Always follow the oil market closely, because it will impact the fundamentals of many businesses — including those we are selling short.
Drivers in the U.S. no longer determine the global price of oil. So oil prices can remain high despite a weak labor market — as we saw in the 1970s. If this winds up being the case, it’s bad news for owners of financial and consumer stocks and good news for owners of energy stocks.
Andy Xie, formerly of Morgan Stanley, is a great strategist who, while most other economists sought to justify the housing bubble, warned of the unsustainable U.S./China vendor finance trade model that grew so rapidly between 2001-2008. He recently wrote an article for Caijing magazine on the factors that might drive oil prices in the future. He writes:
Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.
Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange-traded funds individually or in baskets of commodities.
Oil is uniquely suited as an inflation-hedging device. Its supply response is very low. More than 80% of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.
The Chinese government is sending strong signals to its banking system that it wants lending to slow down from its blistering pace. It remains to be seen whether this will actually result in a contraction in Chinese bank lending or whether lending may just shift from one sector to another. If I had to guess, I think oil prices will have a sharp correction this fall as Chinese stockpiling slows down and as oil and refined product inventories remain more than adequate to meet sluggish U.S. demand.
But this correction will offer trading and investing opportunities on the long side. As you see in the two charts below, the linkage between oil prices and U.S. inventories during the entire post-2002 bull market was not as close as you’d expect:
Here’s why I think a correction in oil prices will offer a buying opportunity: Inflation fears and stabilizing in global demand are not the only reasons the price of oil has doubled from its lows. Oil prices are up because the marginal cost of new supply — including from Canadian tar sands and from under thousands of feet below the ocean surface — is so high.
To Andy Xie’s important point about oil as an inflation hedge, I’d add that OPEC planners understand that they are trading a scarce, extremely energy-dense, nonrenewable, depleting asset for paper money. They also are beginning to grasp that indebted oil importers plan to ease their debt burdens by employing the heavy guns in the inflation arsenal: “quantitative easing.” So their portfolio preferences will shift away from government paper and toward retaining scarce oil in the ground for future revenues. In other words, “Why should we trade oil for dollars now if we receive higher prices five years down the road?”
This is just one of the many intricacies governing how the global oil market operates, and it helps explain why those who are perpetually bearish on oil prices waited for years and years for a rational, free-market supply response to higher prices that never arrived in force. That is, until last fall’s panic brought demand far enough below supply that prices crashed. Now, the conventional wisdom says that several million barrels per day of spare OPEC capacity will keep a lid on prices for years. We may discover by next year just how quickly this alleged spare capacity will come back online, and at what price.
The question then becomes why should national oil companies rush into the risks of making the enormous capital investments necessary to maintain production — let alone grow production. Nancy Pelosi and Ben Bernanke are not promoting policies to make energy cheaper; in fact, their playbooks virtually ensure the opposite. Privately owned exploration and production (E&P) companies that take smart risks will be the ones that deliver more supply at lower prices to help ease supply constraints.
Now, when you consider how the U.S. economy currently functions, you come to understand that rising energy prices induce enormous headaches for practically every consumer and business. Call rising energy prices a “deflationary force in the real economy” if you like. The point here is the irony of the situation: The Fed and Treasury are trying to reinflate a deleveraging private economy, and much policy could wind up accelerating the deleveraging process by adding pressure to the prices of nondiscretionary items like food and energy. After all, these are both global commodities, and capacity in these sectors is tighter than most market participants realize.
Bottom line: There is no easy, painless way out of a credit-financed asset bubble that artificially pumped up consumption. This artificial growth in consumption prompted entrepreneurs to misallocate resources into unproductive sectors that were temporarily pumped up by what looked like sustainable demand. Meanwhile, there are many sectors, including oil and gas, that have been underinvesting relative to the long-term global demand for mobile, modern lifestyles.
Sure, oil prices could correct sharply this fall as traders panic about a temporary glut in aboveground supply at storage terminals. But to use manufacturing terms, it’s the “raw material” and “work in process” inventory that really matters. That type of inventory, sitting higher up in the supply chain, is much tighter than the “finished goods” inventory sitting in storage terminals like Cushing, Okla. I expect we’ll see this tightness reflected in prices by 2010, even if demand remains stagnant.
Production capacity in oil and gas looks plentiful right now, but capacity naturally falls every year, and requires hundreds of billions in global capital expenditures just to keep supply steady. According to an exhaustive analysis published by Neil McMahon of Bernstein Research on Aug. 10, non-OPEC oil supply will keep declining in the coming years, despite healthy levels of investment. Outside of OPEC (where information regarding capacity and investment plans is murky at best) explorers are targeting smaller formations, as production from giant, decades-old fields declines. McMahon writes:
In the long term, we believe that oil prices will increase in line with the marginal cost of supply, which continues to rise as the complexity of new wells increases and production rates from established fields decline. Basically, not enough significant discoveries have been made in non-OPEC countries in recent years to help the supply situation before 2015. Additionally, flow rates from the few discoveries that have been made do not give rise to much optimism and, as in the past, the drop in absolute oil demand will be offset by rapidly declining mature field production with the recent fall in industry spending. So the continued decline in non-OPEC supply will provide an additional support for prices, as it feeds through to OPEC spare capacity. We believe that 2010 will see the next inflexion point in prices, as OPEC spare capacity begins to decline and demand shows positive growth for the first time in a number of years and we expect to see oil average $80 in 2010, $103 in 2011, $111 in 2012, and increasing to $140 in 2015.
You can imagine what this type of price trajectory will do to U.S. businesses that rely on cheap fuel, and have no ability to push through price increases. Considering how many more trillions of U.S. dollars will be floating around the global economy in 2015, and savers’ willingness hoard them declines, $140 per barrel might be conservative.
Global oil production capacity, rather than demand, will eventually drive prices. Bernstein projects 2020 oil production capacity will be about the same as it is now: 85 million barrels per day. We must consider net exports too; the global trade flows of this oil will certainly change. Over time, more tanker shipments will be diverted away from the U.S. and Europe and head to Asia. Also, in recent years, OPEC countries have been consuming more of their own product at home. Plus, the Chinese government has shown that it will beat any and all comers in the competition to secure supply under long-term contracts.
Regards,
Dan Amoss
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