Oil: Higher Prices Lead to Lower Prices?

Will higher prices for crude oil lead to lower prices? The debate rages on in these days of oil north of $135.

Rob Fraim 's recent report (Investment Postcards Blog, one of the finest on international investing.The paragraphs below are extracts from his excellent report.

I have for quite a lengthy period of time – going back several years – been bullish on energy markets and energy-related stocks. And fortunately this has been a decent call.

So now what? Last week a $10+ jump in the price of crude in one day. Visions of $200 oil dancing in their heads. Articles in the media about $15 gasoline, outcries about speculators driving up the price of oil, and the inevitable somewhat late-to-the-party recommendations to pile into the energy sector now.

Spoiler Alert: I’m going to suggest lightening up positions a bit in the energy sector. Sorry for ruining the suspense, but you’re busy, I’m wordy, and you were probably going to skip to the end anyway.

I’m not suggesting a complete exit – since I still believe that we will have reasonably high energy prices for the foreseeable future and that energy companies will be strong and profitable. However, I also believe that the oil market in particular has gotten a little goofy and frothy and that we are due for a meaningful pullback in crude – which is likely to impact the psychology and pricing for other energy markets as well. We all know how it is when the “hot money” gets out of a sector and how much volatility that can create.

Do I think that oil is going to $50? Not a chance? Not $50, not $60, not $80. But I do think that there is a better than average chance that we are going to revisit $100-ish and stabilize there for a while.

This being the case I am suggesting that reaping some profits and reducing energy positions a bit might be a wise move – at least on a trading basis. Keep a core holding for the long-term, but lighten up. Sell some stuff. Write some covered calls. Hedge a bit. Maintain the core but trade with part of your energy investments. Do something other than get whipsawed.

Why? A combination of fundamental, anecdotal, and emotional factors actually. (I might also throw in technical, psychological, sociological, zoological, anatomical, and astrological if I get really cranked up.)

Here are a few of the reasons why I am reaching this conclusion.

There are some indications that demand is actually beginning to fall – somewhat in the same way that it did in 1979 and 1980 when gas pump pain reduced gasoline use by 5% and 6% respectively.

Miles traveled in the US are down – off 4.3% in March. In the last week of May – with Memorial Day weekend – gas buying was down 3.9% from the previous year. Why the declines?

Consumers are adjusting their driving and consumption habits. There is a real switch toward smaller, more energy-efficient cars and away from trucks and SUVs. In May of this year 4-cylinder cars made up 45% of sales versus just 30% in 2005.

Anecdotally, transportation companies are adjusting as well. We had a conversation with a trucking company recently and they spoke of measures that they have put in place to reduce fuel consumption. They are using monitoring and tracking systems and technology to enforce the 55 mph limit on their drivers – instead of the “unofficial” 65 mph or so that was the norm before. They are very serious about this and have enacted real driver penalties for non-compliance. Different studies have shown different results, but roughly speaking the difference between 55 mph and 65 mph is about a 10% improvement in fuel economy.

A potentially strengthening US dollar can have a big effect. While we tend to focus on supply-and-demand metrics and speculative forces when talking about oil prices, the simple fact is that a lot of the rise in oil prices has been not about oil inflation, but rather dollar deflation. The greenback has been in a downward spiral for months – courtesy of the credit crisis, problems in the US economy, and the long series of interest rate cuts. Now that rates have likely bottomed and as the US economy comes out of panic/fear mode the odds favor somewhat of a rebound in the dollar.

Jeffrey Saut at Raymond James – a strategist for whom I have the utmost respect – has adopted a more bullish stance on the dollar after years of warning about dollar weakness. If he is right – as I suspect he is – dollar appreciation will bring down crude oil pricing – as the need is also lessened for oil producers to keep prices high on crude, which is their primary greenback denominated export.

Back to the supply and demand issues, we know that real (or perceived) energy consumption in the emerging economies in China and India has taken up all the supply “at the margin”. And it is those last few incremental percentage points of usage data that make the difference between tight markets (rising prices) and looser ones (stable to lower prices.) While the China and India growth stories are real – and will be a continuing factor – there are certain things that speak to a modest lessening of demand.

When government subsidies in many Asian nations disappear by year’s end, demand should slacken. And China, stockpiling supplies for the coming Olympics, will likely shift gears and cut back on its energy purchases by August according to some. Now, today’s report regarding potential demand from China speaks otherwise, but then again I could find another item that would again talk about demand leveling off. It’s always a tug of war of course, but I am getting the feeling that the picture is not nearly as one-sided as has been reported.

Furthermore a slackening economy here in the US should also take a little pressure off of the demand side of the equation.

While not the end-all of supply problems, there has been some modest production growth – largely from Russia. So all in all the supply and demand balance seems to be tipping back in a more favorable direction – at least for now – with some estimates and reports indicating that we have moved from a deficit of 900,000 barrels a day that had to be made up by dipping into reserves, to a global “cushion” of 600,000 barrels a day.

I also wonder at what point political ideologies and environmental concerns will crumble to voter dissatisfaction over painful energy prices – possibly opening up drilling in previously “off-limits” areas.

“There is no justification for the current rise in prices,” said Saudi Oil Minister Ali al-Naimi on June 9, 2008, calling for an energy summit between producing and consuming nations. Now to be sure, we can take anything from OPEC nations with a grain of salt, but ultimately it serves the interests of the oil producers for oil prices not to skyrocket too far – since this would encourage serious conservation measures and bring about further political pressure. While excess supply capacity is not huge, Saudi Arabia itself has about 2,000,000 barrels per day in potential production expansion capability.

So with all of that in mind, do I think that we’re going to return to the days of cheap energy and a huge energy price decline – as occurred after the 1980 spike? Hardly. It was easier to increase production back then since oil fields were less mature and exploited. Also there were a lot more energy inefficiencies (in cars, appliances, building materials and techniques) back then than there are now – areas that could be markedly improved easily enough.

No, not cheap energy – just maybe cheaper by a bit. It would not surprise me to see $100 to $105 oil by the end of the year. That probably equates to gasoline in the $3.50-ish area.

Of course the unknown and unknowable regarding crude oil is the geopolitical picture. What if Israel bombs Iran and the Straits of Hormuz are blocked? What about Nigeria? And Hugo Chavez down in Venezuela? And Iraq? Terrorists! Floods! Plagues! Locusts! Well, as we saw last Friday those types of concerns (absent the locusts) have been moving the energy markets. Did anything really happen on Friday – something other than rhetoric – that fundamentally impacted the picture? Not really. It was a speculation and fear-driven spike.

Now I’m not one of these folks who vilifies speculators and blames them for high prices. It’s a free market and speculators actually serve a purpose. But blame it or not, speculation does enter into the pricing picture as speculators vie with actual users of the commodity for a relatively limited pool of sellers. But like ’em or hate ’em, speculators give us our market timing opportunities – to buy when people are selling or sell when most are buying. It just seems to me that more than a little of today’s $136/barrel price tag on oil price has geopolitics/fear/speculation written on it.

Last week I wrote about the (in my view) somewhat silly finger-pointing and ranting about the role of speculators in having driven up the price or energy and noted that ultimately speculators aren’t bigger than the markets and that supply-and-demand always wins out. Speculative moves can last longer and go further than we expect – and no one, me especially, can hope to “top-tick” the market by selling at the very peak. That’s why my recommendation is not a 100% all-or-none exit from energy positions, but instead an attempt to be level-headed and proactive by taking advantage of speculative fever and “ringing the register” on portions of energy exposure.


Source: Rob Fraim,


Mid-Atlantic Securities, Inc, June 10, 2008.

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