The Daily Reckoning PRESENTS: Everyone is wondering what the falling price of crude means – and how long it will last. Today, Outstanding Investments’ Justice Litle gives us some perspective on this market. Read on…
After holding in the $60s for many months, crude has dropped precipitously in the past few weeks, and is now in the vicinity of $50 a barrel. A number of reasons have been given for the sharp fall in price, all of them more or less linked.
To begin with, warm winter weather has resulted in lower seasonal energy use than anticipated. (Global heating oil demand, for example, is estimated to be off by 20-30%.) At the same time, OPEC’s production cuts are seen as ineffectual in the face of cheating, and Russia has been hesitant to slash its record output.
On top of this, commodity speculators have become bearish and institutional investors are getting cold feet. When spot crude fetches a higher price than the further-out futures contracts – a situation known as “backwardation” – it becomes profitable to buy the back months and wait for prices to rise as the spot draws closer. The persistence of backwardation in 2006 led institutional investors and commodity index trackers to load up on long-dated crude oil contracts; now that the market is no longer in backwardation, those same players find themselves losing money.
As icing on the cake, the crude oil market is suffering from intrigue fatigue. Like a jaded child desensitized to violence on television, the market has grown bored with overly familiar catastrophe scenarios. (Yet if anything, the geopolitical situation is more precarious today than a year ag Israel leaking plans for a tactical strike on Iran; Saudi Arabia threatening to aid Iraq’s Sunnis if the Shia majority pushes too far; U.S. military morale at low ebb; escalating tensions between Russia and Europe; nationalization on the rise; Iran accelerating its nuclear program; and so on.)
In light of all the recent bearishness, it is worthwhile to ponder the Energy Information Administration’s recently released “Annual Energy Outlook 2007 (Early Release version).” Here are the two most interesting sentences out of the whole thing (in your humble editor’s opinion):
“Oil, coal and natural gas… are projected to provide roughly the same 86% share of the total U.S. primary energy supply in 2030 that they did in 2005 (assuming no changes in existing laws and regulations…
“In 2030, the average real price of crude oil is projected to be above $59 per barrel in 2005 dollars, or about $95 per barrel in nominal dollars.”
Trying to predict anything 23 years out is a foolhardy exercise… but the EIA projections are nonetheless instructive.
For one thing, the projections show just how small the alternative energy base still is in comparison with fossil fuels. It is not that the EIA expects zero growth in alternative energy’s slice of the pie over the next few decades; rather, the EIA expects total energy demand to overwhelm all else, with fossil fuels filling the breach. (For this same reason, the EIA expects nuclear power’s share of the pie to actually fall in percentage terms, even as more nuclear power plants go online.)
The EIA’s second prediction is chuckle inducing. For crude to be just above $59 in 2030 – not far from where it is now – means little will have changed on the whole. And how helpful of the EIA to let us know that $59 in 2005 will translate to $95 in 2030. That’s a wonderfully benign inflation rate… just over 2% per annum between here and there.
As you might have guessed, the point here is not to put faith in government agency predictions. Instead, it’s to get some perspective on where we stand for the long term.
As a government agency and an offspring of the Department of Energy, the EIA is congenitally optimistic in its conclusions — much as the Bureau of Labor Statistics is congenitally blind to inflation. And with all the data at hand, the EIA’s projected long-term price band of $50-60 crude (more or less) is truly the optimistic case.
Such a prediction almost completely writes off the ramifications of Peak Oil, and relies on heavily aggressive assumptions in regard to deep-water drilling and Canada’s oil sands. Such a prediction also requires an almost touching naivete in terms of U.S. monetary policy; can we really expect inflation to run just 2.1% per year for the next 23 years? (What happens when the dollar goes down in flames?)
There are far too many variables to make an informed guess at crude oil’s 2030 price. But we do have enough information to note that, given the piles of data presently available, the optimistic number crunchers at the EIA see crude trading solidly for the duration. In fact, their $50-60 price range represents the shiny happy scenario, leaving out the ugly but all-too-real possibilities looming before us.
The other thing we can gather from the EIA prediction is this: Nobody knows nothin’. Meaning, all the data points in the world can’t predict the distant future. To grasp how ludicrous these types of specific predictions are, just observe the fate of those who make them. In the real world, the best you can do is marshal the facts to get a sense of what’s possible and what isn’t… what makes sense and what doesn’t. In this sense, broad observations regarding the possible course of future events should be rooted in the laws of physics. What goes up must come down… that which cannot persist must eventually cease… and so on.
In the short run, a market can do most anything – especially one dominated by speculators with a quarterly, or even monthly, time horizon. But in the long run, as Jesse Livermore noted, the best and truest allies will always be underlying conditions. You’ll see all kinds of numbers fly around in the coming weeks and months, feet stampeding this way and that… but through it all, the long-term energy picture won’t shift much.
