True North_

It's the Oil Price, Stupid!

High oil prices were a factor in the economic debacle of 2008 - but only one of several. There was a confluence of events that drove what occurred - I doubt that the extra $1.2 trillion in cost was sufficient, of itself, to cause the collapse that did occur. It contributed, but was not the sole or even most important issue.

It's also not clear to me that the oil price run-up in 2008 was related to supply / demand issues (the quote from the article: "...the price run-up of 2007-08 was caused by strong demand confronting stagnating world production"): in fact, if anything, the collapse in price suggested the opposite (which is that it was largely driven by financial investment in the commodity and the price collapsed when other factors drove the financial players out of the market in August/ September/ October last year). Demand in the US (the bellweather for the oil market) started to drop in late 2007 - as Americans increasingly parked their cars.

As for the cancellation / delay of oil projects, Mmmark's comment above (that $50 oil isn't sufficient to justify investment in replacement supplies, also needs careful consideration. First, most the projects were delayed or "cancelled" when prices hit the $35 mark, and seemed poised potentially to drop lower. Expanding your investment in an environment where oil prices are dropping is tough to justify to shareholders. Second, the credit markets were frozen. The small to medium players had no access to capital (indeed, entirely worthwhile projects collapsed because alternative funding could not be found - for example, Oilexco's North Sea project). Investment was impossible (and continues to be difficult). The larger players also saw their cost of capital rise, and saw no rush to develop or aggressively pursue their projects.

Things appear to be loosening a bit now, as credit markets become more accessible and oil prices stabilize - Imperial Oil just announced that it is proceeding with its major oil sands development in Alberta (the Kearl project - projected to produce about 100,000 bbls/day). Ironically, it was the downturn in the investment environment that helped push the decision - the overheated Alberta labour market has essentially collapsed, and Imperial Oil has managed to reduce its overall costs on the project by at least C$1 billion. I expect other projects will similarly be brought back online over the next few months.

My Oil Outlook

Todd's link indicates that he's a buyer of oil (perhaps including oil-related stocks?) at $40, which suggests that in the short to medium term he expects it to fall. Given current supply/demand parameters, where US and European storage levels are nearing record levels, to say nothing of the oil that has been stored at sea (anyone got any information on whether that is starting to come in now?), I'd have to agree with him. While long term views may be upward, it is still a commodity and there remains, for now, an imbalance in available supply compared to demand.

One comment on the oilsands - you need to take care to distinguish between existing producers' costs (including the costs of expanding their existing production) and those of entirely new sites. The former are currently running costs of between C$30 - $35/barrel (e.g., Suncor, Syncrude). That's about US$25-30/barrel at current exchange rates. Properly managed expansions will see their costs rise, but they will probably remain under US$35/barrel overall.

New sites, which require the full panolpy of infrastructure to process the product and bring it to market, do require higher prices. For them, they probably need long term prices in the US$60-70 range to justify their investment and risk.

Oil Inventory Nears a 20-Year High: Does It Matter?

Re: Curious John:

I am not suggesting that you can ignore what you are calling "cross asset and cross sector trades". I think much of the price run up in 2008 was driven by that type of trading. However, although commentators are now starting to talk about commodities as "currency", oil is still, ultimately, going to be priced by users. Financial trading in the commodity can result in (or increase) demand destruction (by driving unsustainable price increases, which lead to curtailed use). Demand destruction will eventually lead to price corrections - which can be magnified by the need of the financial traders to off-load their "paper" positions.

A 2006 US Senate report suggested that the effect of commodity trading for financial purposes, had probably accounted for much of the (then) significant increase in the price of oil. See: levin.senate.gov/newsr... at p. 2, where it notes:

"The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

Although it is difficult to quantify the effect of speculation on prices, there is substantial evidence that the large amount of speculation in the current market has significantly increased prices. Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil, thereby pushing up the price of oil from $50 to approximately $70 per barrel. Additionally, by purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $70 per barrel, if the futures price is even higher.

As a result, over the past two years crude oil inventories have been steadily growing, resulting in U.S. crude oil inventories that are now higher than at any time in the previous eight years. The last time crude oil inventories were this high, in May 1998 – at about 347 million barrels – the price of crude oil was about $15 per barrel. By contrast, the price of crude oil is now about $70 per barrel. The large influx of speculative investment into oil futures has led to a situation where we have high crude oil prices despite high levels of oil in inventory."

That trading/speculation, in my view (for what that's worth), became excessive in the spring & summer of 2008. As oil topped $140 a barrel, use (which was already dropping) waned dramatically. At some point, I wonder if an economist will examine the question of how much that bubble price in oil exacerbated the problems experienced in the US economy in September/October 2008?

You are right, of course: financial "speculation" will impact the price of oil. However, if it runs too far ahead of demand/supply, it has created a bubble and, barring other factors, will eventually correct.

Oil Inventory Nears a 20-Year High: Does It Matter?

The rise in oil prices last spring was driven not by demand (which was falling), or by any supply issues (there was plenty), but by the aggregation of large positions by financial investors. When those positions had to be unwound - as a result of the other economic pressures that emerged, and the increasing requirement for hedge funds to post collateral and cover other losses - the price collapsed. Ultimately, oil remains a physical commodity that has a value based on its use (unlike gold, which has been a medium of exchange literally throughout recorded history). If supply runs significantly ahead of demand, there will eventually be a price correction, as happened in the period September - December 2008.

