The new factor affecting the oil price

James Woodburn - Thu 08 Jun, 2006

...The new factor affecting the oil price...And it's not wrench-wielding OPEC oil sheiks threatening to choke off world supply, nor grand-standing revolutionary leaders in South America's petro-nations. Nor Russian oil oligarch's or their masters in the Kremlin flexing their strangle-hold on Asian and European consumers...Today's villain, argues Doug Casey, Chairman of Casey Research, is the speculator...

There's a new phantom haunting the oil markets.

And it's not wrench-wielding OPEC oil sheiks threatening to choke off world supply, nor grand-standing revolutionary leaders in South America's petro-nations. Nor Russian oil oligarch's or their masters in the Kremlin flexing their strangle-hold on Asian and European consumers...

Today's villain, argues Doug Casey, Chairman of Casey Research, is the speculator...
    
"Last week, US senators were echoing Citigroup's contention that traders had added as much as $20 to oil prices. Politicians are now calling for stricter oversight and tracking of energy trades."

And it's true. Citigroup wrote in a May report that speculators now own $30.3 billion in natural gas contracts and $30.1 billion in crude oil.

The new factor affecting the oil price: 'Petro-mania'

So what does this mean? Are traders really to blame for the current 'petro-mania'? And what does that mean for your investments if they are?

"The effect of speculation on oil is difficult to measure," says Doug, "but one gauge is the Commitment of Traders data for the NYMEX. The major point of interest is the number of 1,000-barrel contracts outstanding.

"The number of contracts - ie. the amount of oil being bought by speculators - has nearly doubled over the past two years. And this roughly coincides with a major price jump.

"Although this is far from proving anything (the number of oil contracts also doubled between 1987 and 1994, while the price was generally flat), it does smack of a speculative fervour. And today’s energy markets certainly inspire a lot of speculation."

When was the last time we experienced a week without a disruption to our oil and gas supplies being reported in the news? Nearly every day we read about some new threat.

The main worry for investors is that an oil price driven by speculation could deflate faster than a pricked balloon.

The new factor affecting the oil price: In the past

Just take what happened during the first Gulf War...

In the latter part of 1990, crude jumped nearly $20 in under four months as US forces headed to Iraq. At the time, investors feared that oil supplies would be disrupted by a long, ugly war. But the fear premium dissipated almost as fast as it came. Just a few months later, the price plummeted back to near pre-war levels.

And this is another point Doug draws on:

"The parallel between 1990 and the early months of 2006 is obvious: In late February and March of this year, prices dipped below $60, and it seemed the peak-oil pundits might be ready to pack up and go home.

"Not so fast. On March 24 came reports that Iran was rapidly expanding its uranium enrichment programme. Nations worldwide, including the US, denounced the effort.

"Immediately the media began buzzing about the possibility of an embargo or military strike against Iran. Over the next month, crude beelined to $75, up 25%.
 
"But as with the Iraq reversal a decade ago, gravity could take hold of oil hard and fast if the Iran worries end without a major intervention. Indeed, some suspect that Iran’s president Mahmoud Ahmadinejad will cave quickly when push comes to shove and others believe that Ahmadinejad’s hardline talk on uranium enrichment is simply a ploy to keep oil prices high.

"By whipping up a war of rhetoric with the West, the Iranian has almost single-handedly pushed oil prices to recent highs, a direct consequence of which has been to bring in billions in extra oil revenue for his country."

The new factor affecting the oil price: Iran's oil revenue

What you have to realise is that Iran needs all the oil revenue it can get. In the last fiscal year Iran overran its budget by 27%. Without oil revenue the country would fall into a financial crisis.

So what’s a fanatic president to do?

"Posture like America’s worst nightmare and bring US forces to the brink of attack, all the while reaping immense profits," says Doug.

"But if Ahmadinejad is a paper tiger, it’s unlikely he’ll risk a real war. More likely, he’ll veer off at the last moment, leaving the oil price like Wylie E. Coyote trying to tread air after running off a cliff.

"A quick fall to $60 - below - would be possible."

That may very well be the case but the way I see it, a fall similar to that following the first Gulf War is unlikely in 2006.

For one world crude supply is tighter than it was in the early 1990s - it leaves less room for pumps to go off line. Worldwide oil production capacity has declined by almost half since the early 1990s to about 2 million barrels per day.