We’re dealing with sweeping sea change here, not ephemeral seasonal stuff.
That’s why I’m not inclined to worry too much about this recent crude oil slide. There’s never any money in running around like a chicken with your head cut off. Traders rely on speed and reflex, investors on patience and fortitude; to the best of my knowledge, nervous panic is no help to either discipline. If anything, the short-term roller coaster gives an edge to those with a taste for the long-term view.
for The Daily Reckoning
January 17, 2007
Editor’s Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert’s Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).
Do you have your eyes open, dear reader? Well, look carefully, because what you are seeing is one helluva show.
Unfortunately, it is likely that we are only in the middle of it, and it is almost surely a tragedy. When the fat lady finally sings, there are going to be a lot of people with tears in their eyes.
But we are getting ahead of ourselves.
Every great public spectacle turns mass man into a chump…a patsy…and a stooge. He gets sent off to fight and die in wars that are of no real importance to him. He gets caught up in the delusions of politics…joins a lynch mob…or watches TV and wonders what Paris eats for breakfast. Or, he is ruined in market crash, inflation, or depression.
It is all very well for wealthy speculators to be ruined. They usually gamble with money they can afford to lose. But in this last go-round, the average fellow put everything he had on the table. Without realizing it, he speculated with the family home.
There is more to it than that, of course. What we are seeing is really a massive transfer of wealth…the biggest transfer ever.
You see, what drew the average man into the mortgage market was the allure of getting something for nothing. Without lifting a finger, his house rose in price. He looked…and thought he saw free money. He could ‘take out’ this extra wealth…and still have as much equity in his house as he began with. He felt he was actually getting richer…so why not spend a little more?
The catch is that he wasn’t really getting richer at all. That is the curious thing about a boom fueled by asset price increases. In general, they do not really make people richer. Instead, they make SOME people richer.
You already know who those people are, don’t you, dear reader? We have mentioned them often in these pages. They are the lucky 1% of the population who have substantial assets…and the few hundred thousand who work in the financial industry. Hedge fund managers, investment bankers, substantial property owners, people who own art and antiques…even people who own stocks. Most U.S. stocks are less valuable, in real terms, than they were seven or eight years ago. But they are a lot more valuable than they were 20 years ago.
For the first time in history, the rich really are getting richer at a rapid pace. Here’s how it works. The world’s central banks, led by the U.S. Federal Reserve, and other financial intermediaries, create new forms of ‘wealth’ – paper dollars, securitized debt, derivatives, etc. Bond issuance, for example, has doubled in the last six years. Derivative creation has soared over $300 trillion. This ‘wealth’ never seems to reach the hands of the masses.
Instead, it stays with the investing classes – bidding up prices on financial assets and other forms of wealth favored by the rich (such as London houses and works of art by people without talent). In other words, a new form of ‘inflation’ has been loosed upon the world, one that everyone seems to love. It boosts the wealth of the wealthy, spectacularly.
According to a new study by McKinsey and Co., the value of all the world’s stocks, bonds and other assets has ballooned to $140 trillion. These assets are traded across international borders; and they are growing much faster than the real economy that supports them. There you have the fundamental difference…and the theme that runs through this whole farce. A company may produce $10 in profits, growing at a rate of maybe 5% per year. But the loans, stocks, bonds, and derivative positions based on this company’s output are growing at twice the speed.
The average person works in the real economy. If he is lucky, he could see his wealth grow along with the growth of the real economy. But the people who own financial assets are watching their wealth grow much faster.
Wait, how is this possible? The real wealth of the economy depends on the real output of its real businesses. That is where the goods and services are produced. Trading, speculating, lending, acquiring, buying-back, refinancing – these are just peripheral activities that have no direct bearing on real output. So, how can it be that one segment of the society, a very small segment at that, is getting so much richer than the growth of real output?
Ah…there’s the slick, tragic, disastrous side to this performance. It is as if the central banks had printed up huge quantities of additional dollars, and instead of distributing these to the economy at large, it gave them only to the rich. Thus, the rich gain the benefit of the inflation; their purchasing power rises dramatically. But the rest of the population suffers because of it; their own purchasing power declines. They have no more income, while they have higher living expenses; health care, housing, energy and education have all gone up sharply. And to make matters worse, they now have to pay off the money they borrowed when they thought they were getting rich.
Stay tuned, dear reader. This spectacle is bound to get even more interesting.
