What should we make of the Saudi’s call for the heads of state of oil consuming and producing countries - meaning all countries - to meet to discuss oil? Is it possible, as Mr. Market seemed to think this morning, that the Saudis would go to all that trouble for naught? Here’s what we know:
1. Such a meeting is unprecedented on at least two levels. The Saudi’s have never before stepped up to a global leadership role and there has never been a global meeting at such a high level (or any level, to my knowledge) to discuss oil.
2. The current oil supply/demand crisis appear to be largely a function of two beliefs that have taken widespread footing in the oil markets: that there is a lack of light, sweet crude compared with growing demand for diesel and other refined fuels and there is a lack of refining capacity for the heavier, sour crude supplies that are not in short supply.
3. The Saudi’s are bringing on stream two new oil fields that produce light sweet crude, one this year with 500kb/d capacity, and a second one - Khurais - next year with 1.2 mb/d.
4. The Saudi’s are also bringing on stream substantial new refining capacity for heavier, less pure crude, as are the Indians and Chinese.
5. The Saudi’s super-giant field, Ghawar which yields about 5 mb/d, is old and some analysts believe it could be at the point of declining production. Part of the new Kharais project is an additional 4.5 mb/d of seawater injection capacity some of which is schedule to boost the South Ghawar fields.
6. Industrial and political leaders in OECD countries are starting to transition the industrial economies away from dependence on oil for transportation.
7. The market has begun to put a high value on long dated oil as evidenced by a slight contango and much higher prices for long dated crude calls. Normally oil in the out years is priced lower than oil in the current periods reflecting the cost of money and the cost of oil storage, which is called backwardation. But now the high demand for oil in the out years is causing a gentle contango, meaning oil prices are starting to get higher in the out years than the near contract. Contango creates its own dynamics for higher oil prices by rewarding suppliers for selling later rather than selling sooner and thus taking some near-dated oil off the market.
8. An important support for oil prices is the falling dollar.
Putting these facts all together, we see an oil crisis caused by the market’s belief that supply is outrunning demand. This belief has taken hold just as Saudi Arabia is bringing vast new supplies to market and is bolstering the credibility of Ghawar, its present oil production backbone by adding new pressurization capacity. Moreover, the Saudis and others are getting closer to adding vast new refining capacity that can sop up the heavy crude that today is in oversupply.
Thus the facts suggest that the Saudi’s have some opportunities to convince the oil market that prices are too high. If prices start to drip, they could change the dynamics of oil trading for the next year or two, perhaps longer. This seems the possibility that underlies the Saudi call for a global conference on oil.
The fact that the proud Saudis, who have always guarded their privacy, are now volunteering to take the lead at this time underscores the importance of their desire for lower oil prices. Why? Their two goals are both threatened by the currently high price of oil. Those goals are:
1. Political peace. The Kingdom’s oil has given its rulers unprecedented influence and wealth. But their ability to enjoy it and to build a prosperous country is threatened by the possibilities of war in their neighborhoods. KSA is surrounded by guerilla or national wars in Iraq, Lebanon, and Palestine plus an aggressive historical competitor, Iran. In fact, the Iranians’ nuclear ambitions might generate a pre-emptive strike that could reverberate into a threat to the security of the Kingdom. The Saudis would like to enjoy their wealth in peace.
2. Longer term continuing strong demand for oil. High oil prices are pushing OECD countries to develop hybrid electric technologies that will eventually be cheaper than oil, thus threatening long term demand for oil. While the price of oil could go to astronomical levels in the short term, the longer term results might ironically result in much lower prices for oil perhaps 20 years from now, particularly given the world’s growing desire for a clean environment which could result in the social costs of burning fossil fuels becoming an explicit part of the price of oil via taxation.
