Crude Oil: What Goes Up Must Come Down?

It was only two months ago when I wrote my surprisingly well-received post, Ten Notes on Crude Oil: The Fixation. It was surprising to me because I’m not an expert on energy issues. I’m just a good generalist portfolio manager who knows a little about a lot. So, I have to be careful what I say, and candidly say that I’m not sure, when that’s the case.

Here’s a graph of the price of crude over the last year.  Over the last two months, it was up fast in month one, and down faster in month two.  What a ride!

One Year Chart of the front month future of WTI Crude Oil

As prices rose in late June, President Bush called for lifting the restrictions on offshore drilling in the US.  If opening up ANWR was tough, this would be tougher, as there is a visceral feeling against drilling in states with significant coastal populations, even if the rigs can’t be seen from shore.

Another hurdle would be the lack of equipment capable of doing the drilling in the short run.  Think of all the industries with relatively tight capacity constraints that would be stimulated if the ban were lifted.  Drill-ships and rigs, specialty steel, coal, industrial gases… and more.  It would be quite a project.

As crude oil rose over $130/barrel, the exchanges moved to put limits on oil contracts.  Two weeks before the peak, credit conditions were leading shorts to cover positions.  Refiners began to let their crude inventories fall because it was getting more expensive to finance them.  So, as the market approached the price peak, there were a wide number of financing issues pushing the market around.

One week after the price peak, the demise of SemGroup made the headlines.  They were reportedly short the crude oil market, and were forced buyers covering near the peak.  Capitalistic markets are unstable, and that is mostly good thing, because it motivates market players to respond to the need.  At any significant peak/valley, some player who was taking significant chances gets uncovered as a fool who took big risks without a sound capital base, exacerbating the peak, and the decline, though the fool doesn’t get to benefit.

As the price peak passed, this article posited why we would see oil down below $100.  The summary answer is demand destruction and supply encouragement.  High prices are the solution — users don’t buy as much, and suppliers see reason to produce more.  As for demand destruction, it is well underway in the US, but in places where prices are subsidized, or are artificially high due to taxes, the process is slower.

Every market has momentum players.  Momentum is a really simple strategy; do what the majority are doing.  That exacerbates the swings in the market, but given the needs of hedgers, whether they are producers or users, momentum tends to occur anyway for reasons of fear.

No surprise that high oil prices lead to conservation efforts on the part of corporations, as well as individuals.  High prices solve themselves.

One month after the recent peak, journalists point out the recent price peak.  Hindsight is 20/20, gentlemen.  I understand the need to explain what is going on, but I have more respect for those that take a position before the reversal, when it is painful to do so.

Crude oil is inelastically supplied and demanded, so it it should be no surprise that the price is volatile.  Small changes in expectations can produce big results, as is posited in this article on queueing theory.

I am not a peak oil “true believer.”  I believe that it is more likely than not.  As a result, I offer some time to the other side, because we can learn from them.  How much of the recent price spike is supply and demand, and how much  is speculation?  Hard to disaggregate, because speculation is normal to capitalistic markets.

Buffett: my guess is that he is accumulating a large stake in ConocoPhilips.  I could be wrong here; badly wrong, as he could be selling off.  But COP is cheap, has a large refining capacity, as well as significant E&P efforts around the globe.

Finally, a book review.  I was going to do reviews of two books on opposite sides of the peak oil question, but the book on the negative side was never sent to me. 

As for the pro-peak oil book, Profit from the Peak: The End of Oil and the Greatest Investment Event of the Century, my disappointment was that it was not written by an expert in the industry.  He posits that not only are we at peak oil, but we are at peak energy.  We are at or close to the peak in many forms of energy: coal, uranium, natural gas, etc.

This is a bold claim, an one that I think will be partially falsified, as men make efforts to expand energy with the incentives that come from high energy prices.

Full disclosure: long COP.

Also, anyone entering Amazon.com through a link here, and buying anything, ends up giving me a commission.  No increase of cost to you.  It is my version of the tip jar.

Comments

[Randy Fay:]

Your guessing that Warren Buffett is accumulating shares in COP? That sounds like yahoo message board material. Other than that your article is fairly reasoned.

2008 Aug 18 01:29 PM

[Frankfurt/H...:]

I am sure as investors like Buffett,who are buying for dividend accumulation and future stable profits are buying Oil/Gas stocks.But you need a proof,you think Buffett will call you at work at McDonald's and tell you what he is buying or selling?
Be nuts if you want,people like Buffett make their accumulation process top secret,wait till his next general shareholder meeting,then you will know if he bought Oil/Gas big caps or not.

2008 Aug 18 01:53 PM

[mkreisel:]

If Buffett is selling off COP, his tiny 17M stake could be sold off within 10 trading days => no need to claim the SEC confidentiality thing 45 days after the end of the quarter.

2008 Aug 18 02:50 PM

[alpha24seven:]

"He posits that not only are we at peak oil, but we are at peak energy."

Well I'll posit we are at (or damned close) near peak demand. The tired ol "India & China" story is well -- tired. Spend one single afternoon looking at innovation coming on stream from about 1,000 different directions funded to the tune of billions and driven by some of the smartest people you haven't yet met.

The company(s) delivering game changing energy solutions will make Google look like a rounding error...

2008 Aug 18 03:32 PM

[ripskii:]

According to this Streetinsider.com report Buffett sold all his 17M shares of COP.

www.streetinsider.com/...;+Raises+Stakes+in+Ing...

2008 Aug 18 06:19 PM

[Jason Rines...:]

Have to say I would have loved the ride on the way up. But the problem with the global oil market is there are just too few visible variables to make solid educated guesses. My shot from the cheap seat in March was $135 peak. Perhaps I would have made some scratch but knowing thyself, I would have acted like a teenager at the horse races and wound up like Mortimer and Randolph Duke.

2008 Aug 19 06:16 PM

[Old Trader:]

A thought crossed my reading this piece (and others) about the price of oil, both current, and future. Two terms I see bandied about constantly are "price elasticity" and "demand destruction". It appears as if many (most?) use the terms almost interchangabely, and I'm not certain that's the case.

Certainly, the spike in the price of gasoline has altered driving habits, here in the States (demonstrating "elasticity"), but what happens as the price eases back down? If, as the price of gas drops (as a result of crude dropping in price), consumption starts to creep back up, where's the "destruction"? I'm thinking it would an extended period of "high" prices to result in true "demand destruction".

Also, I'm guessing the "demand" for oil/gas is more "elastic" than the supply. If more is needed, the days of poking a hole in the ground and watching it bubble up are gone.

Lets not even start with all the OTHER things oil is used for (plastics, for example).

old trader


PS: Yeah, long oil (CanRoys, specifically, and pipelines)

2008 Aug 19 08:37 PM