Saturday, June 28, 2008

Dynamics of 'The Oil Price'

. . . . . . . 'At $100 oil OPEC could potentially buy Bank of America in two months worth of production, Apple Computers in two weeks and GM in just 6 days. It would take less than three years of production for OPEC to own 20% (which essentially ensures a voting block in most corporations) of every S&P 500 company' . . . . . . IAGS, Oil and the new economic order

Think what it can do at $150 oil.

OPEC and other oil rich regions have gathered such tremendous amount of wealth that a shift in the global economic order is imminent. While the world talked about the Asian growth and how it will supersede the western 'first world' in economic prosperity. However OPEC and other oil rich nations (OORN) are the one making a bounty and raking in the moolah.

All this has happened in the last 9 years when crude oil prices have risen from $10 a barrel to $140 a barrel. The demand and supply fundamentals which have been tight form so many years have come to the forefront of every news paper and info vendor. Looking at various demand and supply forecast one can only make out that the prices are headed higher from every point. But does all this demand and supply, including the politics explain the change in price of such magnitude.

There have been oil shocks of this magnitude previously. The current economic scenario looks like a repeat of 1970. However the oil price shock had abated at precisely the time we are experiencing currently. There is a strong correlation between oil spikes of 10% or more with a recession in the US. Have a look at the following graph.

In order to understanding where we stand in the demand and supply, it is important to note that the demand for oil is inelastic up to a threshold price. Determining this price form fundamental factors might be of great interest to some economist. However glancing at price prediction of some industry heavy weights in the oil sector we find that the current price is no where near these estimates. This story can be told later.

There is another important issue. I am not going to discuss the demand and supply figures. Everybody can logon to EIA and the IEA and see what are the 'true' figures. The point is will the crude oil price spiral lead to economic bust. The painful answer to this question in 'Yes'.

Consider these facts about some demand sectors. Lets take up the automobile fuel consumption. The world average of crude oil demand per capita per annum is at $9. At this pace the mammoth western energy eaters eats up nearly half of the world's oil. The car density or cars per 1000 people is very high in countries like US and Canada to the tune of 700 for every thousand. For EU-27 its nearly 450 with some countries having 500 for every 1000. China has the 40 car for every thousand and India 10 every thousand. At current demand rates the oil for demand as measured in the terms of price at $140 is in excess of $1 trillion. However I don't buy the fanciful argument of 'investment banks' that the emerging economies will mimic the demand pattern of the western world by some 2020 or 2030 because there wouldn't be that much oil left. If we analyse the other sectors the demand figures will become so grand that it would be difficult to match supply. At these astronomical demand needs and given the threshold price elasticity the price is bound to go up.

Now this raises a question that whether the price shock should be so severe that it takes the price from a odd $12 per barrel to $145 per barrel. I feel the price rise is exaggerated by market participant to some extent. But the numbers are supported by huge demand figures as well. in the last half a year there has been a reported demand destruction of nearly 2 million barrels and an addition of nearly 800,000 barrel a day of supply. If we scan the history we find that the previous oil spikes came to a halt after the US economy plunged into recession and world economy experienced a slowdown. Although it is happening again it would start getting intense and the slowdown probably wouldn't be a temporary one if price don't fall back to $100 a barrel. Looking from the demand elasticity and working up some numbers, $155 seems an important level where demand will be effected as we reach that price. One may argue that $10 from $145 wouldn't make much of a difference but in reality it does. If price run up $10 from here there would be a very swift reaction in emerging economies like India, China, Indonesia and others. The general consumption would be exposed to further higher prices and would destruct demand on an already inflationary fragile economic setup. This would destruct demand gradually.

The previous oil price shocks saw prices plunging back to the levels they started to climb from. It can happen this time as well. But at that time the demand pattern was much more localized into the western world than it is now. Presently there are huge demand drivers like China, India and even the gulf is eating up large amount of oil. The infrastructure development in Gulf is mind blowing and Asian countries are not far behind. So the long term price inelasticity still stands tall.

Stock market pundits have been seeking a recovery in the markets as and when the oil prices abates. The Federal Reserve is now expected to raise rates by the end of the year with ECB keeping the rates constant. This would lead to a stronger USD and weaker commodity prices which would induce investors back to the equity markets. The 'fanciful' equity markets.

There is a major flaw in this argument. Even if USD strengthens and commodity prices come down, it would only be a temporary shift in price uptrend. The basic economics behind the demand for food grains and energy is driven by addition of 2.5 billion people in the last 20 years to the world population. At this rate the demand is bound to go up exponentially. So any fall in commodity prices would be temporary unless there is huge demand destruction before prices plunge. This means the world should have a phase of slow growth over the next few years in order to have economic balance over longer period of time. The present scenario in no sense can be compared to a 1990 style recovery. We do not have cheap resource sector and lower inflation levels with cheap credit. The way out of the present scenario is a slowdown and some serious demand destruction which is already underway.

Another deeply debated topic for crude oil is the role of speculators. Although one cannot rule out the possibility of mass hysteria that builds around all violent price rise, the oil market seems far from an oil price manipulation cartel. The only cartel is the OPEC itself and is supplying the oil it can. If we consider the futures market to be the reason behind the rise in oil price than it doesn't fit one important aspect. Why is the real demand still holding on? If prices were indeed manipulated in futures markets than a commodity which has no futures contract traded on an exchage should see low volatility if not low prices. But take the case of onions.

A latest article on onions read like this - ( link -

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

The volatility has been so extreme that the son of one of the original onion growers who lobbied Congress for the trading ban now thinks the onion market would operate more smoothly if a futures contract were in place.

"There probably has been more volatility since the ban," says Bob Debruyn of Debruyn Produce, a Michigan-based grower and wholesaler. "I would think that a futures market for onions would make some sense today, even though my father was very much involved in getting rid of it."

Now does all the above arguement support the fact listed in the beginning of this article. The answer lies in the alternative to oil. But can we find and alternative to Crude oil ? The answer is in the deep black/dark gray stone called oil shale. It is a kerogen which is found in huge quantity in earth which would turn to oil in millions of years. What we can do now is expedite that process using high temperature process. Back in the 1980's with the middle east oil crisis born the oil shale experiment. When crude prices fell below $25 most of the companies shelved there plans for tapping this resource which is speculated to have 500 billion barrels of oil in the US alone. There are huge untapped region in Africa as well which can last for hundreds of year. Shell being one of the biggest oil major and a avid R&D power house has spent millions if not billions on getting oil from shale and tar sands. There are about 200 patents for shale oil and it is building a refinery for the same in US. It would be a first in 30 years. There has been none, even for crude oil for the last 30 years in US. I am a great believer in science and truly believe that in the next 50 years or so energy will become as cheap as sand due to alternate energy development which include nuclear energy and solar energy. Its just the information content of the present race that would have to go up to reach these levels. However there are serious issues of water being wasted in development of alternative energy from biomass and oil shale. The water being used would not be from main conventional water system, but from saline water reservoirs. Still elections are to be won over these issues and it will take time.
We are still a 0.7 type civilization and approaching the type I mark in next few hundred years where our energy needs would be met in a blink of an eye. But a trader can't trade this information and needs to know what will happen on Monday. We can have a view on this using the wave principle which is as beautiful as the music itself. I would be posting some price targets and expected levels of retreat next week.

Comments are welcome.

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