Why We Continue to Expect Exorbitant Oil Prices

We originally wrote this post in response to a comment on one of our recent articles.

There is no doubt that businesses have tried to become more efficient in the last 20 years, and not carrying excess inventory is a part of that. Ask Ford if high days of inventories is a good thing. We agree that days inventory have not been a predictor of prices over the last 20 years. We do contend, however, that looking at total supply in barrels (rather than days of supply) as some of the bears were doing is an incorrect metric for considering supply/demand balance.

Our belief is that the long-term trend of shrinking inventories was due to the fact that holding oil during that time was a money-losing proposition. As oil prices fell producers, wholesalers and retailers were more willing to hold less inventory, as holding the inventory presented both storage costs and the potential that prices would decline further. For the same reason, companies also underinvested in finding new sources - whether they be new oil fields or alternative sources - there was no business incentive to do so.

Even now, with oil in the range of $70 per barrel, alternative energy sources have major drawbacks. To make a tank of ethanol deprives the world of enough food to feed someone for a year. So in addition to the actual cost there is an opportunity cost that makes ethanol effectively cost something like $350 per tank. Solar? MIT’s Technology Review talks to the inventor of the most efficient solar cell, who says:

A very reputable journal [Photon Consulting] just published predictions for module prices for silicon for the next 10 years, and they go up the first few years. In 10 years, they still will be above three dollars, and that’s not competitive.

Yes, people are trying to make silicon in a different way, but there’s another issue: energy payback. It takes a lot of energy to make silicon out of sand, because sand is very stable. If you want to sustain growth at 40-50 percent, and it takes four or five years to pay all of the energy back [from the solar cells], then all of the energy the silicon cells produce, and more, will be used to fuel the growth.

And mankind doesn’t gain anything. Actually, there’s a negative balance. If the technology needs a long payback, then it will deplete the world of energy resources. Unless you can bring that payback time down to where it is with dye-cells and thin-film cells, then you cannot sustain that big growth. And if you cannot sustain that growth, then the whole technology cannot make a contribution.

With regard to the dye-cells [he invented], silicon has a much higher efficiency; it’s about twice [as much]. But when it comes to real pickup of solar power, our cell has two advantages: it picks up [light] earlier in the morning and later in the evening. And also the temperature effect isn’t there–our cell is as efficient at 65 degrees [Celsius] as it is at 25 degrees, and silicon loses about 20 percent, at least.

If you put all of this together, silicon still has an advantage, but maybe a 20 or 30 percent advantage, not a factor of two. [Meanwhile] a factor of 4 or 5 [lower cost than silicon] is realistic. If it’s building integrated, you get additional advantages because, say you have glass, and replace it [with our cells], you would have had the glass cost anyway.

So realistic solar cell production that are cost-effective without subsidies are still a few years away. In the meantime, we’ll have to dig deeper and deeper for new energy sources.

Meanwhile, demand continues its steady upward march. The last five years have been the wake-up call, saying “Hey, you need some new energy capacity.” Now higher prices are starting to provide the business incentive but it will take years for the new supplies to make it to market. Eventually they will, and when they do they will come in large numbers just as consumers have started switching en masse to more energy-efficient products and prices will plummet for 20 years. That’s the way the free market tends to work in the commodities business.

But for now - we expect higher prices. In the interest of fairness, though, here is the other side: Forbes has the case for oil going to $45. But the Forbes pundit once again says “inventories are at record levels” when justifying his belief - we reiterate that the amount of inventory is only relevant in the context of how much is being used. And while that number too is rising for now, it is at least 20% below record levels.

Crude 2-yr chart:

Comments

[WC Whiner:]

Thanks for the considered response; next time I'll check back in on the original thread.

Your headline thesis, that those who look solely at high inventories to make a bearish call on prices, is well-specified. Your proferred rationales, that lower inventories makes for higher turns and better profits, but that contango recently has helped encouraged storage build, are both probably correct. On your fundamental call, we disagree less than my quick comment previously might indicate. In the very short term, you're fighting the tape, which I mention to establish context: I am not a technician, I often make fundamental bets on reversals, and I am often wrong. In the medium term, we agree that ethanol and solar are distractions, though in my ethanol accounting natural gas costs are at spot and subsidies are charged to taxpayers, not corn distillers. In the long-term, we agree completely: petroleum is a resource which no reasonably expected technologies replace in the next couple decades.

My skepticism about your short/mid-term market call bases on expectations for consumption and production, not measurements of storage. The critics whose arguments you should be addressing are the thoughtful bears like the MS group, for example here: www.morganstanley.com/...

Once production comes online, it is used; I do not expect much growth there, but some, especially when it comes to refining capacity and gas, less crude. Demand is the big variable. My view is that the housing market need not drop much to crimp demand in the coming year or two. In 2005, home-equity withdrawals were over a half-trillion, and I do not see that continuing. That comes right off the top of all consumption. US demand currently drives (cough, sorry) more than just North America. As consumer of last resort in an unbalanced global trade picture, when the US catches cold, China sneezes. Risks to this scenario are the same everyone knows: production problems, especially unpredictable political ones, and demand growth. Are you bearish on production declines from aging fields, or bullish on global economic growth, then I can see your position in the middle time range, as well.

