The Crude Oil Price Disconnect

What is the driving force behind the surge in commodities? If it's a supply and demand issue than the rally in gold, oil, and agricultural companies like Monsanto (MON) and Agrium (AGU) is for real. If not, than this rally won't last.

Daniel Dicker, a contributer on www.thestreet.com and a well respected floor trader of oil for 25 years had this to say:

let me be clear -- fundamental arguments cannot account for this tremendous up move in oil and other commodities -- and don't be fooled by those who would try to convince you otherwise... At the end of 2007, Nymex reported average daily volumes of 1.485 contracts per day, an increase of 25% over 2006. So far in 2008, growth has continued at an astronomical pace: January volumes increased 6% over the same period in 2007, February was up 28% and March increased an astounding 62%. We don't need to be geniuses to recognize where most of this growth is coming from... it all represents an enormous increase in flow of speculative trade... the speed of global growth, as compelling as it is, is just not sufficient to explain the 60% rise in price last year and the more than 20% rise we've seen so far this year. As my old trading mentor used to tell me, 'In an up market, all news is bullish.'

He's right -- analysts are forced to find reasons to fill time on CNBC every day for the inexorable rise of the crude barrel and reach for fundamental reasons that are simply insufficient. Just take a look at the crude curve -- the representation of how the market feels crude will be trading one, two and three years from now."

Investing 101 teaches that such speculation leads to a bubble and all bubbles burst. Commodities are experiencing their bubble. It is expected that next weeks Fed meeting will be the beginning of the end of interest rate cuts. Prior cuts have led to bubbles in equities and real estate, this time it's been commodities. This commodity rally is based on market dynamics, the talking heads want us to believe that we have shortage issues but it just isn't true. I don't know of anybody who has experienced an actual lack of supply. This Earth is able to provide all that we need. Underpopulation might even be more of a problem than overpopulation.

If that doesn't convince you, try doing a simple Google search for the latest oil findings. There have been huge findings in the Gulf of Mexico, Southern Utah, Indonesia, and Brazil; all within a one year period. Does that sound like the makings of a shortage? I don't think so. In the absence of real supply problems, commodity prices will decline back to historic norms.

Of course it is difficult to time the bursting of a speculative bubble but a smart investor methodically averages in and waits for reality to claim false perception. My favorite play is the Pro Shares Oil and Gas Short (DUG). It ended Friday near a 52-week low of $30.66, its high is $59.21.

Disclosure: None

Comments

[BrucePile]

The new projects schedule puts about 20 mbpd online by 2010. That's a lot of oil and has led the ultra optimists like CERA to predict a wall of oil coming with as much as 7 mbpd supply over demand by 2010 and oil at $40 or less. But there are several facts of science and math that the CERA types don't consider.

For example, there is the math of net energy. Even much of the oil bear contingent accepts that we are at or near the global peak for the old fashion conventional oil from easy to extract fields. They say we are nowhere near an oil problem though because of the flood of new unconventional oil on the way. However, if you look at the new oil we are depending on over just say the next 3 years, you see that about half of it is the rampup in deepwater and tar sand oil. These two sources have EROEI (energy returned on energy invested) estimated at around 3-4 with the old declining conventional field production EROEI at about 10 or better. Comparing these two values on the EROEI oil displacement curve means that it is taking 3 barrels of this new production to offset each barrel of declining conventional production! This amounts to about 7 mbpd in 2010 production that will be missing from the physical barrel to barrel accounting of new replacing old - 7 mbpd missing in action from the globe's net energy supply. This one factor alone completely does away with CERAs wall of excess oil by 2010.

Also consider the ELM (Export Land Model), which tabulates the effects of internal oil consumption increases by the enriched oil exporting nations. In the model, if exports are half of total production and conventional production is near peak (roughly the global case) and assuming conservative figures for existing production decline rate, internal consumption increase rate (about half of what is actually occuring in many major exporters), the amount of oil exported post peak winds up being just 10% of the total exporter's post peak production! A full explanation of ELM is at theoildrum.com. This causes much of the forthcoming wall of oil in the future to fall somewhat flat.