Both Saudi goals are directly threatened by high and increasing oil prices. The high oil price enables Mid-East political instability by empowering Iran. Lower oil prices would reduce the power of Iran which is the chief source of all regional conflicts. It is Iranian intervention that fuels most opposition to the Iraqi regime, especially Moktada al-Sadr. It is Iran that is chiefly fueling conflict in Lebanon. And it is Iran that is chiefly supporting Palestinian radicals. Lower oil prices would pressure the Iranian economy, possibly making the mullahs more likely to listen to the deals being offered by the U.S./E.U./Russia/China negotiators.
Lower oil prices would also help the King accomplish his second goal, taking the air out of the OECD’s efforts to develop alternative fuels for transportation. If the Saudi’s could move oil down to $120, then $110, then $100, and maybe even to $80 by the end of 2009, there might be very little left of OECD efforts to build electric public transportation, pass 55 mph speed limits, and throw a lot of public funds into R&D for new battery technology, new cellulosic ethanol technology, and public electric refueling stations the way Israel and Denmark have already begun to do. Moving oil prices down would convince consumers and many executives that this past year’s high oil prices were really just a false alarm.
Could It Work?
What could the Saudis say to make a difference? Certainly not just that the are putting another 200 kb/d on the market as was disclosed by the U.N. Secretary-General Ban Ki-Moon. Today’s oil market is giving a big raspberry to that disclosure. And surely the Saudi King did not go to the trouble of demanding a global audience just to say that. So something else must be going on.
First, the King must flesh out his vision of near term oil plenty, as described above. He will highlight the Kingdom’s major investments in new oil fields and new refining capabilities. He will pledge that all 1.7 mb/d of new Saudi light oil coming on stream over the next 12 months will be put on the market and sold to the highest bidder, even if that drives the price back down to $50. He will promise that the new saltwater pressurization capacity, not an asset that has been well noted, will keep Ghawar flowing at 5 mb/d for at least another decade.
Second, the King may call for a solution to above ground problems in Iraq and Nigeria, perhaps asking for the formation of separate Iraqi and Nigerian task forces made up of the Energy Secretaries of the major powers plus local officials in each country. The task forces would work to solve political and military problems in Iraq and Nigeria, allowing both Iraq and Nigeria to increase output by 2 mb/d each within two years, a goal that could realistically be accomplished if the political will were present.
On the demand side, the King might ask OECD countries to take some easy steps to reduce their demand for fuel inefficient vehicles perhaps through very high taxes on the purchase of automobiles that get less than, perhaps, 25 mpg. That is a very practical and potentially effective way to reduce global fuel use that the King could implement in his own country.
Is the King Working Alone?
The kicker in the Saudi oil event next Sunday might be a request that oil be priced in a barrel of currencies, perhaps managed through the World Bank. This would be a great way to remove oil from trading as a tool for investors to protect themselves from a depreciating dollar. A decoupling might serve to strengthen the dollar, but it would certainly reduce the value of oil, if not immediately then over time assuming the dollar continues to weaken.
Whether or not the King makes such a dramatic request, I firmly believe that this conference is not his work alone and it did not spring to his mind in recent days. There have been a number of visits to the region by both President Bush and V.P. Cheney in recent months. They came away looking like weak beggars but I doubt that was the full story. I think they visited the King with a much more substantive agenda. Decoupling the dollar from oil might have been a big part of it. Such a move would save face for America - and have a better chance of succeeding - if it came as the request of the King rather than a plea for help from the President.
Whether the King asks for a decoupling of oil from the dollar or posits some other startling idea, it is clear that the King’s objective of lowering the price of oil and weakening the economy of Iran to pressure it on the nuclear issue and regional peace are goals that are also very near and dear to the hearts of the American government and, not so incidentally, the Israeli government. Giving the King of Saudi Arabia center stage in what is clearly a rehearsed script is a clever way of using the most sympathetic of world leaders to do the heavy lifting.
Could it Work?
