Some Thoughts About the Oil Price?
Some Thoughts About the Oil Price?
March 28, 2011
David Kotok
http://www.cumber.com
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The TV is crammed with industry folks and analysts calling for the oil price to fall $20 or $30 per barrel. They argue there is a geopolitical risk premium that is part of the current price. They may be right, BUT no one knows how to measure a “geopolitical” risk premium. We can only guess at it.
Market forces set prices. We see them in the oil market for various types of oil and for various maturities in the futures markets. Those prices are all well above the $70-$80 range. As Dennis Gartman points out well in his daily letter, the futures market tells you the expected cost of holding an oil inventory in actual storage vs. using a financial instrument in place of the physical storage. If you go by the markets, the outlook for oil is well above $70-$80 and headed higher.
Various estimates of global oil demand center on 88 million barrels a day for 2011. In some excellent research Barclays assembles the outlook for oil from four key sources. Barclays also runs longer-term supply/demand analysis on a global basis and then projects the oil price.
Barclays estimates that the oil price can be about $185 by the end of this decade. It can be $135 within a couple of years. This is without a supply shock that may result from current violence in MENA. In addition, we add, it is without any supply shock originating in Nigeria or other Sub-Saharan African oil sources.
We remain overweight oil and energy in our US exchange-traded fund portfolios. The current weight of the energy sector in the S&P 500 index is about 13.5%. We are about 20%, which is about as high as we would go with a sector this large. We remember that the energy sector reached nearly 25% of the total market weight when the Shah of Iran fell in 1980 and the oil price then spiked to $30 a barrel. We also remember that the sector weight fell to as low as 7% when oil plunged in price to as little as $10 per barrel a few years ago.
The key to oil is to be nimble. You can buy it and hold it forever or you can change your weight, depending on richness or cheapness. When the energy sector is priced as a single-digit percentage of the US market, it is cheap. When it is above 20%, it is richly priced. Currently we are in the middle.
Oil and energy is currently neither cheap nor dear. Therefore, the pricing of the stocks in this sector depends on the outlook. Here the information is available and the outlook for US companies remains positive.
The US is dependent on imports of oil. We get it mostly from ten countries. Dennis Gartman reports the sources in his letter today. They are listed by size of imports: 1. Canada 1.972 million barrels per day, 2. Mexico 1.140 bpd, 3. Saudi Arabia 1.080 bpd, 4. Nigeria .986 bpd, 5. Venezuela .912 bpd, 6. Iraq .414 bpd, 7. Angola .380 bpd, 8. Colombia 338 bpd, 9. Algeria .325 bpd, 10. Brazil .254 bpd
Since global oil is priced in US dollars and is likely to be priced that way for a long time, the issue for a US investor is the dollar price discovery and how that will unfold. MENA violence aside, it is clear that the US dollar price of oil is likely to go up.
Some of that “up” will be due to weakening currency. Some of it will be due to rising global demand. Some of it will be due to the absolute failure of the US ENERGY POLICY WHICH MAKES US DEPENDENT ON FOREIGN-SOURCED OIL. And some of it will be due to the supply shocks from geopolitical risk in MENA and elsewhere.
The total of these things suggests that the upward price bias estimated by Barclays is a correct thematic view for an investor. At Cumberland, we remain overweight the energy sector. As we have written several times: “This is nowhere near over.”
~~~
David R. Kotok, Chairman and Chief Investment Officer
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March 29th, 2011 at 2:09 pm
The two things I’m interested in are:
How much does it cost to take it out of the ground and how much per barrel do competing energy sources cost? Once the price starts to climb above the cost of competing energy sources (assuming easy substitution) you are reaching the price ceiling in the market IMO.
March 29th, 2011 at 2:45 pm
common man… your assessment is logical but its not reality… I think your easy substitution assumption hits the core of it. Our economy runs on liquid petroleum products – trucks, buses, rail, air. Millions of vehicles are transporting goods 24/7 around the globe. These vehicles are the economic architecture that keeps us going — linking buyer and seller. The replacement cost of changing the engines to handle a “substitute” liquid energy form is in the trillions and will take years. This is what keynes would call something that has “stickiness” — while on paper you can assume substitution and a new supply demand equilibrium, this would not move as intended for some time due to substitution costs and, frankly, the lack of workable technologies and solutions. (you cant fly a plane or a propel a ship on CNG or solar can you).
no doubt sustained oil prices (call it $200/bbl) for a long time (ie 2-4 ++years) would drive massive substitution where relatively cheap and where technology exists.. but it would take a decade for the existing capital stock to cycle through to the next form of liquid transportation fuel.
In the interim I am with Kotok and am bullish on energy (though there may be some pullback), and also very bearish on many things that are very dependent on cheap oil (ie Airlines).
March 29th, 2011 at 3:44 pm
dr dre,
In Brazil they have replaced their fuel source with ethanol and it is powering a good majority of their economy. I’m also thinking about bio diesel. At what price do these fuels become viable? These are two that come readily to mind.
That said I do own energy and the latest run up in gas prices was more than compensated for in my portfolio. As a form of consumer price insurance, energy stocks work quite well and are what I recommend folks who want to boycott the oil companies.
March 29th, 2011 at 3:48 pm
I am just a concerned citizen and don’t know a lot about how the investment world works. But the question I have is when an investment in oil is made, where does the money in your investment go and where does the profit that you make from your investment come from?
March 29th, 2011 at 5:39 pm
common man, you do realize why they did that? when they did it, they had to as they couldn’t afford to buy oil (their economy wasn’t that well of). and they had a readily available source of ethanol (sugar cane). and as it turns out its a lot better than corn.
but it still requires some oil, as 100% ethanol doesn’t work well, and has lots of down sides for IC engines and their components. not so sure about the newer flavors. seems likely all we doing in their cases also is just diluting the need for oil.
and oil is a commodity, which has been produced for over a 100 years, and we know pretty well how to get it. but there are lots of ‘assists’ from government and others that hide the real costs. and no producing country really tracks the production well. so nobody really knows how much is really produced and shipped as those are competitive information to be hidden.
and never mind the high number of speculators in the oil market who buy but never take delivery. as its not a time constrained commodity (like saw corn?).
and we are likely to only really get serious about reducing oil use when it hit $200. but only for energy use, as it has lots of others (materials, drugs, etc)
March 29th, 2011 at 6:51 pm
re: “…due to substitution costs and, frankly, the lack of workable technologies and solutions…”
you may be interested in ..
http://www.cleanenergyfuels.com/trucking/index.html
http://baftechnologies.com/
for examples of ‘solutions’, available, for Automotive & Trucking..
March 29th, 2011 at 8:30 pm
It would help me if Kotok named two or three oh TV people cramming the airwaves with $30 oil predictions.
March 29th, 2011 at 8:50 pm
The largest pricing component in crude price today is the USDollar Debasement. It’s $17/barrel this week and could be $44 by 2012Q4 – the time I believe oil price will peak @ $149. It is the secular decline of the US$ driving this year’s price run … not Libya.
Inventories and surplus capacity are both above average. Unless Congress addresses its structural deficits, Price will continue to rise ’til the next Election: http://trendlines.ca