Oil Prices Are Poised on a Political "Knifes Edge"As explained in the June 2006 Trends issue, the price of oil is not up because the world is running out of oil.
It’s fair to say that new technologies are adding to the world’s known oil reserves faster than we’re consuming them.
And, if we just consider traditional proven reserves, OPEC is sitting on 902 billion barrels of oil.
In 2005, despite the global economic boom, the entire world only consumed about 30 billion barrels.
In other words, OPEC could satisfy worldwide oil demand at our present rate of consumption for the next three decades without doing any further exploration.
And, according to a report released by the Joint Economic Committee of the U.S. Congress, this counts only the 11 OPEC nations.1
It ignores all the non-OPEC oil-producing nations in the world.
Consider the fact that Canada’s reserves could supply all of the world’s petroleum needs for four years,2 while Russia’s could do so for three years.
So, if there is plenty of oil in the ground, does some sudden increase in the cost of producing the oil account for the dramatic increase since 2004?
Hardly! When the Joint Economic Committee released its report in late 2005, the committee’s chairman, Jim Saxton, observed that it costs just $5 a barrel to produce oil in Saudi Arabia.
BusinessWeek3 quoted Tim Evans, senior energy analyst at International Financing Review as saying that the average cost of getting oil out of the ground runs from $7 to $9 a barrel.
So “rounding that number up” to a generous $10 a barrel and doubling the price, you get a price of $20 per barrel ? which, coincidently, was close to the average inflation ? adjusted market price between 1986 and 2003.
So, how do we come up with the extra $30 to $50 in price that the market has placed on a barrel of oil in 2006? What formula do traders use to arrive at oil that costs $70, or more, a barrel?
The answer is simple.
They use a fear factor.
There is no rational formula.
The world price of oil is set by buyers and sellers in commodities markets. Since the months leading up to the invasion of Iraq, consumers of oil have been building inventories to protect themselves against such a disruption.
At the same time, speculators in these markets have been betting that a sizeable disruption in supply will occur.
They’ve been buying into the oil futures market, driving up prices.
At the same time, they’ve been looking ahead to a crisis that disrupts the supply of oil for a few weeks or longer, permitting them to unload their positions when the price briefly tops $100 a barrel.
And, right now, this gambling game is transferring $1 trillion a year from consumers at the world’s gas pumps to the treasuries of oil?exporting countries.
OPEC controls 70 percent of the world’s known reserves and manages production to agreed?upon levels.
The much?publicized profit surge among the global oil companies is just a drop in the bucket compared to the windfall reaped by the producing countries.
But now, unless the long?feared catastrophe materializes in the near future, that “fear premium” is going to become unsustainable, and prices are going to fall precipitously.
To start with, there is a high probability of an actual drop in the short?term demand for oil.
China’s demand has leveled off, and in early June the Wall Street Journal4 reported that OPEC nations were having trouble selling crude at prevailing prices.
Saudi Arabia was being forced to cut back its daily output because of decreasing demand at the prices set by the futures market. Storage facilities in the United States and elsewhere are full.
And, Iran has begun stockpiling unsold oil.
After briefly going above $75, the price seems to have stalled at under $70.
And, as of late June it was only hovering in that range pending the resolution of one or more of the conditions we referred to earlier as “fear factors.”5 Those factors include the threat of supply disruptions in the following countries:
Nigeria, where local unrest in the Niger Delta hobbles production.
? Venezuela, where Castro protege Hugo Chavez threatens to hold back its production.
? Iraq, where the insurgency has prevented restoration of the oil industry infrastructure long abused under Saddam Hussein.
? Iran, whose pursuit of nuclear weapons threatens to precipitate a military confrontation with the U.S., potentially shutting down all shipments from the Persian Gulf.
? Saudi Arabia, the United Arab Emirates, Qatar, and other moderate OPEC states, which face the ongoing risk of terrorist threats against the oil industry.
But, after three years of increasing tensions, the world’s political climate is changing.
For example, the Iraqi terrorist Abu Musab Al-Zarquawi is dead.
Iraq now has a new government.
And, it’s in the interest of nearly every faction in Iraq to start sharing a growing pool of oil revenue.
Iran, for its part, doesn’t really want war with the U.S., especially before it has a nuclear capability.