[oilseekr]

None of your huge discoveries of crude are significant in relation to spiking world demand of crude.
OPEC does not increase production for a very simple reason. It can't without doing great damage to its reservoirs.
I agree that speculators are flooding into the commodities markets.
However, they may just happen to be correct in their assessment of oil.
It is becoming apparent that our planet can only produce 87 million barrels of oil per day. Consumption is on ocassionally exceeding that amount. We have been spoiled to cheap energy for too long.

Now everyone wants a quick fix and some politicians are proposing to instigate another windfall profits tax on crude. (Obama)
The windfall profits tax of 1980 caused over 8,000 domestic oil wells to be plugged and abandoned and reduced our domestic production by 6 percent.... thereby adding to the present high price factors.
We can't afford to repeat that error again.

[slocro]

All the countries the article references for slowing populations are in industrialized countries, but population is growing fast in the developing countries where use of energy is growing exponentially. We are growing by 80,000,000 people a year globally. That is 30% of united states population every year. Compare that do the fact that there are a couple hundred right whales left in the world. Plant and animal extinction has exponentially grown as well. Yes we are over populated based on our preferred life style choices. Could not disagree with you more. Your viewpoint is western euro-centric, versus total world vision, and we are now sharing the oil pie with everyone.

You may be right in the end though. Spain is close to providing 40% of their electrical needs from wind. I am not as sure as you,about the never ending abundant supply with this backdrop. There are so many variables. I imagine we are due for a correction. I am ok though with it not going down. Oil price success will be its death, the sooner the better, and hopefully, that won't be true for us as well.

[AmesTiedeman]

We are now almost over 120.00 in overseas trading.

[srini100]

the article is right on the money, pure speculation and strange that the feds and the politicians have nothing to say to break this. I am sure they will come and blame everyone else after the bubble bust, just like housing and Stock market crash. Also there is lot of research on alternative fules and also research to grow in labs just like stem cells so this should be no issue in terms of exhasuting our resources. One other point is the media is scaring eveyone about this and geeting as many ionvestors as they can suck in so they big buys can dump them. One odd thing i have noticed is that daily there is some news about a supply problem but there is no news about people unable to get gas for real use. Also futures market should be investigated and send people to prison. We would nto need the rebate checks and sqandring of tax payers money if we only stop this mad speculation in basic food and oil.

[Jack Yetiv]

I continue to be amazed by articles that speak on this issue and yet fail to realize that "bubbles" occur in many (maybe even all) "commodities"... when neither the demand nor the supply is artificially controlled. For example, we get "housing" bubbles.

But oil is simply NOT such a commodity. OPEC accounts for 40% of global oil production, and they have shown great ability to cooperate of late in controlling demand. Saudi Arabia has made it clear that it is VERY happy with oil at $120, and nobody--including floor trader Mr. Dicker--can possibly argue that Saudi Arabia ALONE can FULLY control the price of oil, regardless of what Mr. Dicker or the author think the demand is.

What would happen to oil price if SA decided to decrease its production from 10 million b/d to 9 million? 8 million?

And that's our "friend" Saudi Arabia.

What about Iran's Ahmadinejad? Venezuela's Chavez?

Jack Yetiv

[paultaut]

The Saudi's were our friends...very past tense...They no longer feel threatened by Iraq...Saddam's departure ensured that they no longer had to abide by our rquests.

Speculators do have an influence on trading...but they do not, as a norm, take physical delivery....inventorie... of most commodities are severely depleted...It takes years to replace them.

Natural Gas inventories are now near 4 year lows...are the speculators taking delivery??? How long will it take to bring the new fields on line? Who has the excess refining capacity to handle the additional amounts coming online...No new refineries here, lots in the emerging markets...

The US is screwed by the shortsightedness of its politicians...

[cal48koho]

IN many of the articles here on Alpha, the comments are interesting counterpoints to the original thread. The highly intelligent comments here are exceedingly valuable in showing why Jason's postulation is faulty. The EROI comments are key to the understanding of where our energy future lies. Shorting oil at this point is dangerous.

