Now For Something Really Scary: Oil Price Black Swan On The Horizon

Includes: BNO, CRUD, IEF, OIL
by: Andrew Butter

If oil prices don't crash down to $67 within the next two months (Brent), that means for sure the evil one-eyed-drooling-spirit of Peak Oil, which everyone has been studiously trying to ignore for so long, has finally arrived.

The dotted red-line on the chart is the "fundamental" or "equilibrium-price", or if you use International Valuation Standards, the other than market value. That roughly follows the algorithm:


That says the whole world can afford to spend no more than 3.3% of the whole world's (nominal) GDP buying oil, more than that and economic growth is compromised. So if that's right, then other than market value is that number divided by supply (or consumption - same thing).

Another word for that is Parasite Economics because insofar as the seller of oil is concerned, he needs to judge it right so that he sucks just so much money out of the golden cow (Daisy) so that he get's the maximum. But at the same time he has to be careful she stays healthy, it's a delicate balance, suck too much and Daisy can get mastitis. Another way of saying that is when the Saudi's say $100 oil is "fair" (two years ago they were saying $75 oil was "fair"), they are concerned about the health of their (CASH) cows.

The Parasite Economics line can be calibrated using the algorithm:

E2 = MC

Where [E] is the "equilibrium", [M] is the minimum after the bust, and [C] is the crest of the preceding bubble-wave.

That's "The General Theory of the Pebble in The Pond," which is another way of saying "what comes around goes around"; interestingly the math on that is remarkably similar to the fluid dynamics of Tsunamis, looks like perhaps markets, like water, are incompressible.

From a practical perspective, that simple algorithm allows you to figure out where the fundamental was after a bubble/bust cycle, so that way you have two independent ways of working out other than market value, or in other words Daisy's mastitis threshold.

That's all very well, except there is another way to value oil in the ground, if you are a seller.

That is to let some of the less productive Daisy's keel over and die in the knowledge that the Daisy's that survive will be the strong ones, and they will produce baby Daisy's who will be more productive in terms of delivering the golden milk when they grow up.

That's called "Survival of the Fittest".

The idea there (if you have oil) is that you need to price it according to what other people (your future competitors) are going to have to pay to find, develop, and ship to market, oil that so far hasn't been found or developed, which according to the IEA is over half of the oil that will be needed ten years from now.

Another word for that is depreciated replacement cost (DRC) which is an equally valid way to work out other than market value as Parasite Economics, according to International Valuation Standards at least.

So, if you judge that the prospect of income today, plus 2% a year parking what you get paid, in U.S. 10-Year Treasury bonds, is less attractive, than just waiting for the price to double over ten years, and selling it then, well you can just sit-tight and watch the tide go up and down.

Putting that another way, you got the option of selling oil, so Hank from Huston says, "Great deal lover-boy, I'm happy to fix the price on Brent … just one little thing, can you give me some credit?'

And you say, "Sure thing sweetheart … what you got in mind?"

Hank says, "How about 10-Years at 2%?"

And you say, "Hank … Hank … HANK … I can't hear you … looks like we got cut off … how about calling me next year!"

Here's the rub, the "swing producers" don't need the money and in fact they have a problem finding places to put it.

OK there are those nations full of crooks who will take any deal, then steal the money and park it in London (the best place to launder that sort of money in the world), but that's going out of fashion these days. In places like UAE particularly, and even Saudi Arabia, well stealing the birthright from your own people is considered, what the Brits used to call … "bad form." Not that the New-Brits go by that idea, apparently, for $250,000 you can get David Cameron to give you a happy-ending, which is incidentally even more than Tony Blair gets for opening supermarkets in Guangdong.

So the longer Ben manages to duck and dive to keep the yield on the 10-Year at or around 2% to "stimulate" bankers and to help USA to pay the interest on their mountain of debt, the more attractive the idea of just sitting looking at your oil, rather than selling it, becomes.

That sounds as if the Big Idea behind letting those who can't pay their debts off the hook, or at least giving them a free ride, courtesy of the long-suffering American taxpayers, might have some unintended consequences.

So which Daisy is going to get the bullet in the head first?

Not many people know this, and those who do would often prefer not to know it, but the way that America finances her current account deficit (that's basically the balance on Goods and Services), is by selling securities.

Those come in three main flavours, from the BEA numbers on International Transactions, Line 58 is U.S. Treasuries sold to Foreign Governments (net), Line 65 is Treasuries sold to anyone else who is foreign (those are the guys who have to queue up under a big sign that says "Aliens" at Miami Airport), and then there is Line 66 which is "Securities Other Than U.S. Treasury Securities", commonly referred to as Toxic Assets. Those sold great up to 2008, but the sparkle has kind of dropped out of that market. Add all those together and you get to the amount of money from foreigners that can be used to buy foreign stuff, over and above what you earn selling stuff to foreigners … a lot of which is oil.

This is the rub, when the amount of money coming in from selling the birthright of America to foreigners, so that everyone in America can drive SUV's and the politicians offer election candy about how they are committed to keeping gas prices less than $4 a gallon, which makes it half the price it is in Europe, and that is an explicit subsidy.

When the amount of money America can borrow to pay for that luxury … is not enough to pay for it (that's when the orange line in the following chart goes below zero) … there is trouble in store.

Click to enlarge
(Click to enlarge)

Oh My! When oil prices go up above the "fundamental", look-see, America IS IN TROUBLE, as in they can't even borrow enough to support the lifestyle that they have become accustomed to, see how that "oil" line pushes the orange line down.

Looks like Daisy might just have to start producing more milk or she might just not be getting her feed tonight; either that or she will need to shoot down that pesky Black Swan.

Perhaps a Patriot Missile can do the trick?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.