Oil, Commodities, Instability?

Is the price of oil settling on a long term price of $40 a barrel? Some hard evidence is showing up. The Iranian government is setting its 2009-10 budgets on a price of $37.50. This week’s price started below $40 but March futures are in the $43/$44 range. The world recession is tracking to have an equal impact on the price of commodities.

Not being an economist, I would have assumed that consumption was in sharp decline and thus the supply and demand cycle kicked in. It appears this has been aided by the action of hedge funds as well. From Steve Austen’s blog: http://www.oil-price.net/#20080105#20080105

But when the banking industry collapsed, hedge funds had to raise cash by "deleveraging", liquidating their leveraged energy ETF positions sending the price of oil tumbling. Anecdotally shorting of banking ETFs was suspended by the US Securities Commission during that time but not shorting of energy prices, and the leverage mania soon found an escape route in utrashort oil ETFs, compounding the speed of this downward spiral. By December 2008 the oil price had collapsed 75% and frankly, who would complain about cheap gas these days?

As we enter 2009 the oil landscape has reversed dramatically from a year ago. The price of oil is lower than production costs and new exploration projects are being cancelled. China flush with cash is currently buying all the oil it can get its hands on to pump into its strategic reserves. Once arrogant OPEC countries are willing to sell oil at any price to fund government programs and prevent political instability.

Skipping the word arrogant, the last paragraph does hit on one very big point. With the price of oil lower than production costs, there is no economic support for expanding supplies in current fields or bringing new ones on line. It should not surprise that one of the few counters that a state directed/controlled oil or commodities supply has to counteract the fall of prices is to pump more oil or produce more commodity, trying to make up in volume that being lost in price. Globally, this, of course, further depresses prices. The added complexity is if the lower prices last long enough, potential production will fall as producing fields, mines, etc. begin to decline. Mr. Austen was discussing a potential 9% overall drop in production capability in as little as 12 months.

South American countries like Ecuador – Argentina – Brazil and African countries like Nigeria - Congo have dramatically increased their trade in commodities with China and other countries and were rewarded with historically high prices. Of course, they will find their income tied to the declining consumption rate of China and other consumers. The government agendas of many of these countries have been tied to the funding generated by the pre-recession price of oil and commodities. These cash flows are attractive for many reasons but perhaps the most telling geopolitical plank is this. Rather than more constrictive rules imposed by IMF loans or foreign aid, these cash flows are at the direction of the sitting government without behavioral controls.

 “”Bolivian leaders said Venezuelan aid comes with fewer strings attached. "In the case of the United States, we're locked into specific areas -- aid for roads, aid for health, aid for electricity," Ãlvaro Garci­a Linera, the vice president, said in an interview in his office. The Venezuelan aid "allows us greater flexibility to choose projects with more productive impact, especially those ventures that include a state presence."”

By Juan Forero and Peter S. Goodman
Washington Post Foreign Service
Friday, February 23, 2007; D01

What parts of the world would we see most impacted if the price of oil and other commodities stay depressed for two years? South America’s newer Socialist governments are heavily leveraged on this type of income for their internal programs. They have raised the expectations of the poorest of their population.  Mexico appears to be trying not to become a narco-state, this before oil prices reduced income from PEMEX. And Africa, with no sarcasm intended, beggars the imagination to think about sections of that continent with another major stressor if, most certainly when, income from oil and commodities almost totally dry up from lack of demand. Could more states catastrophically fail and join Somalia, spurred on not only by political instability but also by a starvation of capital?

The West is faced with daunting internal challenges for our economies. In the US, we will be borrowing trillions to fix our own economy in the next few years. What will we have in the way of desire, interest, influence, resources and leverage if the trend is towards instability and chaos in these regions?

For me, the answer is clear. We will hopefully focus far less at throwing money at problems and demanding first place at the table, to tell nations what to do. We will stop using money and military aid in creating dependent states that always seem to end up with abusive governments. We can facilitate, support and lead (when it is helpful not because we are the only remaining superpower in the world). And we will let the natural leaders, the centers of gravity in these other hemispheres, begin to direct traffic. In the end, we may just see a world that stops looking to us for all the answers (and money) and begins to solve its own problems. But, geopolitically, it would appear that it is going to be a very ugly time for the next several years.

