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Economics 101 Might Help Explain Why the Price of Oil Continues to Rise

December 09, 2010 | About:
Canadian Value

CanadianValue

210 followers
As an investor I try to stay quite focused on the fact that most of the investment opportunities in the world belong in my “too hard” pile. I would certainly include forecasting growth rates for technology companies, valuing financial assets on the books of financial institutions and predicting currency movements in any too hard category. In fact almost all macro opinions are certainly well beyond my circle of competence.

Commodity prices certainly belong in the “too hard” pile as well. Have a read of how poorly three of the best leaders in the energy industry have done forecasting natural gas in the past two years:

http://www.gurufocus.com/news.php?id=116295

I have allowed myself one exclusion from the “too hard” pile on the commodity front and that is oil. As I’ve detailed a few times for gurufocus.com, there are two forces at work in driving oil higher this past decade when really only one would have done the trick. The first is the relentless increase in demand from China, India and the rest of the developing world. And the second of course is the fact that the world stopped finding giant oil fields 40 years ago and the production from those giant oil fields declines every year. It takes a lot of new oil fields being brought on to production simply to offset the declines in the giant oil fields that are so crucial to our daily supply.

I have to say though that even with the strong conviction I have in this supply/demand imbalance that I have been very surprised at how quickly oil has gotten back to current prices given the deep recession the entire world has been in.

What has caused the strength in oil prices despite the weak economies ?

If you have CNBC on during the day and forget to turn down the volume (which I sometimes forget) you will learn that the only drivers of oil prices higher are a weak US dollar, quantitative easing or speculative money flows. The only comments I ever hear are “the world is awash in oil” or reactions to a weekly inventory figure that is utterly useless if only looked at over a one week time span.

I think most of that is hogwash and that the answer is much simpler.

Keep in mind that I am just a simple fellow armed only with a computer and at least an average ability to read, but here is my theory on why we are already knocking again on the door of $90 oil.

1) 2010 oil consumption by the entire world (yes 75% of the oil consumed does not relate to the United States) is actually going to be above the highest level reached prior to the Great Recession. Global thirst for oil is back.

2) 2010 oil supply globally is lower than it was prior to the Great Recession thanks to the steep production cuts instituted by OPEC in the fall of 2008. Now they don’t comply 100% with those cuts, but Saudi Arabia pretty much does and those were big cuts that they made.

So to recap. Demand is up. Supply is down. Oil market should be tightening and the price should be reflecting that.

Here is a brief report from Wood Mackenzie on global oil demand:

World oil demand is likely to exceed the previous all time high reached in 2007, mainly driven by huge demand from the Asian countries, a report said on Wednesday.

Oil demand globally is forecasted to reach an annual average 86.7 million barrels a day in 2010 -- 100,000 barrels a day higher than in 2007, said Wood Mackenzie.

Wood Mackenzie forecasts the demand to increase to 88.1 million bpd in 2011 and about 90 million in 2012.

"This year will see the recovery of all the demand lost during 2008 and 2009, while in 2011 world demand will be two percent above the peak pre-recession level hit in 2007. In 2012 demand will be almost four percent higher than this peak,” said Francis Osborne, analyst, Wood Mackenzie. "Only twice before in the past 30 years has demand grown as much as this, and in recent years, 2010 will be second only to the surge in 2004.”

The report said that the recovery in the global oil demand is mainly led by China where diesel, gasoil and gasoline demand is growing at eight percent annually.

According to an IEA report in July, China overtook the US as the largest consumer of energy in the world in 2009.

The IEA said China’s energy consumption surpassed the US by 0.4 percent at 2.252 billion tons of oil equivalent in 2009 whereas the US consumed 2.17 billion tons.

Automobile sales in China reached 13.6 million in 2009 surpassing the US as the world’s biggest auto market for the first time.

On the other hand, India is recording 7 percent annual increase in the consumption of diesel and gasoil. Gasoline demand is growing 11 percent per annum.

The research firm said Asia’s oil market this year will be 3 million bpd larger than the North American market - in 2008 it was 1.4 million bpd larger.



Here is a reminder of just how big the OPEC cuts were:

http://www.nytimes.com/2008/12/18/business/worldbusiness/18opec.html

It is the third time producers have agreed to reduce their output in three months. Since September, members of the Organization of the Petroleum Exporting Countries have pledged cuts totaling 4.2 million barrels a day, or nearly 12 percent of their capacity, a record in such a short time.

And of course the important part is the compliance with these cuts which is at about 55% now and was as high as 80% for much of 2009.

http://www.bloomberg.com/news/2010-11-12/opec-s-october-crude-output-compliance-little-changed-at-55-iea-reports.html

The 11 members bound by quotas produced 26.72 million barrels a day last month, implying compliance of 55 percent, the Paris-based IEA said today in its monthly report. That’s down from a revised 56 percent for September. Supply from all 12 nations of the Organization of Petroleum Exporting Countries, including Iraq, fell by 40,000 barrels a day in October to average 29.15 million barrels daily, it said.

Opec has taken more than 2 million barrels of oil out of the market and 2010 the market will need more oil than it did in 2007. I don’t recall anyone saying that the world was awash with oil in 2007 when we had less demand AND less supply.

I think the US inventory figures get far too much attention. Perhaps if we had some better global data we might be able to better see how much the market has tightened.

Am I right ? I don’t know. I’m not the sharpest knife in the drawer and I certainly don’t have access to the best data. But I do feel like what I’m saying makes a fair bit of sense.

I'm investing for higher oil prices. You can sift through my ideas here:

http://valueinvestorcanada.blogspot.com/

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 4.4/5 (5 votes)

Comments

manco21
Manco21 - 3 years ago


I wish TMFdoodlebugger would answer your question on this...

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