happen tomorrow).

If those two countries decided tomorrow that they would only pump enough oil to finance their essential current expenditure plus capital expenditure, oil prices would go up, easily to $150.

And the NPV of the money that they would normally have got from pumping and saving, or pumping and wasting (which if you take a ten year average has yielded them about 3% IRR), would be five times bigger.

So why don’t they do that?

The main argument is that perhaps new technologies will come along, like after the first oil spike. Back then Europe started saving energy by driving those fagot inspired little cars; plus there was North Sea oil and other breakthroughs in offshore technology.

So the Big Bad Wolf story is that if they aren’t “good”, then new technologies will be developed, and then they will have nothing. So they might as well pump as fast as they can, and sell the stuff cheap before it gets cheaper.

And oil is going to get cheaper…Right?

Ever wondered why oil companies spend so much on hype saying that global warming is nuts, and that they got plenty of oil?

That’s because even now, many oil concessions pay oil companies a fixed dollar amount for every barrel of oil that’s pumped. So if oil prices go up, and if that affects demand, then their revenues will go down.

The last thing the oil companies want is for the price of oil to go up, then they have to start going out and putting their money where their mouth is, and showing how all those reserves that they have on their books, can be brought in, for the cost that it says they can be brought in, on their books.

Baron Von Altendorf has a good explanation about how that all works; like how the “value” of oil companies reserves is worked out the same way they used to value AAA rated synthetic collateralized debt obligations at Goldman Sachs  http://seekingalpha.com/article/174575-the-oil-casino-sec-heading-for-monte-carlo-part-i

Imagine if oil production was cut by 20% like they did in the First Oil Shock?

Then, if the Free World was to go on ticking, the oil companies would need to go out and find oil and bring the bacon home, for less that $150 a barrel.

“Ah” you say “that would be the oil producers cutting off their face to spite their nose, because the world economy would slow”.

Quite so then they would have to spend less money (or oil), to build whatever new infrastructure they want, and to buy fancy toys.

“Ah” you say “without the Great Protector of the New World Order and the Free World, (and don’t forget Tony’s Tommie’s), there would be chaos, and Iran would invade, and there would be rampant terrorism…so much for the trillion dollars spent on The War on Terror (so far).;.. if one seller holding out for a price he likes can do that, well that would have been a bit of a waste, as in “wasting” the 400,000 Iraqi, Afghani, and Pakistani civilians that Tony says “we” were better off without”…(that’s according to the Lancet’s report).

But yes, that’s a good point. There again, after witnessing the fiascos in Iraq and Afghanistan, there may come a point when the people who have the oil, figure “well, we think we will take our chances, thank you very much”.

That day may be closer than you think.

Particularly since that’s what the price of gold is signalling. Ain that context, benchmarking is another way of doing am “other-than-market” valuation (that’s if you believe in International Valuation Standards).  http://www.marketoracle.co.uk/Article24034.html.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. 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.

© 2010 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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