So, at least for the short-term, Iran shares America’s desire for a peaceful Middle East; that’s why this mutual objective is attainable.
As much as Iran would like to flex its economic muscle, it can’t afford to unilaterally shut off the oil.
Why? Because, according to the New York Post,6 oil is responsible for up to 90 percent of Iran’s exports and half of its government’s budget.
In short, Iran can’t function without exporting oil.
More broadly, international terrorism won’t vanish.
But it will be controlled.
OPEC states, with American help, have effectively safeguarded their oil industry even when the terrorists were at their strongest.
It’s hard to believe the terrorists will succeed in hitting these hardened targets now, when they seem to be “on the run” globally.
In fact, it’s the threat of terrorism and the need for a protective umbrella provided by the United States, with the tacit approval of the Chinese, that prevents OPEC from reemerging as the predatory cartel it was in the 1970s.
Similarly, for all its bluster, Venezuela’s threats are “all bark and no bite.”
The socialist welfare state Chavez dreams of building requires a steady flow of petro-dollars to buy the allegiance of the poor.
Cutting off the exports of oil might drive up the short-term price of oil to the hated United States, but it would simply be a gift to the Persian Gulf princes, while taking bread out of the mouths of Chavez’s constituents.
Likewise, Russia desperately needs its oil revenues.
And significantly, according to The Moscow Times,7 Russia also has to consider its aspirations to join the World Trade Organization.
For this reason, it will have to begin improving its infrastructure and sharing pipeline capacity.
Russia has a treaty in place with 50 other nations that allows them to use its available pipeline capacity, and those nations are now pushing for Russia to make good on its promise.
That will only serve to increase output further.
Domestically, supply problems resulting from last year’s hurricanes are finally being put behind us.
America’s crude oil reserves are now at more than 346 million barrels, excluding the government’s Strategic Petroleum Reserve.
That’s higher than they’ve been at any point since the oil glut of 1998, when the price was under $15 per barrel.
Gasoline inventories in the U.S. have been building for almost two months now, which is quite unusual for the summer driving season.
So even with hurricane season upon us again, it’s looking more and more like the disruption of oil supplies that speculators have hoped for simply won’t happen.
Once the perception that a disruption is “virtually certain” disappears, oil prices will plummet following the pattern we’ve seen in all previous commodity bubbles:
Everyone will try to get out of oil before the price collapses.
And, that mad rush for the doors will force the price to fall that much faster.
While we’re unlikely to see a $20 barrel of oil, according to experts quoted in London’s Daily Telegraph,8 we could certainly see the price hit $40.
And, it could even back off to $30, at least temporarily.
This price drop will be a boon to the Chinese economy and American consumer confidence, but a blow to those OPEC countries, like Nigeria, with higher production costs.
And, while lower prices will take oil conservation and exploration off the front page, a $30 to $40 price is still high enough to encourage the more advanced technologies for finding and extracting oil, which we discussed last month in The End of the ‘End of Oil’.
So, unless the geopolitical situation deteriorates in some unexpected and dramatic ways, oil is a commodity in the late stages of a speculative bubble that will collapse in the next six to 12 months, just as industrial metals did in June, with copper losing a third of its value and silver dropping by half.
To sum up this trend:
Political and economic fundamentals point to a diminishing chance of a major supply disruption over the next year.
However, such a disruption is still within the realm of possibility.
That’s why the Trends editors insist, “The price of oil is balanced on a knife’s edge.”
The oil fundamentals are essentially where the Trends editors predicted they would be by now:
? Global demand growth is slowing.
? OPEC can produce more oil than it can sell at 2005 prices.
? The world’s storage tanks are full to overflowing.
As also predicted in Trends, the high oil prices have not created a big problem for the global economy, because it is so much more energy?efficient than it was in the 1970s.
In short, our economy is now resilient enough to withstand the strain of costly gasoline.
The biggest problem with high oil prices is that they create unease among consumers and transfer our wealth to terrorist regimes. The only thing keeping prices up has been speculative anxiety about possible disruptions.
As that anxiety disappears, prices will decline.
In light of this trend, we foresee the following six developments:
First, the Nigerian oil output that has been taken offline by rebels in the Niger Delta will soon come back online.