In the end, of course, settling arguments like this is what the market does well. I was overweight energy until last fall, and will likely be overweight again soon enough. I like the long-term characteristics of fuel, as much for their lower correlation to equities markets generally as for performance alone. In the short and medium term, though, I am underweight the complex generally and short a couple names that exposed to spreads.

2006 Sep 17 01:49 PM

[William Trent:]

I appreciate your interest in my articles. I also like the well-reasoned dialogue. It won't necessarily change anyone's mind, but it is important to know the best arguments against what you believe if you don't want to be taken behind the woodshed.

Luckily I am currently fighting the tape only verbally. I have no skin in this game. However, given the right opportunity I very well could change that, and you can imagine which type of position I would likely take.

2006 Sep 17 05:55 PM

[Sidney Will...:]

Very logical, Watson. Deductive thinking leads to the conclusion that current inventory is an illusion which will be destroyed by the hungry appetite for oil by India and China, pushing oil even higher. Will take a while to exploit the new Gulf find, and even longer for northern liberals to experience a freeze before we will be able to extract the oil from Alaska, and beneath the Rockies. Most of America sleeps and only the readers of arcane editorials are aware of what is happening. Keep up the good writing. Maybe more people will wake up, and not be lulled into a false sense of security. Senator Kennedy once said, that there was no need for an oil depletion allowance for domestic oil producers because we would always be able to buy $3 per barrel oil from the Saudi's. I think he was still suffering post traumatic syndrome when he said this, and I am not sure if it was his brother's assassination or the incident at Martha's vineyard.

2006 Sep 17 08:40 PM

[Paul Meisel:]

Your high opportunity cost for ethanol assumes all relevant agricultural resources are fully employed, which is far from true.

Ethanol will not be an effective full substitute for petroleum soon, if ever, but technological progress indicates it can probably be an effective supplement within the next couple of decades.

That said, l agree, long term oil is going up until technology finds an effective substitute. I do not expect that within my lifetime.

2006 Sep 18 07:57 AM

[William Trent:]

Paul,

I do expect oil to be substituted away in my lifetime. I just hope it's not supplanted primarily by nuclear unless they figure out how to deal with the byproducts first.

As far as ag utilization, if there are people in the world who <i>could</i&g... be fed for a year rather than fill my gas tank I think the problem is lack of distribution rather than low utilization. I know the story now is that there are more obese than malnourished people in the world, but how many malnourished people is too few?

This comment probably sounds bleeding-heart, but from my perspective it is a matter of practicality. It isn't so much where I want to see subsidies placed but rather why I believe there should be no subsidies at all. The products should be used according to their relative value for various uses.

2006 Sep 18 09:28 AM

[Paul Meisel:]

It is clear that in food, the costs of processing, packaging, and distribution far outweigh basic agricultural production. (Remember the old Sam Kinison routine on starving people in the African desert? "Move where the food is!") Solving these problems is beyond the scope of alternative uses of corn..... the corn wouldn't make it to these people anyway even if farmers grew it free.

I understand your preferences for no subsidy, but government incentives to agriculture are a political fixture. I prefer that if they have to exist, they create a product of some utility rather than pay farmers not to grow.

2006 Sep 18 10:02 AM

[chet esium:]

Corn isn't used to feed people. It's used to feed livestock. And at the levels of production forseeable over the next few years, are fairly irrelevant to global food production. Also, if you are going to argue that we can't grow ethanol because its socially and environmentally unsound, you have to argue that we can't burn oil because it is socially and environmentally unsound.

Your comments on alternative solar energy are completely unrelated. Oil is rarely used to produce electricity, and electricity is rarely used to transport goods.

It's not just that crude oil inventories in the U.S. are relatively high, gasoline/diesel/propan... inventories are also high.

High oil prices are simply not sustainable for more than a couple of years. Current prices have greatly reduced demand. The world economy is growing rapidly and oil is growing slowly, and over the past couple of years the energy intensity of world GDP has improved. Current prices have rapidly stimulated increased production. Oil prices can't continue at well over $40/barrel because that simply stimulates the more rapid growth of ethanol, oil sands, deep water production, improved fuel economy, better alignment of refinery demand with type of oil being produced, and natural gas substitution.

It's not like there's only one possible alternative that can be used to counter high priced oil. There is a large array of possibilities each of which only has to be slightly effective in order to bring oils prices back down to the, still high, $40/barrel range.

OPEC experimented with high oil prices during the early 80's. And they paid for that experiment for the next 20 years. The effect of their high oil prices was improved western technology and reduced western oil consumption. OPEC won't use the same experiment again. They'll shoot for keeping prices higher than they've been for the last 20 years, but not high enought to push the rest of the world into drastically reducing oil consumption and drastically improving their transportation fuel technology.

2006 Oct 13 08:09 PM

[William Trent:]

If OPEC were effective at setting prices they never would have reached $12 a few years ago, so I don't buy into any argument (bull or bear) that hinges on OPEC. Further, the "experiment" with high oil prices started in 1973 and continued well into the 1980's, which is exactly my point. While the high prices reduce demand slightly and increase supply slightly at the margin, the effect on the overall system is not felt for some time. Then it will hit like a ton of bricks.

2006 Oct 13 09:40 PM