Don't Believe This Rally in Oil 24 comments
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Dear Clients and Prospective Clients:
Mike Myers is a very talented writer and comedian. His Austin Powers movies really hit my funny bone. In the second Austin Powers movie, Austin’s arch nemesis Dr. Evil clones himself. His clone looks just like him, but is less than half as tall and attempts to be just as evil on a pound for pound basis. Mini-Me, as his clone is called in the movie, creates strife between Dr. Evil and his son, Scott. Scott was the product of Dr. Evil’s dalliance with Frau Farbissina, a loyal employee whom he “got weird” with.
Bespoke Investment Research reported yesterday that Oil has now gone up 108% in price per barrel in 118 calendar days. It is the sixth best bull run in the commodity since 1986. Four of those bull runs occurred in the huge secular move from $11 per barrel in late 1998 to the peak at $147 one year ago. This one and the 164% increase when Saddam Hussein invaded Kuwait in the summer of 1990 are the most violent in the shortest amount of time.
The four other 100% plus gains in price lasted a minimum of 453 days to a maximum of 542. The huge run from $11 to $147 per barrel culminated in a Malthusian orgy and sought to validate a theory called “Peak Oil”. This theory held that the un-interrupted growth in emerging economies around the world was coinciding with the peak of worldwide oil production. In effect, Dr. Evil (those countries producing Oil and companies involved in producing it) would hold the rest of the world hostage and demand “Millions” of dollars (he meant billions and trillions) in ransom.
In the minds of Smead Capital Management there were at least four big problems with all the excitement about “Peak Oil”. First, it was predicated on uninterrupted growth in emerging markets and that has already been debunked. Second, high prices and fat profit margins caused over-production as every country or company which could find and produce oil did. Third, and most importantly, it assumes that the largest oil consumption country (U.S.A) will not permanently modify its behavior. We believe that we will move away from gasoline powered transportation producing air pollution, just as we moved away from horse transportation activated by oats and hay (resulting in manure) between 1910 and 1925. Everything moves faster nowadays and the huge economic reset of the last year and the will of the Obama Administration seem to have jumpstarted the process. Lastly, the move from $11 to $147 per barrel culminated in a “bubble". And “bubble” markets can have bounces, but they don’t get put back together for a minimum of 5 to 7 years from what we read and know of history.
This year’s run from $32 to $72 per barrel looks and acts like last year’s activity, but we think it is a Mini-Me among oil rallies. It is predicated on the idea that emerging economies will lead us out of the worldwide recession. Under that assumption, the use of oil and other commodities would be at the forefront of the economic recovery. Today’s oil bulls think oil is the best place to be because the building of infrastructure, in their minds, will dominate the economic recovery. This compares to U.S. consumers who have permanently reset their spending at lower levels.
We think they are wrong. Even though China or India have one billion people their consumers still control a pittance or Mini-Me level of buying power in comparison to the average American. An old and true business adage says, “If nothing is sold, nothing is produced.” Most production is held hostage by retail sales. Just ask any automobile company today and they will reinforce us. If the U.S. economy doesn’t come back, don’t hold your breath waiting for everyone else to get back their "Mojo" back.
We believe we are in the midst of what we think is a Mini-Me rally in Oil which is attracting the same kind of hot money that it attracted in the first half of 2008. It would like to hold our economic recovery hostage and hog up investment capital. Don’t believe this rally in Oil. We think it is “catnip for clones”.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.
Full Disclosure: No positions in names mentioned
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There is no way in hell that the U.S. can "permanently modify its behavior" in regard to the use of hydrocarbons prior to an economic turnaround. The markets know it, thus increasing prices.
I would add... speculators are part of our markets. Volatility is a symptom of peak oil. Volatility is what we will be living with for many years to come.
re: the SPR...a lot of people minimize the effects that its purchases have on prices...price elasticity of demand for oil is obscenely low (aka its really inelastic) so SPR actions have much bigger effects than casual glances would deduce. Stack China's recent SPR filling and the floating storage and there is a huge impetus for an unsustainable run.
