OPEC Will Assure Oil Prices Stay in a Reasonable Range

'Where goeth the price of oil?' is perhaps the most popular topic these days both at cocktail parties and on the business news channels—especially after last week's record run above $101. This makes sense given the fact that just about every American is impacted by the price of oil, one way or another.

Although much ink (a fair bit of it virtual "ink") has been spilt on this topic, the amount of disagreement on this issue remains substantial. Although nobody can predict the price of oil with great certainty, some aspects of the oil market have become clear in the past few months, giving me a fair degree of confidence in what I am about to say here. My goal here is to focus as much on where oil prices WON'T go as on where oil IS likely to be in 6 months, one year and several years down the line.

OPEC's behavior in the past few months has helped us determine where oil prices will not go. One place the price of oil won't go on any sustained basis is below $80/barrel (this does not rule out temporary forays below $80, although even that is fairly unlikely). OPEC has traditionally "defended" certain oil prices by either increasing or decreasing production, and in 2006 to early 2007, those prices were in the $40-50 range.

In the latter part of 2007, OPEC learned something interesting that has significantly modified its "pricing set point"--namely, that the West, and especially the US, was not bothered by $80 oil, or even $90 oil. Therefore, in late 2007, OPEC concluded that it could keep oil prices in the $90s without any major adverse consequences to it, whether politically or economically.

To be sure, it would not serve OPEC's interests to run the Western economies into recession (because oil demand and prices would then collapse) but keeping the price of oil high would certainly benefit the OPEC producers—as long as it wasn't "too high." Therefore, whether we care to admit it or not, each one of us who has failed to significantly decrease his (and her) use of oil products as prices have doubled from $45 to $90 per barrel in the past year has sent a clear message to OPEC--"Hey, OPEC, you can go ahead and maintain oil pricing in the $80s and $90s without worrying too much that we'll cut our oil use."OPEC has gotten the message, and that is why OPEC snubbed President Bush a few weeks ago when Bush asked that they open up the spigots, to which OPEC replied "No." It is also why OPEC has actually recently hinted that it may DECREASE production, even while oil prices are in the $90s. It is therefore clear that OPEC's new "pricing setpoint" is at least in the $80s, and more likely, it is in the $90s or possible higher (see discussion below).

Another place oil will not go in 2008 (barring rather unlikely geopolitical events) is $200, for the same reasons discussed above, but operating in reverse. OPEC knows that oil--at the "correct" price--is the veritable golden goose. Whereas OPEC will not want to see oil below $80-90, it also will not want to see oil at $150, much less at $200, and OPEC will open up the spigots if oil exceeds $110-$120 by too much.

How much is "too much" is hard to know, and it is doubtful that even OPEC oil ministers know the answer to that question today. If oil breaches $100--as it will do repeatedly in 2008--and if it does so gingerly, OPEC will probably do nothing, wanting to see what happens to demand. After all, 2 years ago, everyone was predicting that $100 oil would wreak havoc on the global economy, and yet, it is now obvious that everyone was wrong. Therefore, if the rise is slow, OPEC might well let $110 oil be tested in the world marketplace, and see what happens. If $110 oil is greeted with the same collective yawns as $90 oil was, OPEC's unofficial (and undisclosed) pricing setpoint might well rise to $110.

Of course, OPEC has to be very careful, especially this year, to not get too greedy for fear of pushing certain economies into a recession that they might have otherwise avoided, but if the US economy recovers in the next few months, this will not be of great concern. If the US economy gets worse, expect sufficient production cuts by OPEC to maintain prices in the $80 to $90 range.

My guess is that OPEC won't let oil go much over $120 this year, and I consider $150 oil extremely unlikely in 2008, barring the aforementioned unlikely geopolitical events. It would probably take an all-out war with Iran or an invasion of Saudi Arabia or Kuwait, or a radical Islamic overthrow of these countries with resultant production shortfalls (all of which I consider extremely unlikely, but not impossible, events) to spike oil to $150. Anything short of such cataclysmic events is unlikely to push oil to $150 in 2008. Of course, a complete American military exit from Iraq does increase the chance of such events, but a complete exit is not likely to occur in either 2008 or 2009.