MCC

Comments

[WILL]

"And we will let the natural leaders, the centers of gravity in these other hemispheres, begin to direct traffic. "

Peerhaps, Walt's view is the better reasoned one in this economic climate.

According to Professor John Mearsheimer's docrine of "Offensive Realism" our role has been just the opposite- to prevent the rise of local hegemons by acing as an "offshore balancer.". From the wiki article:

"Offensive realism is a structural theory which, unlike the classical realism of Morgenthau, blames security conflict on the anarchy of the international system, not on human nature or particular characteristics of individual great powers. In contrast to other structural realist theories, offensive realism believes that states are not satisfied with a given amount of power, but seek hegemony (maximization of their share of world power) for security and survival.

John Mearsheimer summed this view up in his book The Tragedy of Great Power Politics: "Given the difficulty of determining how much power is enough for today and tomorrow, great powers recognize that the best way to ensure their security is to achieve hegemony now, thus eliminating any possibility of a challenge by another great power. Only a misguided state would pass up an opportunity to become hegemon in the system because it thought it already had sufficient power to survive."

This behavior is known as "power maximization." In this world there is no such thing as a status quo power, since according to Mearsheimer, "a great power that has a marked power advantage over its rivals is likely to behave more aggressively because it has the capability as well as the incentive to do so."

States also fear each other, assuming that the other state intentions are not benevolent. The states may have other goals than survival, but survival will always takes precedence. The state may engage in cooperation and initiatives to create world order, but such initiatives are always unsuccessful or short-lived, as desire for power, security and survival creates tensions which lead to their failure.
"

Contrast this view with Stephen Walt's theory of Defensive Realism of International Relations.

"According to balance of threat theory, states' alliance behavior is determined by the threat they perceive from other states. Walt contends that states will generally balance by allying against a perceived threat, although very weak states are more likely to bandwagon with the rising threat in order to protect their own security. He points to the example the alliance patterns of European states before and during World War I and World War II, when nations with a significantly greater combined power allied against the recognized threat of German expansionism.

Walt identifies four criteria states use to evaluate the threat posed by another state: its aggregate strength (size, population, and economic capabilities), its geographical proximity, its offensive capabilities, and its offensive intentions. Walt argues that the more other states view a rising state as possessing these qualities, the more likely they are to view it as a threat and balance against it. "

[Fred]

"The price of oil is lower than production costs..." How did anyone come up with this 'fact'? The production costs in the short term are fixed. If the hedge fund speculation drove up oil futures and market prices that did nothing to the labor and energy inputs required to produce or refine a barrel of crude.

[Michael Chevalier]

Fred:

"The price of oil is lower than production costs and new exploration projects are being cancelled."

From experience, the blogger is talking about the total cost of producing oil in all environments and the cost of bringing it to market. When at Chevron USA, we witnessed the 'harder' wells and lower yield fields being opened or closed based on the price of oil futures.

MCC

[Jose]

One word, Deflation.

"For me, the answer is clear."

If you read past that line, MCC is advocating retreating from our Empire.

I agree.

[R Whitman]

HWGA trying to predict the price of oil and then predicting political action to follow. What folly. The price of oil is, for the most part, unpredictable. Tell me the price of oil one year from today.

[zanzibar]

Putin has also asked for budget updates based on $40/bbl and expects to use up some of their reserves to manage the budget deficit.

The broader oil equity sector has held up well this week despite pressure on the front month WTI contract. Strong upward movement today.

There's of course a lot of crude on the "high-seas" as traders have captured the contango spread.

The effect of lower crude prices is most visible in the capital expenditure reductions of the oil companies. There's already significant cutback on projects in the Gulf of Mexico deepwater and Canadian tar sands.

From a financial investment perspective (10+ years) this sector deserves a good look. There is a large universe of companies with very strong balance sheets and sufficient capital reserves to fund growth. This shakeout is creating excellent opportunities.

[Michael Chevalier]

Zanzibar, points are excellent. I would also say the word Consolidation could be in play if the credit markets weren't so wretched right now.

