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Energy - Commodities
Oil $200 - Don't Bet Against It!
Goldman Sachs Predicts $200 per barrel Oil!
Can you bet on it?
The headline definitely froze attention on the mind-numbing reality of $200
per barrel oil. If oil is $200 per barrel, isn't gasoline $8 or $10 per
gallon?
The Goldman Sachs Group's Global:Energy:Oil Report issued on May 5,
2008 was an update to their "Super-Spike" Report from March 6, 2008. The
real guts of the May 5th Report was the statement:
"The possibility of $150 to $200 per barrel seems increasingly likely over
the next 6 - 24 months, though predicting the ultimate peak in oil prices
as well as the remaining duration of the upcycle (in oil prices) remains
a major uncertainty."
The Report re-pegged the upper range for the price of a barrel of oil between
2008 and 2011 at $125 for 2008, $200 for 2009, $150 for 2010 and $75
for 2011.
The gap between the current price at the time of the Report (just rising
to $100 per barrel) and the subsequent jump to the $125 - $135 per barrel
price levels was startling. Although nothing within the overall markets had
changed significantly (supply, demand or distribution disruptions), the estimate
was immediately validated as the price jumped to then record levels.
Not so evident in the various re-hash of the Goldman Sachs Report were the
facts that Goldman Sachs saw in the energy markets. The Report observed that
the lack of supply growth from the OECD was finally capping the growth in
demand in the US. The up-cycle in oil prices might actually be changing as
the up-cycle in demand was slowing or being extinguished in response to supply
capacity limits. Their conclusion: The industrial nations are effected by
the limits on oil supplies.
The key insight from the Goldman Sachs Report however is their observation
of "constrained supply driving demand rationing"... "One cannot demand that
which does not exist."
If only Goldman Sachs and its hedge funds and energy traders and all of the
others actually lived under that rule. They buy nearly unlimited futures
contracts and then rollovers into next month's higher price futures. No one
probably knows the real volume that those trades represent - but pushing
prices up for trades puts higher prices back into the real commodity contracts
that get delivered. With hedge funds chasing high returns they have ignored
the high risks of trading paper that could not all be filled if the underlying
commodity had to be delivered. Artificial - YES! But it plays into their
, self-fulfilling, more demand and constrained supply assumptions.
In the face of economic growth in the emerging markets of the world, the
world's oil producers are not increasing production. Users conserving and
reducing demand are not having an impact on prices. Those actions may have
an impact on economic production but the oil producers have entered an era
where voluntary reductions in demand within the industrial nations does not
slow the overall increase in demand and lower the escalation in pricing.
More directly - The long-term demand for oil is rising as the emerging economies
grow, efforts by the industrial nations to conserve, cut-back or off-load
demand to alternatives are much less than that tide of new demand, and the
producers are not expanding supplies. The result, as stated in the Goldman
Sachs Report, is that the producing nations can and are rationing the supply
of oil.
The major oil producing countries obviously see the global demand for oil
increasing dramatically as India, China and other emerging economies grow.
That future demand is an incentive for them to hold oil production at current
levels making the oil in the ground a reserve asset that grows in value.
Flush with funds from the past decade, they can now ration production to
prolong their economic power.
An additional tack in the oil producer's strategy is to build their own refinery
capacity.
Rather than export the crude oil and then import the higher-value refined
products - gasoline, jet-fuel and diesel - to meet their internal demand
and growth priorities, the producing nations are building refineries to control
their own energy destinies and capture the value spread between crude oil
and its refined products. Owning production and refinery capacity also provides
those nations the options of selling their overall higher margin refined
products in the future as world demand increases and prices escalate.
The actual ability to forecast global oil production and demand is very limited.
Accurate global data on oil production is not available. The majority of
countries and state-controlled corporations manage their national oil production
and do not collect and/or do not release data on production. Of the
Industrialized G-8 nations only two, Canada and Russia, are particularly
large oil producing states. The US, UK, Japan, Italy, France and Germany
are not significant oil producers. Canada is open in reporting its production
and its sales and it is the largest supplier of oil to the US.
The OPEC producers have some transparency and reporting of their oil production
and sales into the US, UK, Japan, Italy, France and Germany. They also have
production that is termed "off-market" and not part of the official trade
data.
Russia is not transparent and is much less predictable in their oil production
and sales even as it has great potential for increased oil production -
particularly in its eastern regions.
The lack of data on the overall global oil markets forces most analysts,
including Goldman Sachs, to focus on the US markets and the OECD production
because reliable sales and consumption data are readily available for that
trade relationship.
The US-OECD oil pricing relationship is also a data-source more relevant
to their areas of interest - the US and Euro-centric companies and capital
markets that they analyze, finance and trade.
The US-OECD oil pricing relationship is also used as the trend-setter - it
is reliable, readily available and can be expanded as a best-fit proxy for
the overall global market into which there is less transparency.