That being said, if the price drops below replacement, we are setting ourselves up for a demand shock at some point in the future (I would guess it's not that distant - say 12 to 24 months? But that's only a guess). There's lots of talk about, for example, the cost of oil sands production in Canada. It's important to distinguish between existing production (and the cost of expanding that production) and "greenfield" (perhaps "brownfield" would be a better term) sites, where all of the infrastructure must be put into place (e.g., the Fort Hills site, prior to the proposed PetroCan, Suncor merger). For existing producers - such as Suncor and Syncrude (Canadian Oil Sands & other partners) - production costs run about Cdn$30 - 35/barrel (that's about US$26 - $30 at current exchange rates), not the [uncertain currency] $70 that is often touted. New oilsands projects, depending on input costs (which are now falling, as labour and materials costs drop with the current recession/depression), however, probably do require oil to be between $60 - $70 US a barrel long term, to generate a sufficient IRR to justify the investment and risk.

Two strategies seem possible: buy on dips, and hold long (say, a 5 year time frame). If doing that, I think you'd want to accumulate if the prices pull back this summer/fall if demand destruction outweighs future estimation of supply concerns and speculative interest. Alternatively, buy on dips, and sell on strength, popping in and out of the market. The former seems easier to me.

Oil prices collapsed last autumn, because the disconnect between supply & demand could no longer be papered over by financial investors, who had other demands on them. Even if you accept that long term price inflation has to occur (for a variety of reasons), you probably could watch for pull backs to invest.

On the storage point, does anyone know what the total private storage capacity is in the US? The EIA website is silent on this point. Working storage (as opposed to total tank space) of refiners is about 152 million barrels (versus total shell capacity of about 180 mm barrels) - see: tonto.eia.doe.gov/dnav... .
With respect to Cushing itself, the storage capacity there has been variously quoted – a report on Reuters, however, suggests a shell capacity of 46.3 million barrels (see: uk.reuters.com/article...). Working capacity is generally 80-85% of the shell amount (so, about 37-39 million barrels). The February 2009 EIA figures for Cushing are among the highest shown since 2004 (when the separate data set was broken out by the EIA), at nearly 32 million barrels in storage. See tonto.eia.doe.gov/dnav... .

But, any estimates out there for total private storage capacity for crude oil (as opposed to refined or other products)?

Oil Price Moves (February 11 - April 9)

A really handy summary. In your first graph, could you use actual daily oil prices (say WTI Cushing) instead of (or along with) USO?

Expect Oil to Approach $100/bbl Again By Summer

Sorry, an incomplete sentence in my last paragraph (see the part in all caps).

As a long term investment, well capitalized oil producers and the major integrated companies are likely a safe bet. Smaller exploration and development companies, in this environment (where access to capital is difficult and the ability to survive the price volatility - see the example of Oilexco (TSE listed)) ARE A RISKY BET. Some articles published on Seeking Alpha have suggested that, as a hedge against the possible (likely?) devaluation of the US dollar, US investors look to acquire inter-listed Canadian (or other foreign) oil companies. An interesting angle - playing for higher oil prices, plus something of a currency hedge.

Expect Oil to Approach $100/bbl Again By Summer

Demand destruction was obvious in the spring of 2008 - when the price of oil was being driven largely by speculation, rather than fundamentals, and many of those speculators were then trumpeting the imminence of $200 oil. Oil & gas price spikes in the current environment will both undercut economic recovery and feed back into further demand destruction. No commodity price can be sustained for any length of time if its price runs significantly ahead of demand. That applies also to oil. The larger OPEC members understand this, and would prefer a comfortable equilibrium to be achieved - where oil is affordable (so it dampens down enthusiasm for development of more expensive alternative energy sources), but for them profitable. The Saudis have set a target of $70 - $75 oil (although for them, $50 oil is probably fine). In the summer of 2008, as oil headed to $140+/bbl, the Saudis noted that if anyone had needed more oil, they still could supply it - but no one actually wanted it.

The longer term problem is made more complex by the curtailment of investment in oil infrastructure. The cuts in exploration and development budgets have been legion. That does potentially set the stage for price shocks down the road: but only after OPEC's excess production capacity is absorbed. How long that takes will depend a lot on the macro economic environment and I leave that to others to guess at. In the meantime, I expect oil prices will be highly volatile; I wouldn't be counting on prices north of $100 anytime soon (unless the US dollar collapses - in which case, again, the price increase will feed into demand destruction in the largest oil consuming nation).

As a long term investment, well capitalized oil producers and the major integrated companies are likely a safe bet. Smaller exploration and development companies, in this environment (where access to capital is difficult and the ability to survive the price volatility - see the example of Oilexco (TSE listed)). Some articles published on Seeking Alpha have suggested that, as a hedge against the possible (likely?) devaluation of the US dollar, US investors look to acquire inter-listed Canadian (or other foreign) oil companies. An interesting angle - playing for higher oil prices, plus something of a currency hedge.

(Long CNQ, some Canroys, Talisman).