The Ghost of Crude Oil Futures (Part 1/2)

Most people have heard the phrase, “it takes a big man to admit when he’s wrong.”

Well, I’m about 5’9”, and I don’t believe that people should be exalted when they do something that they’re supposed to do. It doesn’t make you a big man, it makes you honest. You’re supposed to be honest.

I’m going to do something profound. Something most people should do, particularly those in a position or profession of dealing out commentary, suggestions, and advice – especially when there’s money involved.

I’m going to tell you I was wrong about something. And I’m going to do it without giving you a bunch of padding and reminders of the other 1,349 times I was right. Those of you who read my columns may have already guessed what I’m about to say, so without further ado, here goes:

I was wrong about oil. There, I said it.

Right direction, wrong price.

A few months back, during oil’s initial slide, I made it clear that I thought we (as investors) should be getting involved in oil as it broke below $90 per barrel. I honestly thought that anything under $90, and if it continued, under $80, was an absolute steal, long-term.

Regardless of whether I may still be right long-term, the continued price destruction through ever major support level was not something I anticipated. Granted, few of us saw the destruction of our entire financial system and collapse of several companies we expected to survive for centuries, but I don’t see this as an excuse or justification for sweeping past predictions under the rug.

Before we head down this old, beaten, well-funded-but-poorly-maintained road, I would like to make two specific points: I enjoyed paying $1.67 for gas on Tuesday – I filled my tank for about $30. Truthfully, I’m a little embarrassed by the elation I felt, disheartened that the highlight of my day involved getting a relative deal on the fossil fuels I pour into a machine that will drag me to the mall so I can do my part in lending a crutch to a crippled retail sector and tear a small hole in the ozone layer along the way.

Ho, ho, ho. Scrooge has competition.

The second point is that the minute savings on gas does not compare in any way to the profit that stands to be made if an investor were in a long oil position when what will inevitably happen… well, happens. Should I get the chance, I’d be spraying myself with $4.00 gasoline with a smile on my face – if I own a boatload of oil stocks.

Disclaimer: I’m buying oil. Let me rephrase that – I bought oil. Not literally, of course. I’m buying derivative securities in the form of energy companies and oil funds, but essentially I’m putting myself in a position to make money if the price of oil goes north.

So what convincing argument can I provide that will instill confidence this time around? Well, let’s skip the opinions based on contrived scenarios and look at the facts.

Santa’s sleigh is powered by reindeer. Automobiles are not.

Let’s begin with the glaring reality that people are not going to start riding bikes to work. If you can ride a bicycle to work, then you obviously live close enough that you weren’t using much gasoline anyway. In other words, people are not going to stop driving altogether.

Trucking companies are not going to convert to horse-drawn carriages. Airplanes are not going to throw it in neutral and glide to their next destination. And, let’s face it, it’s not feasible for Americans to begin chopping down all the trees in the neighborhood to burn logs in their homes.

The countries, cities, towns, and food markets are not suddenly going to drift closer together to make travel more economical for anyone. We have to get around, and with 250+ million cars on the roads in the US alone, it is far more difficult to find/develop/purchase alternative means of transportation.

Great, so what does this mean?

Experts agree, digging costs money.

It is the contention of not just myself, but one of the world’s foremost oil experts Matthew Simmons (chairman of Simmons & Company, an energy investment bank), that demand has not fallen as much as prices reflect. In fact, in a recent interview with Fortune, Simmons stated that “we don’t have precise data… but there is no way demand is falling to the extent that the pundits seem to think it’s falling.”

A week ago, OPEC announced a production cut, citing a slowing global economy and reduced demand as justification. The market blew off this news and oil dropped below $37 per barrel. Simmons explained that OPEC is cutting supply because they’re panicked. At $40-$50 per barrel, many of these oil-based economies just “don’t work”. This is because there are certain fixed costs of production that cannot be changed. In other words, it hasn’t suddenly become less expensive to dig a hole.

Therefore, prices will not stay where they are now. If it means cutting production until these economies reach the price they want… or more accurately, need, then that’s what will happen. As Simmons accurately points out, because of differing cost structures, $30 per barrel oil today would actually be less sustainable than the $10 per barrel oil of long ago.