We'll look at the US SPR purchases since 16 2009 was when EIA reported the SPR started purchases again (first time since week of Aug 8th 2008). If you plot the band where SPR purchases were heaviest and then compare to WTI prices...2/27/09 thru 5/22, you will see the SPR filled at a 1.3m bbls per week rate (average)...or roughly 20k per day. According to phil verleger's study (see here: www.iie.com/publicatio...) he concluded that the elasticity of WTI is as follows: "a one-percent reduction in the light sweet crude supply would require a price increase of between 25 and 40 percent to balance the market." (as usual, there are numerous assumptions, so i will no go over them here, please read the study). Given that the DOE may
be taking between 0.1 and 0.5 percent of the light sweet crude from the market on a daily basis (over the period cited above)...this means 15-20% of the runup can be directly attributed to SPR purchases... then combine floating storage demand which has grown at a multiple of the SPR storage (150m bbls over past 6-9 months vs. 20m bbls in SPR over past 3 months...so, the SPRs run rate would be 1/2 to 1/3 the private run-rate) plus Chinese storage (i have no clue how much they have stock-piled, but its probably not any smaller than the US' purchases), pile on delta hedging and we get a better picture of how we doubled in 100 days. These drivers are clearly transient and do not (in my opinion) represent any sort of sustainable behavior (the SPR just halted purchases last week, in fact).
(no positions nor should this be construed as a recommendation to take any positions)
I just rolled out of DXO and into DTO this morning (should have waited till the end of the day, but oh well ...).
My rationale was this - we are hitting a physchological level in the markets where people will cash out to lock in their returns, coupled with a natural resistance level at ~$70/bbl in crude. The final factor is that the dollar is moving up again, albeit briefly.
All of these factors impede any further increase in oil prices. Could crude go higher? Yes, and it probably will before the end of the year. Will it do this in the short term? I think not. My belief is that it needs to retrace a bit before it can move any further.
I admit to being torn about selling DXO today, but think that I can pick up a few percentage point being short on oil right now before getting back on the long side.
Recommended ERY on my website today based on these factors:
1. no fundamentals
2. no technicals
3. high interest rates
4. increasing dollar this week
5. cpi data should hurt it more
6. when you read news about oil and they say why it went up its usually...uh a mystery.
Check out more of my pick at theoxengroup.com/oxenp...
David Ristau
President, The Oxen Group
On Jun 15 03:05 PM MadScientist wrote:
> Excellent comment stream on this article - very informative.
>
> I just rolled out of DXO and into DTO this morning (should have waited
> till the end of the day, but oh well ...).
>
> My rationale was this - we are hitting a physchological level in
> the markets where people will cash out to lock in their returns,
> coupled with a natural resistance level at ~$70/bbl in crude. The
> final factor is that the dollar is moving up again, albeit briefly.
>
>
> All of these factors impede any further increase in oil prices. Could
> crude go higher? Yes, and it probably will before the end of the
> year. Will it do this in the short term? I think not. My belief is
> that it needs to retrace a bit before it can move any further. <br/>
>
> I admit to being torn about selling DXO today, but think that I can
> pick up a few percentage point being short on oil right now before
> getting back on the long side.
To characterise peak oil as a 'theory' perpetuates a misunderstanding economists have habitually had on real physical constraints.
Old-fashioned classical economics assumes that demand automatically productions, productive capacity being assumed to be infinite.
It is hard to see why we are not still burning whale oil then.
The economist retorts that Other resources will be substituted, as mineral oil was for whale oil, as the price rises higher.
This did indeed happen, but this formulation ignores the disruptive effects.
A peaking commodity does not rise and fall smoothly, leading to ample opportunity to bring alternatives on line, but follows a saw-tooth pattern of booms and crashes - rather similar to the recent oil price spikes and declines, in fact.
Airy talk of switching to electric cars and nuclear or renewable energy ignores the historical record, where such transitions have taken around 40 years, say from coal to oil, and are not accomplished at the flick of a switch.
Peak oil is not a theory, but a geological fact, and the oil resources which remain such as tar sands will be much more expensive to produce, and take a long time to bring on line.
Meanwhile efforts to substitute other resources will be hindered by the switchback behaviour of oil prices.
Those billions of Indian and Chinese consumers dismissed in the article now have autos, and savings, and will take quick advantage of any dips in price.
Has every one already forgotten all the talk not many months ago around the globe that the NYMEX contract no longer reflected fundamentals? At that time, major players were using oil contracts in other parts of the globe because they could not get a fair price on the NYMEX contract.
><snip>
> them. I've noticed for several years that something like a piece
> of plastic shaped into a food plate will cost a minimal amount,
> but if you mold it into something like a Corvette fuel rail cover
> it will cost you several hundred dollars. I wonder why this is?