Although I think $150 (and even $130) oil is quite unlikely in 2008, I think that longer-term (eg, 3-5 years from now), $200 oil is quite likely--if not downright expected. This is because demand growth in the future will exceed supply growth (see the excellent article on this topic by Jim Kingsdale on Seeking Alpha dated 2-15-08), and because once demand exceeds supply, OPEC will lose any power to increase production to lower prices.

On the demand side, it is unlikely that China, India, Brazil and other developing countries will slow their growth anytime soon, and there are a billion (or more) consumers out there who want to drive cars and improve their general standard of living. On the supply side, many big fields are in decline and newly-found oil is usually much more expensive to produce than the "low-hanging fruit" that was found decades ago. Indeed, I have seen estimates that the Tupi field off the coast of Brazil will cost $70 to $80/barrel to produce and transport to the refineries. Given inflation, it is not inconceivable that similarly-hard-to-access-and-produce fields will cost as much as $100/barrel to produce in 5 years from now. Under that circumstance, and as absolute demand outstrips absolute supply, it seems that $150 to $200 oil a few years from now is not that far-fetched.

The question this all presents, of course, is how to make money from these predictions, and what I have done is to acquire a substantial position in HTE, one of the very-high-yielding Canadian oil and gas trusts. At today's price ($24.38), HTE offers approximately a 14.8% dividend yield. Given the foregoing prediction that oil will likely remain close to $100 in 2008 and probably higher in future years, it seems extremely unlikely that this Canadian oil and gas producer's income will do anything other than go up, meaning that total return is likely to exceed 15%.

To me, this seems like an excellent place to invest a substantial portion of one's investment dollars, especially given the uncertainty of decent returns in other investing spaces. HTE is a bit more complicated than other energy trusts (of which there are several good ones, but HTE is my favorite) because it also owns a refinery and refinery profits tend to be very volatile, but despite that, I believe any stock that offers nearly a 15% return and has very little downside risk is a compelling value in today's market.

Disclosure: Long HTE

Comments

[Jeanne M Ca...:]

I completely agree with your evaluation of Harvest Energy and have been acquiring it since late 2006 through late December 2007. After evaluating the decimation of the CanRoys after the 2006 Halloween Massacre, Harvest Energy was also my favorite to add to my long-term income portfolio. Owning the refinery will probably add volatility to the stock price, increasing its beta, but should prove lucrative overall. Thank you for your timely evaluation.

2008 Feb 25 12:46 PM

[CAMBERSPIFT:]

From what I've read, this article is pretty much in agreement with some other analysts of Canroys. I own some HTE.

2008 Feb 25 01:16 PM

[Ivo Cerckel:]

TRUTH AND THE HUMAN PSYCHE

What is it that prevents the human mind to acknowledge the Truth when it discerns/sees the Truth?

Truth is ad-equation between the thing and the intellect, said Thomas Aquinas. (1)

In Saudi Arabia, inflation is at quarter-century high because the country pegs its riyal to the weak US dollar. (2)

As a result of Bush’s pleas to Saudi Arabia for OPEC, the Organisation of Petroleum Exporting Countries, to lift its production ceiling
in order to bring down the price a oil which is now hovering at around 100 US dollar a barrel,
the Saudis seem to have adopted the “a friend in need is a pest” attitude. (3)

Why can’t observers conclude from this
that Saudi Arabia should de-peg the riyal from the US dollar
and
that OPEC should price its oil in another currency than the US dollar?

What is that prevents the mind from ad-equating itself to these facts?

Is it that, as Aristotle writes,
when human intelligence is confronted with the highest truths,
it is in the same situation as the bat who is dazzled by the light of the sun?