It all boils down to this:

Oil is a business, although many people seem to be under the delusion that it’s some form of inalienable right. If a business isn’t profitable, it will not run, and the energy industry is not a charity – it is, in fact, quite the opposite. Instead of running in deficit in order to make gasoline more affordable for all of us, they will more likely tighten the noose that is already around our collective necks until they get a price they can live with.

Next week, part 2 – price barriers, the possibility and horror of cutting into a balanced market, and where this is all going.

Disclosure: No stock positions, but I own derivatives securities in energy companies and oil funds.

Comments

[Ferdinand E...:]

I'm not sure that I like the mathematics in this article. At $40-50/b most of the oil producing countries in the Middle East, as well as the 'majors', work fine. Of course, they don't work as good as some of the decision makers in those countries and 'outfits' want them to work, because no amount of money would satisfy them.

Over the Christmas holidays I have chalked up quite a bit of TV time, to include watching interviews with a number of OPEC potentates, These are obviously some very intelligent men, and you can be certain that they understand the oil game better than any outsider - to include my good self. Even so, let me make it clear that if they had had another year or two of racking up super-profits, and diversifying out of oil, those of us on the buy side of the market would really have something to worry about.

2008 Dec 28 09:00 AM

[toobad41:]

Finally, someone has addressed the true nature of the oil business.

2008 Dec 28 09:19 AM

[long_on_oil:]

Oil companies hedge by selling futures contracts. It is the number of contracts sold at specific prices that determine revenue. So even though prices have fell to the current levels there are still contracts that were sold as long as 9 months ago that are bringing over $100 a barrel. If the oil companies refuse to sell future contracts at these low prices, you will see the prices start to rise. They can always leave the product in the ground. The oil companies use futures contracts to hedge sales and level out returns.

2008 Dec 28 09:21 AM

[petervankan:]

Sure we need oil to get around. However, there are many - simultanious -developments that cut into demand:
people want to save money
non-hybrid cars are on their way out
there's ethanol and biodiesel
Rentech has produced its first barrels of diesel (from coal) for airlines
there's a new president

I expect oil to go up again in 2009 and 2010, up to around 150 again, and from 2011 it will be downhill. The era of oil will be over much sooner than most people expect.

2008 Dec 28 10:31 AM

[bowman711:]

I don't have any proof, but the government has said it will do whatever it takes to save the economy, so it seems reasonable to me that the government is driving the oil price down to help save the economy. There is also an outside chance it is done to give the Big Three auto companies time to sell out their large vehicles and to build fuel efficient autos and trucks.

2008 Dec 28 11:45 AM

[ACEMAN:]

Y'all got the wrong concept here and I wonder why. It is nearly impossible to time the market when it comes to the direction of the oil & gas markets only because y'all are looking at price only and not the demand side. Contrary to supply side theory, oil & gas futures do not statistically corrolate in any significant and measurable way. Thus y'all are looking at the wrong measure. And stay away from the oil ETF's they are always going in the wrong direction at the start of any price movement. The best thing is to find the very best oil & gas companies and analyze them in terms of a business and the known reserves they have. And always use a discount to future value in your evaluation. This way you will find great companies some of whom are under the radar screen and will make you real money. You really have to work at it! One note on Mathew Simmons: go to his website and have a ball but remember there is the little question of conflict of interest always shading his commentary. Also, stay away from anything from "T-Bone Slim-Pickens."

2008 Dec 28 12:39 PM

[nmelendez:]

Everyone keeps forgetting about LNG. I find Honda has the right idea, diversify away from oil. They're civic is fueled in your garage on a daily basis. It still is not usable for long hauls but great for local use. In the US there is plenty of LNG. And then we have Clean Coal Fuel. They all pollute but thats where technology comes in. We gotta get away from the middle east, way to dependant on them.

