As the price of oil in dollars hit a record on September 12, breaking $80 for the first time, the question occurs: Is the breakout a harbinger of consistent and significantly higher prices or just the Pit Boys on testosterone? For perspective let’s note the environment surrounding this news.
A. The price of oil in Euro’s is far from a record. Clearly, $80 has something to do with the drop in the dollar. In fact, oil is becoming like gold, something of a hedge against a falling dollar and, perhaps, inflation. A friend recently asked me if I hold a portion of my funds in currencies outside the dollar and my reply was, “no but I have a lot of oil.”
B. The dominance of national oil companies (“NOCs”) and rise of oil hoarding is becoming a generally recognized reality. I suggest you take a minute to read the following account of a discussion of this topic by the CEOs of three oil majors. In fact, you might take another minute to look at my essay on hoarding oil. I won’t repeat the logic that underlies oil hoarding, which is discussed in detail in the referenced essay. But please note that the combination of hoarding by some NOCs and the supplanting of private corporations by NOCs in global oil production, it is clear that oil hoarding is a growing trend.
C. Oil broke $80 despite “bearish” news. Just preceding the breakout, OPEC announced it would increase production by 500,000 b/d — after various OPEC leaders had spent the preceding months saying they would not increase production. On the same day as the breakout, the International Energy Agency in Paris (“IEA”) reduced its estimate of oil demand based on a slowing U.S. economy. In fact, the preceding several weeks of financial news has focused on the increasing likelihood of a weaker economy, which implies lower oil demand. Finally, we are in a traditionally weak “shoulder” season. Last year at this time the price of oil had started a free-fall from a record of $77 in August to just under $50 in January. Add it all up and you get a classic indication of strength used by professional futures traders: if prices go higher in the face of “bad” news, it generally means that the trend upward is for real.
D. Longer term fundamental trends are disturbing. Recent months have seen the following developments:
Kazakhstan has pulled its contract with ENI, the Italian oil major, and a consortium of other majors for developing the world’s most promising new oil field in the Caspian which was to have added 1 million b/d, first in 2008, then in 2010. It is no longer certain when this oil will be seen.
Mexican oil production continues to stall out and, more importantly, its exports are falling even faster as domestic use continues to rise. The solution requires major new investment in Mexican production, but so far that’s not on the horizon. Moreover, violence is increasing against the Mexican government, threatening to make Mexico into the next Nigeria. I don’t think it will get that bad, but the trend is not good. As Mexican exports fall, the U.S. has little option for replacing Mexican oil other than to outbid other consumer nations for Middle Eastern oil.
Chavez continues to strangle Venezuelan oil production and to divert more it to any customer other than the U.S. Recently, in addition to China, he plans more exports to Iran and to his “friends” in South and Central America.
In the Middle East, where the world’s only spare oil capacity is said to exist, the UAE is planning to shut down production of perhaps 810,000 b/d for three weeks in November for field maintenance. The Saudi spare capacity is still a matter of conjecture among oil experts both in terms of how much is really there and what the quality of the oil is. Many believe that virtually all Saudi spare capacity is heavy, sour crude, which requires special refining capacity that may not exist. The Saudis are in the process of building their first refineries, to come on stream in 2010, and some experts believe they are doing it because there is insufficient global refining capacity to handle their less valuable heavy, sour crude which makes up the bulk of their spare capacity and which will increasingly become a more important part of their output in the next decade.
Political chaos in Iraq and Nigeria is not indicated to decline much in the immediate future. Shia are fighting each other in southern Iraq for oil control, now that the British are leaving, which has the potential to lower current production. The Kurds have signed contracts for new exploration and production, but even if that goes forward it will not produce oil for several years at the earliest. In Nigeria the efficacy of the new government’s efforts to curb corruption and bring peace with the local tribes in the southern oil producing areas is unknown as of now.
There are some positives like the growth of Angolan oil production and the fact that oil inventories are not currently strained. In fact the latter is one reason that OPEC was leaning against raising its production quota.
On the whole, however, it looks to me like the wind is to the back of the oil price if the dollar continues to weaken and exporters continue to lean increasingly toward hoarding oil. But the kicker is the new, never-previously-experienced level of demand for oil that is forecast to occur based on winter heating requirements. If the world breaks the 87 mb/d threshold of oil demand for the first time in history during the fourth quarter this year, as forecasted, it is not at all certain that production of oil will be sufficient to meet that demand.
The fourth quarter will be the final exam of oil production capacity. If the world fails this test, we will find ourselves on a new price plateau. If that happens, I suspect that the current range expectations of $50 – $75 may be replaced by a new range with a bottom number well north of $80.
We thought the last few years have marked the end of cheap oil. Everyone has sort of agreed to that. But as oil routinely sells for $70 now instead of $30 a few years ago, demand does nothing but expand. We may find that anything under $100 is still cheap for the price of oil and that the true end of cheap oil is still over the horizon.