There are fewer replacement taps to turn on if wells are taken out by a bombing, revolution or natural disaster. More worrisome, of the current estimated excess capacity, nearly half is in Iraq, Venezuela and Nigeria, all countries with serious political grief.

Oil traders are jumpy simply because they should be. A major supply disruption in such a tight market would send prices to the moon.

The question we now have to ask is... what effect would an unfolding 'worst-case scenario' have on global supply and demand balance? 

The new factor affecting the oil price: Doomsday 2006

Imagine this...

Nigerian militants knock out the country’s production.  At the same time, Venezuela decides to shut its taps in an effort to teach petroleum-importing nations a lesson. And for good measure, the US launches a military strike against Iran...
 
If these events occurred at the same time, 9.5 million barrels a day of production - about 11% of global output - could be knocked offline. Prices would invariably take a panic jump.
 
"But," says Doug resoundingly, "the panic would probably be short-lived, due to a little-discussed factor: global stockpiles of emergency crude.

"More specifically, the 26 member nations of the International Energy Agency currently hold a staggering 4 billion barrels of strategic reserves, in both government and industry tanks. Even in the unlikely event that Iran, Venezuela and Nigeria all went completely offline, stockpiles could make up for the production shortfall for well over a year.
 
"And those are just the stocks of IEA members. In 2000, the agency surveyed worldwide oil stocks and found some 5.9 billion barrels in total held by government and major commercial oil suppliers and consumers around the globe. Adding oil held by smaller retailers and consumers, the number came close to 7 billion barrels."
 
But for argument's sake, suppose that Middle East insurgents try to amplify the Nigeria-Venezuela-Iran oil crisis by hitting production facilities in Iraq and Saudi Arabia...

"The world would lose another 7 million barrels a day," says Doug. "But even with this additional disruption, IEA oil stockpiles could still meet demand for about eight months. If chaos reigns beyond that, we’re likely to be driving motorcycles and sporting multicoloured Mohawk hairdos rather than worrying about oil prices.

"In short, while there is little question that the world’s energy production is under pressure, there is a lot of oil waiting in the wings. So any jump in price following a major supply disruption could very well reverse shortly thereafter as a flood of stocks swamp the market. In fact, that’s exactly what happened after the Gulf hurricanes last autumn."

"Following the storms, the average monthly price for crude leapt $7. Then the US opened its strategic petroleum reserve - and other IEA nations stood by to do likewise - pushing the price back down to pre-hurricane levels. (Meanwhile, the price of natural gas, for which there are no emergency stores, jumped 100%.)
 
"The IEA had similar plans for the 1990 Gulf War, drawing up a contingency strategy to release 2 million barrels per day. Only a few million barrels ended up being used, but the supply was there if needed."

The new factor affecting the oil price: Why I still remain bullish on oil in the long-term

With emergency stockpiles at such lofty levels, it appears that the oil spike today’s traders are banking on would be short-lived.

Of course, a prolonged disruption that continued as stocks were drawn down substantially would drive prices back up again.

But for Doug, the foreseeable future, the fear premium in the oil market is hard to justify...

He says: "If supply fears indeed prove to be unfounded, much of the speculative air could go out of the oil market. As mentioned, in the short-term, a fall of $10- $20 is not out of the question."
 
So what does this mean for your investments?

A fall in the oil price would almost certainly trigger some knee-jerk selling of oil and gas shares. But this needn't hit your portfolio hard.

While share prices of larger producers tend to surge and sputter with the vagaries of the oil price, smaller, rapidly expanding companies have a life of their own.

That’s exactly why you'd do well to buy small outfits and catch the updraft of a company with growing reserves and/or production.

I remain bullish on oil for the long-term, and so does Doug (after all, even a 20% drop in the oil price would still leave us with $55 crude… still an extremely profitable level for producers). But he doesn't relish the heart-stopping drama that comes with picking stocks that live and die by the oil price.
 
Volatility in energy prices is assured as more and more speculators pile into the market.

But if you listen to this advice and traders suddenly turn bearish on crude - after an attack on Iran fails to drive prices through the roof, for example - you will have crash-proofed your portfolio and could look to use any sell-off as a buying opportunity.

And if in the meantime oil rockets...even better!


Regards,

James Woodburn
for The Daily Reckoning

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