Why Oil Will Sink to $20-$40 Per Barrel

Includes: OIL, OILC
by: No Guilt

Anything can be overvalued and anything can be undervalued. It's usually pretty apparent why you would want to own the most desirable assets in the world like beach front property, but investing isn't just about owning the best assets in the world, it's about owning them at the right price. Often times the most desirable assets and the "obvious" trades get crowded and have bull arguments that people can't or won't argue with. In the case of oil, the followers have developed a religion.

You can't argue with the bulls
Real Estate bubble
People need somewhere to live right?
They aren't making more real estate!
My favorite... Don't get priced out of the market.
The dollar is worthless toilet paper, you want to own euros.
Banana Ben is printing money like a mad man!
We won't just have inflation, we'll have HYPERINFLATION.
Oil Bulls
The world is running out of oil.
Where are they going to find more oil?
China is putting 10,000 cars on the road every day!

Data can be found clicking into the XLS spread sheets found here. The fact is that the world is NOT running out of oil. World oil reserves have gone up every year, year over year since 99' to 00'. I've done my due dilligence and and know why, but I doubt many of the oil bulls have even bothered researching the data. They've all read TIME, Newsweek, and maybe even a book or two about peak oil. To them it's the alarmist, " where are we going to find more oil? We are running out!". If they ever bothered to look at the data they'd see 10 years of increased World oil reserves.

US Oil Consumption
2005 = 20.80 mbpd
2006 = 20.60 mpbd
2007 = 20.68 mpbd
2008 = 19.50 mpbd
2009 = 18.77 mpbd
2010 = 18.93 mpbd ( predicted)
2011 = 19.06 mpbd ( estimated)

So American oil consumption peaked in 2005, dropped 5 years in a row and "might" increase this year to 18.93 mbpd which is what we consumed over a decade ago in 1998. (Link to the EIA data.) The idea that we are using more and more and have less and less is simply not true.

Price of Oil in Terms of Natural Gas

A barrel of oil has about six times the energy content of a thousand cubic feet of natural gas. The graph below compares the dollar price of a barrel of oil with the oil-equivalent cost of natural gas, calculated by multiplying the price (in $/1000 cu ft) by six.

Based on the NG equivalence, oil should be about 6 times the price of natural gas and given today's price of natural gas, that means oil should be $23 a barrel. That is another fact for the oil bulls to ignore, link found here.

Spare Capacity

The last two times we had spare capacity over 4 mbpd, the price of oil was $15 and $25 respectively. People forget oil was $22 per barrel as late as 2002 and in 1998 had a yearly average price of $11.91 per barrel. In 1979, 1980, 1981 oil was in the 37-38 range, and twenty years later was basically half the price... It's hard for people to imagine the future, but the economics call for much lower oil prices. Not only is spare capacity above 4 million bpd, it is expected to go up to 5 mpbd in the next year or two.

Why is it $70-$80 now? The reason is contango. If you can buy oil now at $70 today and sell it for $85-$90 in five years, the price is going to stay around $70. Somebody is betting on higher oil prices in five years.

Supply and Demand
I've seen this movie before. Supply and demand dictate that when prices soar demand goes down but we are told, "Nope, oil demand is inelastic." MasterCard (NYSE:MA) showed a huge drop in gasoline sales in the Spring and Summer of 2008, miles driven were way down, even mighty China was using less oil but people still believe in peak oil and inelastic demand. If the "rich" US consumer is going to cut back on expensive oil, then why wouldn't the "poor" consumers in the emerging markets cut back?

On top of that, oil was over $100 for only five months and then promply crashed after that. Once oil hit $100 a barrel, demand dropped. The $70-$80 range seems to be the highest price oil majors can get without demand dropping off and without huge hits to world GDP.

A report from the US Inspector General for Iraq Reconstruction, issued in July said that Iraqi production, currently around 2.4 million barrels per day, could reach around 12 million bpd by 2017. Saudi Arabia currently produces around 8 million barrels per day. But believers in the religion of oil don't like to look at facts, they just "know" the price is going to go "up".