And guess what?

Former Federal Reserve Chairman Alan Greenspan said on Monday in Jeddah, Saudi Arabia's second-largest city, that dropping the Gulf dollar peg would ease inflation. (4)

Hence,
the Gulf Cooperation Council (GCC) foreign ministers are to meet on Saturday, March 5, to discuss continuing pegging their currencies to the dollar (5),
the next OPEC meeting being scheduled for Wednesday, March 5

Meanwhile,
the Iranian Oil Bourse opened on Sunday February 17.

The mystery concerning the Bourse remains however complete.

Indeed, we do not know in which currency oil is being traded on the Bourse.
Some sources say it’s the Iranian rial.
Others say indeed it’s the Russian ruble. (6)
Hence the importance of this Friday 21, 2008 International Herald Tribune-article.

Moscow deepens ties to Iran's energy sector (7)
SNIP
DUBAI: As the United States warns the world away from business with Tehran, Moscow is deepening its ties to Iran's energy sector, underscoring Russia's differences with Washington over Iranian nuclear plans and Kosovo's independence

What if it was gold
(which is no longer available in Fort Knox,
but is marked to market on a quarterly basis by the European Central Bank)?

Gold left last week for da moon!

We watch this new gold market together, yes?
Thank You
Another
6/29/98 ANOTHER (THOUGHTS!) (8)

Here’s a February 20 article of the Iranian News Agency which says
that Iran's Oil Exchange Market, which I suppose is not to be confused with the Iranian Oil Bourse, will be inaugurated on Wednesday February 27
and
that oil dealings on that Market will be based on euro or Iranian rial (9),
thus not based on ruble.

Still watching …

Ivo Cerckel

ivocerckel AT siquijor DOT ws
blogs.siliconindia.com.../


ENDNOTES

(1)
Conformity, con-FORM-ity, concerns only the form.
Ad-equation says that not only form,
but also the matter/substance/conte... of both the thing and the intellect must equalize.

(2)
Saudi inflation at quarter-century high
Dubai: Sat, 23 Feb 2008
www.tradearabia.com/NE...
SNIP
Saudi inflation hit 7 per cent in January, its highest level in more than a quarter century, as rents and food costs spurred price rises in the world's largest oil exporter for a ninth straight month.
Saudi Arabia has been grappling with inflationary pressures as the economy, the largest in the Arab world, booms on a near five-fold rise in oil prices since 2002 and because it pegs its riyal to the weak US dollar, pushing up some import costs.

(3)
From The Sunday Times
February 24, 2008
Sun shines on some as storm clouds gather over US economy
American Account
Irwin Stelzer
business.timesonline.c...
SNIP
Most important of all, Opec, which accounts for about 40% of world output, refuses to lift its production ceiling, despite personal pleas to the Saudis from Bush. The Saudis seem to have adopted the “a friend in need is a pest” attitude. Opec fears an economic slowdown will cut into demand, and that the dollar will fall further, reducing the purchasing power its cartel members receive in return for their oil.

(4)
Greenspan: Dropping Gulf Dollar Peg Would Ease Inflation
Monday, Feb. 25, 2008
JEDDAH/ABU DHABI
moneynews.newsmax.com/...
Former Federal Reserve Chairman Alan Greenspan said on Monday near-record Gulf Arab inflation would fall "significantly" were the oil producers to drop their dollar pegs, in contradiction to Saudi policy.
+
Saudi and UAE central bank chiefs spoke in favour on Monday of retaining dollar pegs, while QATAR's prime minister advocated regional currency reform to avert possible unilateral revaluations designed to curb inflation.

