Oil at $50/bbl: Where to from Here?

I think oil has more chances of going down than up from here. My main reasons for oil corrections are the following:

1. Marginal cost of production: In the long run, supply curve is determined by production costs of a marginal supplier. The key feature of the oil supply curve is that for the majority of oil demand, supply can be provided at roughly a $10-20/bbl level (mainly Middle Eastern countries). For Russia, it's probably higher and is in the range of $30-35/bbl. Any extra demand would be met by producers with much higher cost levels of $60-70/bbl. In the first half of 2008, it was assumed that marginal producer would be Canadian oil sands with a $80/bbl cost structure. Speculators were expecting that it would take too long before Canadian oil sands producers start supplying oil to the market and, thus, further production was needed which was expected to come from even more expensive sources (mainly offshore with over $100/bbl cost levels). This assumption clearly did not work out given the drop in global oil demand.
2. In extreme scenarios, oil supply curve turns negative (meaning downward slope) because of OPEC cheating members. With financial markets still half frozen, developing countries have strong incentives to substitute unavailable external borrowings with extra oil supply. Thus, current OPEC discipline cannot be expected to last long.
3. A significant number of oil projects were coming on stream in Q1 2009 and at the same time a lot of refiners were shutting down for maintenance in spring 2009. This should lead to an over-supply situation, the evidence of which is ever growing oil stocks in the US.
4. It's still a deflationary environment and so production costs are expected to continue to fall, bringing down the supply curve.
5. Technically, the oil forward curve (made of futures prices at different settlement dates) still has a steep rising shape which points to future price correction. This steepness was created by unavailable funding to buy oil on the spot market and sell in the future and also by too high storage fees. But it seems that a few banks (including Morgan Stanley) hired tankers and bought oil for storage a couple of months ago and soon this oil will be coming to markets causing further downward pressure.

So, why is oil not at $30/bbl or below? Because the general mood is that the economy is bottoming out, we will soon see recovery and then, due to point one, oil will jump to above $60 levels. Another reason is inflation expectations given the amount of financial stimulus announced around the world (oil as inflation hedge-thesis). I personally disagree with the first point. I also think the second point would be relevant at the end of 2009 or 2010 (US stimulus is comparable to the amount of capital loss of US banks; besides, with banks still not functioning properly, credit is not flowing and money is not created through credit).

Nevertheless, it does not mean oil cannot grow further from here. I would definitely short it at $60 if you see it at these levels in the near future. If you can wait a few months, shorting it even at these levels should probably work as well.

Comments

[Dr. Charles...:]

It is impossible for any expert (I am considered one of those experts, since I have been writing about oil prices in addition to being in the oil business as a "wildcatter" for thirty-five years) to predict pricing due to many unseen variable. The fact is that oil prices will rise to $100.00 a barrel by April 2010 and then move upward to$150.00 a barrel by the end of 2010 or early 2011 and possibly upwards to $200.00 to $300.00 by 2012. Low prices now create high prices later because supply is not being developed, while nearly all oil fields worldwide are declining in production capacity. Demand worldwide for oil will increase in spite of alternatives even if world economies were not robust, however Asian economies will consume much more putting pressure for much higher prices and high inflation for Americans because we are not drillng enough here. Our studies indicate we have Saudi type fields right here in the United States, but government regulations are slowing killing our own oil industry. Dr. Charles Laser

Apr 20 11:17 AM

[Dr. Charles...:]

Dr. Charles Laser has been a "wildcatter" for over thirty-five years full time in the United States drilling in Texas, Colorado, Michigan, Illinois, Indiana and Wyoming. He served as Executive Vice President for GeoSpectra Corporation a firm who provided geological satellite remote sensing services for oil and gas to the top fifty oil firms worldwide in the 1980's. He has written numerous articles for finance publications and newspapers on oil pricing.

Apr 20 11:28 AM

[blu:]

Dr. Laser,
I fundamentally agree with your post, however I would love to see your "studies" that "indicate we have Saudi type fields right here in the United States".

This is my 30th year as an independent producer in Texas, and I guess I've had my head in the sand, because I haven't heard of any such potential oil fields here that even come close to the depleting Saudi fields that have produced hundreds of billions of barrels of oil.

I also agree that governmental regulations are one cause of our stagnating industry. Drill Here, Drill Now!!

Apr 20 11:30 AM

[Ferdinand E...:]

I don't believe that government regulation is the cause of a stagnating US oil industry, and I definitely don't believe that there are Saudi type fields in the US, and even more than these things I believe - and am always ready to prove - that I am the leading academic energy economist in the world.