Oil and the Economy
Most people don't realize that oil is more correlated with the general economy than you might think. Oil isn't just used for Clark Griswold to pile the family into the SUV to drive cross country to Wally World, oil has heavy industrial useage. That's why Japan is a heavy consumer of oil even with their mass transportation. Oil is not only consumed by "arrogant/selfish" energy unconscious Americans like the mass media wants you to believe.

Bond Market Not Seeing Inflation
In stark contrast to the oil bulls, the bond market was factoring in lower inflation in 2008. Anyone bullish on oil had to call the bond market stupid, and some did to their eternal regret. Now we have the same thing. Anyone predicting the demise of the dollar has to call the bond traders complete idiots because they are telling the dollar-is-dead, hyperinflationists to jump in a lake... again. As for supply, go ahead and ignore the government data as government stopped publishing M3 the broadest measure of the money supply. Of the people you know, do they have more or less money than 2007? If the answer is yes the money supply is up, if the answer is no the money supply is down. Bernanke might have dropped money from Helicopters, but I haven't got my check yet, have you?

Now whenever deflation or it's potential comes up, the inflationists talk of debt/deficit. The dollar soared in the late 80's when the US had record debt and deficits. Japan is now the industrialized nation with the highest Debt/GDP ratio in the world, and yet the Yen at the moment is the world's strongest currency. In the late 80's the dollar soared in value despire record debt/deficits. The correlation between debt and currency does not exist, but look at the correlation between currency and inflation. In the late 80's inflation in the US came way down. Japan has the strongest currency in the world today because they have the lowest inflation rates, not because they have the most debt.

It's not just the amount of debt that matters, but the interest rate as well. No one wants to talk about this and I hate governments running up debt too but, unless you are going to pay off your debt right away (and we know the U.S. is not going to), then the interest rate is WAY more important than the total debt.

For example, if you are $5 trillion in debt and have 12% interest, your total debt in 12 years will be $20 trillion. If you are $10 trillion in debt and pay 2% interest, your total debt will be < $15 trillion in twelve years. That's why Einstein said compound interest is the most powerful force in the universe.

Many Say the Government Won't "Tolerate" Deflation
If you think the government won't "tolerate" deflation you are giving the government more power than it has. No one in government wants housing prices to continue falling or Dow 10,000 but that is what's happening.

Deflation is due to decreased consumer demand. Housing prices falling has cost the consumer $6 trillion. The folks in California, who were sitting on 2000 sq foot homes priced at $1 million, were a lot freer with their spending than they are now with the same house priced at 400K. Toss in the $4 Trillion or so lost in the stock market, and you can see why the consumer is spending a lot less and is busy paying down debt.

The market can stay irrational longer than you can stay solvent. The inflation sentiment that gold is going to $3,000, oil is going to $500, and the dollar will be worthless is dying but far from dead. As of now, these inflationists think that they are not wrong but early.

Once the dollar-is-dead and hyperinflation rhetoric dies down ( and it has a little), oil is going to $20 to $40 a barrel. The anti oil argument is already creeping into the mainstream media. It might not happen right away, it might even take years but we will see oil South of $40 per barrel again.

Smart Money
You go to the racetrack, casino or poker table and see people evaluate risk/reward in varying abilities. There is "smart, sharpe" money and there is "dumb, public" money. Warren Buffet says if you can't make out the patsie at the card table then it's probably you. There are always two sides to an argument, listen to them both and then decide if stock XYZ is overvalued or undervalued because remember, anything can be overvalued and anything can be undervalued. In the case of Oil, the Bears all know and understand the Bull's argument, while the the Bulls have not heard, don't understand, or don't care about the Bears argument. In the world's largest casino of Wall Street, the smart money is betting on lower oil prices.

Disclosure: Author is not long Oil.