Chris Mayer, reporting from Gaithersburg, Maryland…
“…If you ventured outside into the cold and biting wind, sand would get in your nose and mouth and ears. You would hurry back inside and cough up black. While inside, people soaked sheets and towels…”
For the rest of this story, see today’s issue of The Rude Awakening
And more views:
*** Getting used to the low prices of gas and crude? Don’t get too comfortable…our commodities guru, Kevin Kerr gives us a taste of what could be waiting for us just around the corner…
“Shut your eyes and imagine with me for a minute. (Time travel music fades in)
“Fast forward to April 2007. We’ve just gotten through the worst of winter, a surprisingly late winter due to EL Nino…bitterly cold the refineries had to ramp up and make more heating oil, (some had already changed over to make gasoline figuring winter was over in December) so they had to switch back.
“Two refineries have had to shutdown altogether due to maintenance taking 600,000 bbls’ of refined product out of the system. Crude is trading back up around $58 now and fear is that this summer’s hurricane season will be much more active than last years. Some forecasters even predict it will impact the Gulf Coast closer to the Houston Ship Channel. Israel attempted to bomb facilities in Iran – but missed and the bunker buster bomb with nuclear payload is now spreading minor radiation through the region.
“The Saudi’s and all of Opec have condemned this action and an emergency meeting has been called in Vienna. Reports are that the cartel will reduce exports to the West by 3 million bbls a day and is opting to send those supplies to China and the Far East.
“Summer driving season is here and oil is trading at $69 a bbl. By August, prices creep up to $70. Tensions remain high in the Middle East, but the big story now is a major hurricane headed toward the Gulf. Bam! A direct hit into Houston, which was well overdue for a major hurricane. Oil terminals are destroyed, pipelines and shipping destroyed. Millions of gallons of crude and refined product lost. Gasoline prices surge and crude is pulled higher on the newss trading to a new high of $80. Rigtht about now all the Opec cuts really start to kick in and the crude prices jumps to $90 +.
“Fairy tale? Not quite. All of these scenarios are very possible, and in my opinion it would really only take one of them to send the market 30-40% higher with prices sold off this much. Demand remains the same, the supply situation is getting worse. There is no substitute for oil. Ethanol is certainly no answer. Solar, nuclear, coal…all great for the future of generating electricity – but you can’t run you car on them.
“Bottom line: is gasoline prices are going to be the big driver of the energy market, and as we get close to summer, likely in March when Opec meets again, if not before.
Reality will sink in the shorts and this market will begin to run for cover. You will see this pendulum swing back the other way – hopefully with some basis in the true fundamentals. Right now crude should be, in my opinion, about $63. This summer it should have been at about $68 not $78. By years-end I fully expect this market will be making a new high…if not much sooner.”
*** Yes, we did it again. We mixed up ‘lebensraum’ with ‘liebensraum.’ When will we learn German? On the other hand, we like the error…it reminds us of the time we went to a restaurant in Italy and ordered spaghetti with a policeman on top of it (carabinieri, carbonara; anyone can make that mistake). Hitler said Germany needed ‘lebensraum’ (living room), not ‘liebensraum’ (loving room). If only Hitler had made the same mistake…how the history of the 20th century might have turned out differently!
*** We got soaked walking to our London office this morning. It often rains in England…but even the English were not prepared for a downpour.
“It usually doesn’t rain like this,” explained an English friend. “It usually just sweats. But the climate is changing, isn’t it?”
Maybe it is. Today’s International Herald Tribune tells us that the glaciers are receding so fast in Greenland that mapmakers can’t keep up with it. As the ice melts, new islands are discovered.
*** We are all victims of technology. We’ve had our car for a couple of years. We still can’t figure out how to turn the radio off. And this weekend, we spent a night in a hotel with all the latest gadgets. In the bathroom, for example, a toilet had a visible tank and no flush handle. Instead, it had an electronic eye. You simply passed your hand in front of it, and the toilet flushed. The trouble was, the mechanism on the inside must have been old technology, for after flushing, water kept running in the bowl. Normally, we would jiggle the handle in such a case. If this failed, we would reach down into the tank to jiggle the mechanism directly. But there was no handle to jiggle, no tank to open up…and no plumber on duty Saturday night. The toilet just ran.
*** Oh, and today’s news brings both good and bad tidings to Americans overseas. On the bad front, the world has gotten to be very expensive for a man who earns dollars. The cost of a London office, for example, has zoomed to $212 per square foot per year. The last time we looked, our cost in downtown Baltimore was under $20.
But, the good tiding is that at least we will be aware of the cost longer. Here is a report from Reuters:
“People who are fully bilingual and speak both languages every day for most of their lives can delay the onset of dementia by up to four years compared with those who only know one language, Canadian scientists said on Friday.
“The Alzheimer Society of Canada described the report as exciting and said it confirmed recent studies that showed that keeping the brain active was a good way to delay the impact of dementia.”