[Ronmac]

paultaut hit it right on, "The US is screwed by the shortsightedness of its politicians... ".

[JREwing]

This article is total crap and that NYMEX floor trader was probably short and got his ass kicked.

The author is another one of these 'Joe Kernen' types, who think that once an oil field is discovered, it produces instantly at an maximum daily rate and does so until the end of time. And anyhow, oil should be for free. People, who think that is true, probably believe in Santa Claus, too.

Yes, there are still nice discoveries made, and to be made. But new discoveries take a long time to come online. However,in the time new fields come online, existing field are being depleted. For the 'Joe Kernen' types, this means, that they run out of oil. So much for the supply picture.

Now for the demand picture. Just a few things here. China imports of diesel/heating oil quadrupled year over year. Even Japan import a lot more than the year before. India Up.... thailand up....... Australia up and so on. And to make bad things worse: There is no demand destruction in these emerging markets, because the millions and millions of people there don not feel the Pain at the pump, because they get a painkiller from the government in form of price controls. Just check out the Petrochina numbers from yesterday.

So, when you consider the above and the fact that US supplies are 30 million barrels less than last year at this time, THERE IS NO REASON, why OIL PRICES should not be higher than last year.

P.S. I stopped watching CNBC, because i couldn't stand the daily question: What is the 'real' price of oil? What are these people communists? The real price is the latest tick at NYMEX front month contract. Not what you wish for!!

In Oil we trust!

[fxtrader07]

just look at big oil's real exploration budgets over the past 30 years and look at the low per capita oil usage in Chindia and you know why oil will stay high and will go higher for years to come. it's all basic supply-demand arithmetics and what many people do not seem to grasp is that both is highly inelastic in the case of oil. others here have pointed out great facts about why all this talk of huge new oil supplies hitting the market is phony and that those supplies will at best serve to somewhat curb the price increase by offsetting some of the additional demand.
likewise, oil will probably decline at some point but not buntil huge technical innovations have been made to replace it as a source for fuel.
my chemistry teacher back in the 1980s told me that it was a crime and plain stupid to burn oil for heating and eletricity generation while it was so much more important for chemical products and all sorts of useful stuff.
that floor trader obviously hasn't seen at all the seismic shift in demand supply fundamentals that have occured over the past 10 years. floor traders don't always have a clue and when it comes to the Nymex, it is one of the worst exchanges out there. floor traders have a lot of options to make tons of money there on the back of investors, trust me, and they can do so without knowing a thing about oil, gas or gold...

[Mmarrkk]

These "huge" finds referred to are a long way from getting on the market. And the Southern Utah find is hardly "huge". The deepwater GOM finds have been POTENTIALLY huge, but remember none of them have had any extended testing and is purely based on geologic/geophysic studies and some very short term tests. History has shown many deepwater fields to be compartmentalized and much more difficult to predict. AND, there's the tiny detail about the need for technological advances to actually produce in the ultra deep water where these finds have been made. The Chevron/Devon Jack discovery will not be on line for many many years to come. 2010? yeah right. Maybe 2015 if everything goes right. And look at BP's Thunderhorse. Delays delays delays. Many years beyond the original schedule. And that's not a BP issue, its a new technology and state of the industry issue. And that's with the current crop of 40-50-60 years old running the project. Guess how bad it gets when over 75% of those folks retire in the next 5-10 years and the big "gap" hits where we had no new engineers coming into the industry during the bad times!! It aint pretty! So, prices will be high.

Oh, have you looked at the accelerating decline in Mexico's output?? Just a snippet of what will happen everywhere!

[ValueInvestor]

With such large profits at stake, I wouldn't doubt for 1 minute that these huge energy companies have their own trading room full of guys that try to manipulate prices and keep them as high as possible. If Enron could do it why couldn't a multi billion dollar oil company? Its in their best interest.

[AmesTiedeman]

GS says 141. Good grief!