Oil at a Crossroads

Crude oil finally reached $60 a barrel…Is $70 next? Or

Let’s ask the experts…

"The economy has accepted $50 oil. We accepted $2 gasoline,
too… I think within a year from now, you’re probably
looking at $3 gasoline, and you’re probably looking at
something over $60 for oil."

T. Boone Pickens, legendary oilman

"In late 2006, I think you could see oil over $100.
Whenever we’ve had oil shocks, it’s because we’ve reached
capacity, and we are at capacity in refining and
extraction. When we look at each country’s projections of
oil consumption, we find we’re consuming at a rate faster
than it can be produced."

Ray Dalio, CIO, Bridgewater Associates

"As evidence of weakening demand and ample supply
accumulates, the market may panic. The oil market has been
the most speculative in this cycle. I believe it could
correct in the most speculative fashion – it could

Andy Xie, Morgan Stanley

"It is too soon to draw any firm conclusions about the
impact of high oil prices on global oil dependence, on U.S.
and other imports and on increases in conservation and the
supply of alternative fuels… the forecasts of EIA, IEA,
and OPEC must be regarded to be at best illustrative of
what might happen in a world where virtually everything
goes right from the importer’s view, where export
capacities automatically respond to need and political and
military risk have no impact."

Anthony Cordesman and Khalid al-Rodhan, The Center
for Strategic & International Studies

So there you have it…Both sides of the crude oil debate
make a compelling argument, but we are more persuaded by
the bulls than the bears.

If Dalio and Pickens are right, then crude oil consumers
have only just begun to feel the pain, and prices will
continue to rise until global demand is finally hit over
the head with a sledgehammer. If Andy Xie is right, current
prices are the result of a speculative blow off and oil
could come crashing down in an avalanche of selling.

The last quote, which best represents my own perspective,
is taken from a CSIS study entitled "Uncertain Balance of
Global Oil Supply and Demand: Crisis or Business as Usual."
Rather than trying to make a definitive forecast, the
authors of the study point out that uncertainty is
extremely high, there is very little margin for error and
the "happy" energy scenarios out there are based on
everything going right… and nothing going wrong.

In his collapsing oil view (see "Scary Oil," archived on
the Morgan Stanley Web site), Andy Xie cites the potential
for slower growth from Asia, particularly China. He also
points to the aggressive development of alternative
energy/oil substitutes like oil sands, coal liquefaction
and LNG and even mentions the rising popularity of fuel-
efficient vehicles. While Asia has begun to show early
signs of slowdown, the rest of Xie’s argument seems a bit
of a stretch. Alternate energy supplies might contribute
meaningful supplies a few years from now, but they will not
arrive in time to trigger a near-term drop in oil prices.

It’s going to take a long time for new technologies to make
a dent in the rapacious demand for crude oil that exists
here and now, and at least in northern Nevada – where we
are being invaded by yuppie Californians – I see at least
two or three fuel-hog Hummer H2s for every one fuel-
efficient Toyota Prius on the road. Gasoline demand has
actually risen in the United States from this point last

In saying that recent price action represents a "final
frenzy," Xie lays most of the blame on profit-hungry
financial institutions, stating that they have become
dependent on commodity trading profits in the current low-
yield environment. This line of thinking basically argues
that $60 crude is unwarranted by the fundamentals – that
rather than security risk and demand as supporting factors,
crude is at record highs because reckless traders are
pushing it up. This opinion seems a bit cavalier, partially
because it’s too easy to lay blame at the feet of traders,
but mostly because there are reasonable and logical
explanations for the price of crude being where it is.

On the other side of the coin, you have plenty of well-
informed observers who think we’re in big trouble no matter
what. This camp sees alternative energy as little more than
a Band-Aid, and it presents very credible arguments, both
for $60 oil today and for $100 oil within the next few
years. For example, respected authority Matthew Simmons has
written a book entitled, Twilight in the Desert, focusing
on potentially alarming problems in Saudi Arabia. From the
inside flap:

"The secretive Saudi government repeatedly assures the
world that its oil fields are healthy beyond reproach and
that they can maintain and even increase output at will to
meet skyrocketing global demand. But what if they can’t?
Twilight in the Desert looks behind the curtain to reveal a
Saudi oil and production industry that could soon approach
a serious, irreversible decline. In this exhaustively
researched book, veteran oil industry analyst Matthew
Simmons draws on his own three-plus decades of insider
experience and more than 200 independently produced reports
about Saudi petroleum resources and production operations.
What he uncovers is a story about Saudi Arabia’s troubled
oil industry, not to mention its political and societal
instability, which differs sharply from the globally
accepted Saudi version."

So are the Saudis lying about their reserves? While the
Saudi government confidently claims plenty of oil for all,
it refuse to allow outsiders to independently verify those
claims. Seems a bit suspicious, doesn’t it?

If the Saudi fields are approaching a sharp decline, as
Simmons believes, then the government would definitely have
interest in hiding it from the world for as long as
possible. It’s hard to imagine the turmoil and chaos that
would erupt if news were to spread that the "central bank
of oil" is running dry. The Saudi Kingdom would likely
implode, and the world would panic.

So where does that leave us?

Clearly, Morgan Stanley’s Xie makes reasonable points for
the long term. Alternative energy and fuel-efficiency
advances will eventually moderate the global demand for oil
somewhat. But this forecast has to be balanced against the
stark realities that global energy demand is steadily
rising, while the world’s once-reliable supplies are
running down.

In the short term, crude oil’s high price is a rational
response to the uncertainty of supply, coupled with
exceptionally strong demand. We have a demand-driven "lack
of slack" in the system, too little margin for error and
too many potential problems hiding below the surface.

As we see it, the most reckless speculators in the crude
oil market are the brave souls who are betting on a DROP in
oil prices.

Did You Notice…?
By Eric J. Fry

Jay Shartsis is not a reckless speculator, but he is a
speculator – one who thinks oil stocks are ripe for a fall.

Oil stocks won’t fall forever, Shartsis believes, but they
might fall very soon. Shartsis, a seasoned options trader
at R.F. Lafferty in New York, has spent several decades
tracking the sort of short-term sentiment indicators that
can enable an options trader to make a buck or two. The
indicators are not perfect of course – or Jay might be
sharing his thoughts from the cabin of his private jet,
rather than the "trading turret" of his Manhattan office –
but they can be very helpful.

"Oil stocks are on a slippery slope," Jay remarked
yesterday, as he cited a couple of indicators showing
extreme bullish behavior by oil stock investors. "The
approach of oil to $60 per barrel has created a frenetic
mindset among traders as assets in the Rydex energy fund
have soared to new highs of $200.9 million, up from near
$112 million in just one month."

As the chart below illustrates, the last time investors
plowed this much money so enthusiastically into the Rydex
Energy Fund, oil stocks promptly tumbled. Shartsis does not
anticipate an exact replay of the March sell off, but
doesn’t rule out a swift sell off.

In addition, he notes, "plenty of call-option activity has
also been observed in energy stocks. For example, the ever-
popular Valero (VLO, $80.46) traded 44,788 options on
Tuesday, 33,671 of them calls against a daily average of
21,945. The stock made a new high by 30 cents to $82.25,
but may have staged a false breakout.

"Can it be so easy," Shartsis wonders, "to just chase the
energy stocks at these levels and make money?"

Maybe yes, maybe no… We eagerly await the verdict.

And the Markets…



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