Likewise,international pressure will increase output from Venezuela, Russia, and other markets, even as Canada begins extracting more oil from its sands and shale.
In short, strong supply will keep pushing forcefully even as the price collapses.
Second, insurgent attacks that have limited Iraqi output will diminish rapidly.
The appointment of the new Sunni defense minister and the disruption of the foreign terrorist network in Iraq means that Iraq’s oil will soon flood a market that is already glutted with oil.
This will maintain a downward pressure on oil prices, even as the Chinese economy continues to moderate its growth rate.
Third, the U.S. and its allies will successfully pressure Saudi Arabia and the gulf states to maximize their output.
These nations rely on the United States for their defense against terrorists as well as Iran.
Iran is a relatively poor country with relatively high production costs.
Iran’s non-Arab, Shiite, Islamic Republic is a geopolitical threat to the Sunni Arab royal families of the Gulf States.
They will be happy to accept a lower price that still affords them enormous margins in order to minimize Iran’s increasing power.
The Saudi royal family, meanwhile, needs to keep the U.S., Japan, and China addicted to their oil so that the U.S. will continue to protect them from Iran, Bin Laden, and other threats.
As the lowest-cost producer of oil, Saudi Arabia would rather have a lower price that does not give us an incentive to really develop our domestic resources. Once again, fundamentals will quell fears of a supply disruption.
Fourth, short-term efforts are likely to reduce tensions between the U.S. and Iran over Iran’s weapons programs.
While Iran has threatened to shut down shipping from the Persian Gulf, that’s not likely to happen.
Fifth, all of these factors will lead to a tumbling domino effect.
As fears of terrorist threats to oil output in the Persian Gulf fade, Saudi production will increase further.
Countries like Venezuela, Nigeria, and Iran, which need the high volume to prop up their regimes, will push production higher.
As prices begin to fall, even countries with smaller reserves and larger populations will not be able to cut output, because they’ll need oil revenues to maintain power.
As soon as the price begins to collapse, speculators will panic and dump all their oil at the best price they can.
This will drive prices down dramatically.
The wild card is Iran, which would like to see prices stay high.
But Iran’s leaders know that the threat of disrupting the world’s oil supply is the only deterrent preventing the U.S. from destroying their nuclear facilities.
They will reluctantly accept lower oil prices in the short term while they attempt to develop a nuclear weapon.
Sixth, the price of gas at the pump will drop toward an average of $2.00 per gallon by mid?2007.
However, we don’t expect to see gasoline prices drop by as large a percentage as crude oil because of a wide range of downstream factors in the U.S. gasoline market.
These include limited refinery capacity, government?mandated regional blending requirements, and costs associated with environmental litigation.
References List :
1. To access the Joint Economic Committee of the U.S. Congress Research Report #109?28 on more than substantial oil reserves, visit their website at: www.house.gov/jec/energy.html
2. To access the Joint Economic Committee of the U.S. Congress Press Release #109-80 on Canadian oil sands and its potential oil production, visit their website at: www.house.gov/jec/energy.html
3. BusinessWeek Online, April 27, 2005, “Oil: A Bubble, Not a Spike?” by Patricia O’Connell. ⓒ Copyright 2005 by The McGraw?Hill Companies, Inc. All rights reserved.
4. The Wall Street Journal, June 5, 2006, “Saudis Cite Market Forces for Lower Crude Output,” by Bhushan Bahree. ⓒ Copyright 2006 by Dow Jones and Company. All rights reserved.
5. Stratfor.com, June 8, 2006, “Global Market Brief: Irrational Exuberance Redux.” ⓒ Copyright 2006 by Strategic Forecasting, Inc. All rights reserved.
6. The New York Post, June 8, 2006, “The Oil Weapon,” by Peter Brookes. ⓒ Copyright 2006 by NYP Holdings, Inc. All rights reserved.
7. The Moscow Times, June 13, 2006, “A War of Words on Energy at G8 Talks,” by Stephen Boykewich. ⓒ Copyright 2006 by The Moscow Times. All rights reserved.
8. The Daily Telegraph, June 13, 2006, “Oil Prices to Fall.” ⓒ Copyright 2006 by Nationwide News. All rights reserved.