On the other hand I believe that OPEC cheating is less prevalent than it was a few years ago, and I believe that the OPEC oil producers are smarter and comprehend how oil production should be programmed intertemporally, given certain restraints. However I will admit that despite my considerable knowledge, the global macro and financial market situation means that even I could be wrong, because that situation could cause both producers and consumers to do strange (and perhaps irrational) things..

Apr 20 11:58 AM

[BrotherMaynard:]

"why oil is not at $30/bbl or below? Because the general mood is that the economy is bottoming out, we will soon see recovery and then"

You are making an eggregiously wrong assumption by saying this. "mood" implies that there is some sort of future discounting happening at spot prices. but that's impossible. there are no future cash flow in spot prices to discount. i don't know why this equity mentality continues to show itself in commodities. equities and commodities are apples and oranges. if you don't understand that, you shouldn't be talking about oil as if you do.

you need to go back an reformulate your entire argument based upon the fact that there are no future cash flows in spot prices and therefore no such thing as future assumptions in spot prices.

Apr 20 01:41 PM

[Young Min Nam:]

No matter what analysts or people say at the moment, I do believe oil will go up eventually. It is now the necessity of life. I invested in three oil companies, and I am going to hold on to all of them until oil hits at least $90-100/bbl.

Apr 20 10:38 PM

[Hot Richard:]

Young Min Nam,
Careful with investing in oil companies because you believe in oil. The two are not the same.

Remember that airline companies have a poor track record of returns for investors--while execs at those companies (and politicians regulating the airline industry) made billions.

It is very possible that most equity stakes in oil companies will underperform oil ETFs (but ETFs aren't the best buy and hold).

Apr 21 10:15 AM

[Hot Richard:]

"It is impossible...to predict pricing due to many unseen variable. The fact is that oil prices will rise to $100.00 a barrel by April 2010..."

I'm skeptical of your fact there, Doc Laser, because YOU JUST SAID IT IS IMPOSSIBLE TO PREDICT PRICES!

Hot Richard went for a year to a doctor school where they taught the definition of "fact".

Apr 21 10:18 AM

[dw57:]

while oil may go up, we will actually have to see some demand growth as opposed to today's relentless demand destruction. and even while that destruction was gathering steam, it seemed oil was sky rocketing, leading to the obvious conclusion there was a lot of speculation in the market. and since the oil market has so many dark markets and nobody really knows how much oil they really have or what any body else has pr has shipped (proprietary info of course!) it makes a free market impossible because too many are gaming it. so can oil sky rocket again? sure just get some speculators going again!! course they will have to find some capital to do it this time on their own. the investment banks are gone

Apr 21 03:45 PM

[seeking_hap...:]

$150 by the end of $2010? Sorry that just isn't going to happen. Perhaps we'll see between $65-$75 by the end of 2009. And yes, maybe even $95-$105 by the end of 2010. But definitely not $150 or $200! The last 3 years have brought about an increase in production. And we're just not going to bounce back economically that fast. The only glimmer of hope for high oil prices short term (1-2 years) is that we begin to see a spike in inflation.

Don't get me wrong, I'm still buying oil because an increase from $45 to $65 is still a nice return on my investment. But I'm not holding my breath for $150 oil anytime soon.

-Paul

Apr 21 04:17 PM

[seeking_hap...:]

Nice comments. I agree. Where are the hedge funds and the cheap money that once "played the market?"


On Apr 21 03:45 PM dw57 wrote:

> while oil may go up, we will actually have to see some demand growth
> as opposed to today's relentless demand destruction. and even while
> that destruction was gathering steam, it seemed oil was sky rocketing,
> leading to the obvious conclusion there was a lot of speculation
> in the market. and since the oil market has so many dark markets
> and nobody really knows how much oil they really have or what any
> body else has pr has shipped (proprietary info of course!) it makes
> a free market impossible because too many are gaming it. so can
> oil sky rocket again? sure just get some speculators going again!!
> course they will have to find some capital to do it this time on
> their own. the investment banks are gone

Apr 21 04:21 PM

[Freya:]

Shorting Oil when it gets to $60 would be totally irrational Behavior. To get to $60 in the first place would indicate greater demand within a relatively stable supply/demand situation. Inventories could mitigate a rapid rise but they could drop faster than they rose.

But the reality is that oil inventories do not really mean anything. The SPR with its 700- 800 million brls. in inventory did absolutely squat in preventing last year's oil spike. A Global commodity rises and falls based on Global demand, not US demand only.

Apr 20 12:29 PM

[Freya:]

Yeah, right.

Whatever you say.

Apr 20 07:51 AM