The oil price estimates are not just an academic exercise or an opinion to
fill newsletters and advisories. The Goldman Sachs Report 's oil price estimates
are used by their analysts and traders (and others) as critical data for
their analytical models that rate industries and companies.
As their analysts look at airlines - with fuel moving to almost 40% of an
airlines cost structure (labor is the other major component) - a realistic
upper limit on fuel costs is needed in order to project performance and compare
airline cost structures and financing requirements. For those estimates,
the Goldman Sachs Report sets a $150 per barrel upper limit for 2008 and
a $200 per barrel upper limit for 2009.
Obviously, that estimated upper limit on fuel costs is also needed for comparing
all other businesses where the cost of fuel has a direct impact on expenses.
Agribusiness is sensitive to fuel costs for all activities - planting,
irrigation, harvesting and processing.
Even in industries where the fuel cost is carried as a surcharge and passed
along to the customer (such as in trucking) or where fixed contacts do not
have adjustment provisions and rising fuel costs directly reduce profits
- knowing those factors and having a basic assumption on the maximum impact
of rising fuel costs is a critical part of the analysis process.
Even where the cost is passed along to the customer or other middle-men,
the end-user will at some point look for other efficiencies in order to stay
within their comfort zone on expenses or to balance their overall costs within
their budgets. An example of this would be the two car family that now uses
the more fuel efficient compact car rather than the SUV to run its local
errands or for the longer commute.
Anticipating the break-point where the buyer's behavior changes or where
alternatives become viable and compelling is also a critical variable for
estimating the performance of any industry and its companies.
The Goldman Sachs Report's $200 per barrel oil estimate is not, therefore,
their absolute prediction of where that price will actually be within the
next two years, it is the upper limit cost component that they believe has
to be considered today in assessing and comparing business performance scenarios
across all industries. That upper limit is one of the wild-cards that has
to be considered - in Goldman's terms, it is one of the uncertainties.
Understanding the need for an estimate, however, doesn't mean it is just
a hypothetical that gets plugged in. The likelihood of that estimate occurring
also has to be computed. For substantive reasons, the likelihood of $200
per barrel oil is almost guaranteed. The time line of 2009 is as good a bet
as any.
The three components of the supply-demand relationship for oil pricing are
the supply, the demand and the distribution.
Supply is not increasing. Those countries that have supply capacity are not
going to be in the business of selling the oil to the US or anyone else.
Their self interest in their own refineries and their own national needs
will be paramount. Oil that will be on the market will be increasingly more
costly.
Demand is increasing even with the US (25% of the global market) committed
to conservation, fuel efficiencies and added attention to alternatives. China
and India are the most obvious populations that will have more cars and more
industry to feed.
Distribution is highly fragmented and dependent on oil fields, pipelines,
terminals and shipping in the world's most geo-politically unstable areas.
The most fragile chokepoint (uncertainty) for oil transport is the Strait
of Hormuz - the shipping exit point from the Saudi, UAE, Iran and Oman oil
fields bordering the Persian Gulf into the Indian Ocean.
The Strait of Hormuz is 30 miles wide but the shipping lanes are two narrow
ribbons of water each a mile wide. Iran is on one shore and Oman is on the
other shore. Two-fifths of the daily barrels produced in the world go through
the Strait of Hormuz. Seventy-five percent of Japan's oil imports go through
the Strait of Hormuz.
The alternative route for the Saudi, Iran and UAE oil that is shipped through
the Strait of Hormuz would be a 745 mile pipeline through Saudi Arabia to
the Red Sea - its capacity is 5 million barrels per day versus the daily
tanker traffic of nearly 17 million barrels of oil through the Strait of
Hormuz.
The Strait of Hormuz chokepoint uncertainty alone represents a risk that
12 million barrels per day (nearly one-third) of the world's global oil shipping
could be disrupted at any moment.
The catastrophic disruption is not in the Goldman Sachs Report's oil price
estimate. If an event such as that occurs, all bets as to prices will be
cancelled.
Short-term, minor disruptions in supplies or in distribution do get reflected
in the current prices for oil. Disruptions in Nigeria production and exports,
hurricane season and transport delays into Gulf Coast refineries, as well
as random pipeline, terminal and refinery shutdowns are all near term events
that are in the current pricing levels.
Outside of catastrophe and short-term, minor disruptions, the long term price
dynamics for oil will be determined by the X-factor that results from the
decline in sales of oil from the producing countries even as some state's
production increases.
You can't demand something that does not exist. The oil producing countries
will not increase production as they extend the shelf-life of their oil reserves
and leave the oil in the ground. They also will reduce the supply of oil
on the world's market as they re-purpose their production for their own
refineries and their own needs within their own borders. Those are the facts
that will engender and maintain constant increases in oil prices.
Goldman Sachs Predicts $200 per barrel Oil! A lot more exciting than "constrained
supply driving demand rationing". It's a solid headline - either way.
Don't bet against it.
David W. Alvey, Executive Editor - DiplomaticPlanet.net
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Oil $200 - Don't Bet Against It!