> The answer is simple; as I said before, motorists are suckers!
Have you considered the costs of development vs. the quantity produced? Costs+profit must be amortized over the quantity produced.
Let's see, some-far-out-number-of... must be in the billions with a minimal development cost, since the principals of structural strength, extrudability, etc. are well established and "style" is not much of a factor. That means the majority cost is purely materials and manufacturing cost.
I guess you can follow this and apply it to a totally custom part over a few thousand units for a short run. And then additional costs not generally suffered, to the same degreem by paper-plate manufacturers come into play, such as marketing, higher insurance and legal costs, etc.
We may still be suckers, but at least most of us know what we are paying for.
HardToLove
Peak Oil is a "theory" like gravity is a theory. They are immutable. Just because a trader or a consumer doesn't like that gravity exists, doesn't change the fact that it does - and no amount of ill-informed comments will change it either.
>Bespoke Investment Research reported yesterday that Oil has >now gone up 108% in price per barrel in 118 calendar days.
Wow, "sounds" impressive! Too bad it is a totally meaningless statistic. Just how high has worthless Citi gone up? Or AIG? Or Copper? Or Lead? Or Nickel? They are all up as much or
more in percentage terms. And why not say "in the last 365 days, oil is down 50%" (or whatever the actual number is)? But of course, that wouldn't produce the desired "shock" statistic.
>Today’s oil bulls think oil is the best place to be because the >building of infrastructure, in their minds, will dominate the >economic recovery. This compares to U.S. consumers who have >permanently reset their spending at lower levels.
>We think they are wrong. Even though China or India have one >billion people their consumers still control a pittance or Mini-Me >level of buying power in comparison to the average American. An >old and true business adage says, “If nothing is sold, nothing is >produced.” Most production is held hostage by retail sales. Just >ask any automobile company today and they will reinforce us. If >the U.S. economy doesn’t come back, don’t hold your breath >waiting for everyone else to get back their "Mojo" back.
Hmmm. With all your "research", did you really fail to somehow
notice that almost all the growth in demand in oil in the last ~5 years came from the developing world? And that the developing world hasn't gone into recession despite all the claims by the xenophobes that if the US sneezes, the rest of the world catches a cold? If China, India and Brazil have a cold (while still growing 6-10%) then I think every American/European would dearly love to be so sick.
As for China not having the same per capital buying power, so what? Does that makes the 90% yoy increase in sales in cars in China in August any less astounding? Nor the fact that China overtook the US as the worlds biggest car market, selling 1MM vehicles in August? Just what do you think will power those 33,000 new cars added daily in China? Oxen?
While the arrival of peak is debatable (only a matter of when, not if), it is a meaningless argument for consumers. WHAT MATTERS IS THAT THE ERA OF CHEAP OIL IS GONE - the incremental bbl costs more than $60 to produce (oil sands, heavy oil, offshore, arctic, secondary and tertiary recovery medium and light fields etc).
Add in the stunningly steep and massive declines in what was the second largest field (Cantarell) in the world until last year (now ~8th and declining faster than all predictions at 35% yoy), it's clear that the era of cheap oil is over.
When the world's biggest field (Ghawar) starts its decline, the world oil market will panic. That day is coming - soon - maybe 5 years, maybe 10. But it is coming like day follows night. In the meantime, it is sufficient to know that $60 is the likely floor in oil - drops below will only be temporary and will be huge buying opportunities.
Combined they already use over 10mbpd of Oil that is half US and 5x UK consumption, hardly a pittance.
China only uses 2 barrels and India 1 barrel a per capita a year, but if they were to use the same as Brazil at 4 barrels, still a long way from the US's 25 barrels, their total consumption would be 25mbpd 25% more the US.
Domestic Chinese car sales overtook those in the US for the first time in December of last year, and this trend has continued. Say their car sales grow at 10% a year (China's rose 48% in June from a year ago) then their oil consumption could over take US consumption by 2015.
On the second point of over production caused by high price, that is wrong as well, as world oil production has been flat since 2005.
The third point is also wrong, as 95% of all transport fuel is Oil base and that is not going to change fast. Exactly how many of the 230 million vehicles in the US are electric/NG or will be in the next 5 years. As Chevy Volt production is only predicted to be 60,000 in its first year. $70 a barrel is just not high enough to make significant switch to alternatives, as in Europe a US gallon already costs $6+.