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Thursday, July 21, 2005

Is it time to short oil?

Let's stretch our memories back -- way, way, far back -- all the way back to 1999, when oil was under $10 per barrel...
OPEC met November 25-26, 1998 in an attempt to reverse the decline in oil prices. This meeting was a total failure...

The battle that OPEC faces is market share vs. price. The problem is that you cannot have both. To increase market share you must increase production sufficiently to drive prices down to the point that it is not economical for non-OPEC producers to maintain current production rates.

Unfortunately for OPEC the full realization of the impact of lower prices on non-OPEC producers takes several years.
My emphasis. Of course, the effect of higher prices also takes several years. In the next paragraph substitute "higher" for "lower" and it is just as true.
The effect of lower prices is greatest in countries and areas with the highest finding and production costs. Onshore production in areas with high lifting cost are usually the first to show reduction in activity. Because of long term decisions involved, offshore producers often take longer to react to lower prices...

Perhaps the best chance for OPEC is a cold winter in the short term and a rapid Asian recovery in the longer term.
Prescient! But also showing the oil market cycle is not entirely unpredictable.
To better understand the producers dilemma let's look at a year end snapshot. ... A crude oil producer on the low end is receiving $4.65 per barrel or 11 per U.S. gallon. On the high end they received $9.00 per barrel or 21.4 per gallon. Milk producers do much better than that and they don't have to pump their product thousands of feet to get it out of the reservoir.

The impact of low prices on the industry is significant. By October, employment in oil and gas extraction was down 7.2 percent from 1997. Over the same period overall U.S. employment was up 2.3 percent. That is a rate gap of almost 10 percent. When the data comes in for the rest of the year the rate gap will widen...

Companies have been laying off less experienced lower paid workers, but the cuts are now moving up the experience ladder. If prices do not recover soon the industry will lose valuable human capital. Thus the producers dilemma: lose talent, lose reservoirs or lose the business? In many cases, it will be all three...
Ah, those were the days to be SUVing!

Here's the fundamental thing about the oil market: the supply of oil is relatively inelastic -- it reacts to a substantial change in demand only with a lag of years.

In contrast, with the typical manufactured good a change in demand will cause supply to change pretty quickly in response. If demand for green widgets shoots up, increasing their price, the production runs for green widgets will be quickly increased by Amalgamated Widget Corp. and all its competitors about as quickly, and the resulting prompt increase in supply will act to mitigate and contain the price increase.

With oil, however, the short-term level of supply is pretty well fixed. To bring significant new production on line, or take it off, takes a few years. In the meantime the quantity demanded is brought into line with the amount supplied entirely by price -- as it either plunges down or rockets up.

Thus, after more than a decade of strong economic growth and high oil prices that spurred increasing production, a world financial crisis hit in 1997 that sapped demand, especially in Asia -- and the price of oil, which had gone over $90 (inflation adjusted) fell more than 85% from its peak.

In response, producers slashed both production and their work forces, losing "talent, reservoirs and business", over a period of years.

After which the world recovered from recession and demand boomed again, especially in China and among the resurgent Asian tigers -- and here we are now with oil around $60.

OK ... So what would an individual whose memory stretched back far enough to recall an entire pricing cycle for oil expect from here?

Perhaps today's high prices leading to planned major production increases [more detail] over the next few years?

While at the same time high prices do the job of capping and even reducing previously surging demand in China, the world's critical "swing" demand market ...
A sudden and mysterious drop in China's oil consumption helped to push down the International Energy Agency's estimate on Wednesday of global demand for this year.

After growing 11 percent in 2003 and 15.4 percent last year, China's overall oil use declined 1 percent in the second quarter from the comparable quarter a year earlier, the agency said....
[NYT]

The IEA report said net oil-product imports appeared to have fallen to just 150,000 barrels per day, well below the 730,000-barrel rate for May, 2004. [BW]

... and elswhere?

If so, where would such a person think the price of oil will likely be in, say, 2008?

Place your bets now!