Crude Oil: Supply Exceeds Demand For The First Time In A Decade

Jun.22.12 | About: iPath S&P (OIL)

Since May, the price of crude oil (NYSEARCA:OIL) has fallen from $106/barrel to $78/barrel (chart 1). It is very likely that the price of crude oil will continue to decline because for the first time in a decade, supply is exceeding demand.

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Chart 1: Crude Oil Price
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Most of this increased supply is due to technological advancements in the production of oil like the use of long-reach horizontal well bore technology and multi-stage hydraulic fracturing. When supply is higher than demand, prices will go down to seek equilibrium. The exact same scenario happened in 2006 when crude oil fell from $65/barrel to $50/barrel due to supply exceeding demand.

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Chart 2: Crude Oil Supply and Demand

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Chart 3: Crude Oil Price

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So how do we know where the price of crude oil will find its bottom?

If we look historically, we find that oil prices correlate very well with the cost of producing oil. Oil prices simply cannot go below the total cost of oil production for too long. If this were the case, many oil companies would go out of business, drastically decreasing the production of oil going forward. Hence, to know the bottom in the price of crude oil, we simply need to look at the production cost curve of crude oil (chart 4).

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Chart 4: Cost of oil $US per barrel of oil equivalent (boe)

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The cash margin versus the cost of producing crude oil tends to be constant (around 20%). This means that when the cost of producing crude oil goes up, so will the price of crude. For example, in 2000 the total cost of getting the oil out of the ground to the consumer was $19/barrel (chart 1). At that time, oil was around $24/barrel (chart 2). This is a 25% margin. Today the total cost of oil production has skyrocketed to $60/barrel (chart 1) and oil is at $80/barrel (chart 2). This is a 30% margin. This margin of 30% is very close to the historic average of 20%, so I don't see the price of crude oil going down too much. The ultimate bottom could be $60/barrel + 20% margin = $72/barrel.

In chart 4 it is interesting to note that government taxation is the biggest cost for oil companies. Governments around the world will try to take advantage of the increasing profits of oil companies. The higher the operating margins, the higher the taxation. Nevertheless, the other costs involved (operating costs, capital costs and exploration costs) are also steadily increasing over time.

As taxation won't be going down (because governments are highly indebted these days and need the tax revenue) and other costs (operating costs, capital costs and exploration costs) are likely to keep rising, I believe oil prices will keep rising in the long-term.

Conclusion: We have a global economic slowdown. The consequence is that demand for crude oil will go down in the short term. So I advise investors not to invest too much in oil at this stage, but to start to buy oil when the supply-demand curve becomes favorable (demand exceeding supply) or when the price of crude oil goes down below the total cost of producing crude oil. What I do recommend is for investors to buy gold and silver miners, as I am sure that precious metals will continue to go up, while the oil price goes down. This will tremendously increase margins of gold and silver companies (NYSEARCA:GDX). I have already performed a full analysis on this in my previous article "How gold mines will benefit from the coming depression".

Disclosure: I am long PHYS, PSLV, AGQ.