In the world of commodities, success leads to success. There are so many commodity investors who follow trends that when a trend gets started it achieves enormous momentum. The trend eventually alters the policies of commercial players in ways that sometimes reinforce the new trend. That is partly why the price of oil is now over $130 a barrel. The strong belief that oil prices can only rise has kept a certain amount of oil off the market and caused a certain group of oil users, like airlines, to be more aggressive in buying longer dated futures. Such actions, caused by a belief that oil prices will rise, tend to raise the near term price of oil further.
A trend becomes firmly ensconced when the traders not only recognize the trend but also think they understand the reasons behind it. So we now “know” that the growing demand for oil by Chindia and the oil exporting countries will overwhelm supply, which will be limited by Peak Oil and the Export Land Model.
But if the price starts moving down, that trend will also need a plausible rationale. The Saudis could provide that rational at their conference by convincing people that so much more crude is coming on the market in the next few years that, given a slowing global economy and steps being taken to bolster Ghawar’s production, there will be more oil on the market than there is demand for it.
That idea by itself might not be strong enough to overwhelm the present up-trend in oil prices. What, then, might get the price of oil going down? How about a concerted shorting of oil futures by the Saudis, the U.S. and - maybe - the Israelis. And/or London, Mr. Bush’s most recent stop. If such a scheme worked, the participants would actually make money on their futures bets. At the worst it would only cost them some money in a worthy effort.
If the market’s fear of higher oil prices were replaced by a fear of lower oil prices we could see $80 oil in another six months. Certainly the slowdown in OECD growth rates caused by the credit and housing crises provides a ripe environment for a reversal in the price of oil. If such a trend were started by a concerted international intervention in the futures markets and then kept in motion by a fundamental rational and a series of international actions put into motion by the Saudi oil conference, we could indeed see oil prices trending down for the next 12 - 18 months.
No Slam Dunk
The other side of this argument was offered in my two previous essays, Behind the U-Turn in Oil Prices and a follow up and expansion on it, High Oil Prices Start to Work. Is It Enough? where I pointed out two risks to a lower oil price scenario. One is the risk of a military action against Iran if it fails to halt its nuclear program. My guess is that Bush is now allowing diplomacy to have a robust chance to succeed. If it does not succeed, my guess is that military action may well be undertaken after the election, particularly if Obama is elected. Such a likelihood would be enhanced if oil prices have declined in the meantime and Iran still refuses to yield on nuclear weapons.
The other major argument against lower oil prices is the knowledge that new oil fields coming on stream will become increasingly scarce after 2010. Since a field takes about 6.5 years from discovery to first oil, we can now know nearly all the new fields scheduled to produce through 2014. The bulk of such scheduled fields come on stream in 2008 and 2009. Of course slippage is increasingly likely. Nonetheless, if oil does get cheaper for the next 18 months - or even if it simply fails to rise - global economies can be expected to recover their growth rate by 2010, just as oil from new fields is becoming scarce.
In any event, we can be fairly sure that oil will become extremely scarce by 2013. That is a known risk suggesting higher prices longer term. Other risks include
- further violence against oil production in Nigeria
- rapidly increasing costs for oil exploration and production resources including both labor and capital equipment,
- the possibility that if the Saudis try to force down oil prices other OPEC countries will withhold supplies to keep prices high.
It’s a Dialectic, Stupid
The bottom line, in my view, is that there is substantial uncertainty about the direction oil will take in the short run. For the next 18 months or so there will be strong forces at work on both sides of the oil market. If the Saudis (and their co-conspirators) do their utmost to lower prices and such efforts fail, the markets will be increasingly confident on the bullish side for oil prices. If the Saudi’s succeed, it could be a long way down for the price of oil.
In this environment, it seems dangerous to take a bold stance in either direction unless you are a professional oil trader and are constantly watching and listening. The wisest course for an individual investor may be to step aside from the oil market for a while and let the dialectic play out. The oil market has been generous to investors for the past four years. This could be a good time to protect the profits one has already realized rather than to aggressively seek more gains.
That said, if the price of oil does recede for a while, the stock market itself would be helped, although not particularly oil stocks. It would be a better environment for shipping and oil services and drilling companies rather than the E & P’s.