2008 Dec 28 12:47 PM

[ACEMAN:]

Y'all are looking at the wrong measure or measures because the pricing model just can't give you what you want and that is to time the direction of the oil & gas market futures. In order to make money you need to find very solid oil & gas companies world-wide under the radar by analyzing them as businesses first but specifically digging to find out the known reserves and discounting them to future value as it will take 8 years or more from exploration to delivery. ForEx is extremely important since all delivery and all oil & gas deals are in dollars but locally it is in local currency. The spread can make or break you. Note: Mathew Simmons is great but historical in nature and stay away from Boone Pickens as his conflicts on interest are legendary.

2008 Dec 28 01:04 PM

[Pranjay Kau...:]

If we say that OPEC countries cutting production as they cannot sustain at 30-40$, one needs to understand that the cost of production for an Onshore oil well is around 5-6$/bbl approx., and around14-15$/ bbl for off-shore production. Other charges included i.e. FOB price is what we see. Second, treating it as commodity would mean that as the recession in US, Europe and Japan deepens, which it will might bring the price of oil to less than 20$/bbl, and I think for sustained period of time. As there is always new oil discoveries, new more efficient technology development for auto etc. Please be cautious on derivative positions and hedge it well. Happy investing!

2008 Dec 28 01:31 PM

[silverwood:]

Yes, I agree this oil price crash quite possibly was engineered. After all The Fed needed to quiet down the commodities sector and strenghten the dollar so that it could crank up liquidity to bail out the banking sector. It has worked well to quell inflation expectations. In this interview with Don Coxe, Don make reference to this. You can find it here; www.financialsense.com..., part 1 Don Coxe, October 11, 2008
"Homicide: The Crime of the Century"


On Dec 28 11:45 AM bowman711 wrote:

> I don't have any proof, but the government has said it will do whatever
> it takes to save the economy, so it seems reasonable to me that the
> government is driving the oil price down to help save the economy.
> There is also an outside chance it is done to give the Big Three
> auto companies time to sell out their large vehicles and to build
> fuel efficient autos and trucks.

2008 Dec 28 05:11 PM

[greensense:]

It was only 1999 when oil was $12 and all economic indicators are saying our economy is being set back to the mid 1980's. I think there is still some downside risk and I for one am thrilled to not be sending so many $ to the countries that actually hate us and our lifestyle.

2008 Dec 28 11:52 PM

[Tickerphilia:]

The price of oil began to crack when Senate committee chairmen began to rattle that legislation was forthcoming to regulate speculation in the oil markets. It appears that speculators using the CME&ICE began to run for the door. As the price of oil has dropped, so have the equities of these exchanges. A similar oil bubble occurred in the '70's when specs bought up tankers of crude and had them steer in circles until prices rose to a satisfactory level. When the price began to crack everybody ran to the nearest door (read: terminal), and prices plunged.

2008 Dec 28 11:53 PM

[X-15:]

Russia,reliable? Iran still working hard on uranium enrichment. Afganistan comin apart. Iraq, still problematic. India and Pakistan goin eyeball to eyeball. Israel moving hard against Hamas. Dollar about ready to roll over. Mexico fields depleted. Brazil still years from opening Tupor Field.Most exploration and marginal fields being curtailed.
Especially now when the USA has shown that THEE main concern is deflation, I do not believe we wished for OIL price collapse, thereby taking out the new energy buildout that WAS creating lots of good jobs in USA heartland.

Make no bones about it 25- 35 bucks per barrel sets the stage for trouble around the World.

Someone is going to stir the pot.

2008 Dec 29 03:38 AM

[oiler1930:]

The runup in oil prices was funded by the big commodity index funds as a part of their portfolios. when the housing bubble broke, they were forced to sell everything to retrieve capital. The effect was comparable to a night club fire; everyone runs to the exit,and get caught. Like clock work, every month the nearby positions were rolled forward to future postions, which explains the contango. some money is flowing back in, where forward contracts nearby jump $2 above its predecessor, before getting less wild in the more distant futures.

I operate a small lease that raises four millionths of our domestic input (0.0004%). My lifting costs run $25/bbl; the new offshore oil is expected to cost $50-75 per bbl. The analysis above that shows lower costs neglects these facts.

2008 Dec 29 09:48 PM