(5)
GCC foreign ministers council to meet Saturday
www.kuna.net.kw/home/S...
RIYADH, Feb 25 (KUNA) -- The ministerial council of Gulf Cooperation Council (GCC) foreign ministers will hold their 106 meeting in the Saudi capital, Riyadh, under QATAR's chairmanship on Saturday March 1.
In a press statement on Monday, GCC Secretary-General Abdulrahman Al-Attiyah said this meeting held much significance as it will take place after the 28th GCC Leaders Summit in Doha which included announcing the establishment of the GCC's common market.
While saying discussions will include regional and international developments, he added that the meeting's sidelines will include a forum between GCC foreign ministers with their Yemenite counterpart as part of supporting development projects in Yemen. (end) ay.
ayh

(6)
Russian ruble could be used in oil trade deals in Iran - envoy
15:30 | 15/ 02/ 2008
en.rian.ru/world/20080...
MOSCOW, February 15 (RIA Novosti) - The Russian ruble could be used as a payment instrument for deals on an Iranian oil exchange, the Islamic Republic's ambassador to Moscow said on Friday.
"Possibly in the future, we'll be able to use the ruble, Russia's national currency, in our operations," Gholamreza Ansari said, adding that the Islamic Republic was currently busy launching a new oil trade exchange.
The Islamic Republic's oil minister, Gholam-Hossein Nozari, earlier said that Iran would launch on February 27 a commodities exchange for oil, petrochemicals and natural gas on the Persian Gulf island of Kish and that all financial settlements would be made in Iran's national currency, the rial.

(7)
Moscow deepens ties to Iran's energy sector
By Simon Webb and Amie Ferris-Rotman Reuters
Published: February 21, 2008
www.iht.com/articles/2...
DUBAI: As the United States warns the world away from business with Tehran, Moscow is deepening its ties to Iran's energy sector, underscoring Russia's differences with Washington over Iranian nuclear plans and Kosovo's independence

(8)
www.usagold.com/goldtr...

(9)
Russian expert says oil dealings in Iranian Oil Exchange Market soon
Moscow, Feb 20, IRNA
www2.irna.ir/en/news/v...
Head of Iran Contemporary Studies Center in Russia Rajab Safarov says in the coming months, Iran wants to privatize its oil companies, whose number is no more than 40, and start oil deals in Iran's Oil Exchange Market.
Safarov told Moscow-based daily Vermianovesti that Iran's Oil Exchange is a crucial body that is expected to leave a drastic impact on the world oil market.
He said in the market, oil dealings will be based on euro or Iranian rial.
+
Vermianovosti said Iran will inaugurate its Oil Exchange market on February 27.
It quoted Iranian Oil Minister Gholam-Hossein Nozari as saying the exchanges will be in rial and possibly euro and the Exchange will be located in Kish island in Persian Gulf.

2008 Feb 25 07:32 PM

[Genesisgkh:]

I think your oil predictions are dead on. But HTE's 15% dividend is not guarenteed. If HTE pays out $3.50/yr but only makes $1.80/yr that dividend will eventually have to be cut. And canadian trusts will soon lose their tax advantage which will mean higher taxes leading to less profits to distribute. And why, in 4 years of rising oil & gas prices, have the majority of these canadian trust stock prices declined? If you are right about oil prices, I believe oil drillers (RIG, DO, ESV) are better plays. These guys will print money if oil stays in the $90- $120 range this year.

2008 Feb 26 02:13 PM

[Ron2008:]

I have to disagree that OPEC is maintaining prices here.

US inventories have dropped because it is a normal business practice to limit purchases and work down inventories to minimum levels when the price of its' raw product increase dramatically in price. They then buy their raw product hand to mouth.

Also the crude futures market went into backwardation last July. Further reducing any incentive to keep excess crude inventory.

There is no shortage of supply on the market right now. Just a lack of buyers.

If OPEC removed all quotas tomorrow and the price stayed at $100, US inventories of crude oil would not increase at all.

Only the US government maintains/builds inventories at record high prices.

Numerous commodities are at record highs because of increased specualtor investment. OPEC is just along for the ride.

I also disagree that $90 oil is not hurting the economy. But I won't get into that right now.

2008 Feb 28 10:04 AM