Interesting you mentioned Russia. (Did Putin indicate how long they plan on that price?) Relatively deep pockets, as you point out. China is also reserves rich. As I'll try to keep on pointing out, contrast these nations to others in a far more precarious economic place. Not just oil, all commodities are going to be oversupplied, probably for 2 entire years. It will stress any government whose agenda is built on cash flow from nationalized commodity assets. To what point is the question.

MCC

[zanzibar]

Michael

It seems from this article that Putin's budget review is for 2009. I have always contended that what blew up the Soviet Union was the collapse of resource commodity pricing as opposed to the conventional wisdom that it was Reagan's arms buildup. In fact I believe the Reagan era is when the US began its intense love affair with the free lunch based on debt. Total debt as a per cent of GDP has only accelerated ever since then.

Commodity producers need to recognize the cyclical nature of their economies and be counter-cyclical in their government policies. Cut back in good times (as the private sector is doing well) and the opposite during the downside of pricing. No doubt they will face difficulties in the near term but over the longer horizon prices will recover and the global reflationary efforts will be manifested in higher commodity prices at some point. Investing as opposed to trading means building positions in the strong when the near term outlook is "deathly".

If you look at company reports from the natural resource sector there is a preponderance of cutbacks and shutdowns from Alcoa to BHP to Rio Tinto. When the next tide comes in the financially strong who capitalized on the opportunities in the current downturn will have outsized gains.

You mentioned consolidation. Yes, that will be a big part of the restructuring and those with the cash reserves and strong balance sheets will have significant advantage relative to those that need to tap the credit markets. IMO, now is the time for investors to do the deep homework.

[Michael Chevalier]

This URL has an accopanying graph that nails the increase in debt vs GDP in the last two stretches of GOP presidency. As Zanzibar has it, it hit its low point with Carter, took off with Regan/Bush 1 and started down during Clinton 2nd term. The Decider reversed that trend.

http://zfacts.com/p/318.html

Double Whammy: 50-Year Record on Sept. 22. $10 Trillion on Sept. 30, 2008.

The gross national debt compared to GDP (how rich we are) reached its lowest level since 1931 as Reagan took office in 1981. It skyrocketed for 12 years through Bush senior. Clinton reversed it at a peak of 67%. Bush junior crossed that line on Sept. 22 and hit 69% on Sept 30. That's the highest it's been since 1955.

[another_David]

Zanzibar,

Yes,the collapse of the old USSR was in large part due to the collapse of commodity prices. One of Gorbachev's advisers wrote an article on this very point. Forgot who specifically wrote it, but I recall that it was put out by the American Enterprise Institute.

[zanzibar]

Michael

To get a complete picture of the debt debacle we are in you should look at total debt (government, business & individual) as a per cent of GDP. Total debt to GDP is north of 350%. With all these senseless bailouts of the banksters (so that John Thain could redecorate his office for $1.2 million) all we are doing is growing the government debt pie which relative to the private sector is small.

If you have the inclination read this "non-conventional" note by Van Hoisington and Lacy Hunt. Its their 4Q08 review and outlook.

[Kolya]

Some more info on oil prices / cost of production from CHARLEY MAXWELL @ Consuelo Mack WealthTrack:

http://www.wealthtrack.com/transcript_01-16-2009.php

You can stream the video online as well.

[rcthweatt]

Investing in the oil patch in downturns has been tried and true from the days of John D. Rockefeller himself- buy up cheap the assets of the excessively exuberant unable to make their notes, and wait. My former employer, Tidewater Marine, became the largest boat company on earth this way, and it's how Standard Oil became Standard Oil, after all. I remember a man in the mid'80s who was filling large fields in Texas with all manner of oil field tools coated with preservative. He was very confident he would eventually sell them all at a handsome profit- he had done it before(and since, no doubt).

But, from a strategists' point of view, this doesn't look to be a viable model going forward. With the exception of Iraq(hence Cheneys' interest), future oil fields are going to be smaller and harder to develop than in the past. This implies that high, and sustained, capital investment will be needed to bring adequate supplies on line- just the thing that oils' endemic price volatility makes impossible. A basic drilling rig is pretty cheap; a drill ship is the most complex and expensive vessel this side of a capital warship.

If, as a result, developed economies, especially our own, restructure them selves to use significantly less oil, investors may have a longer wait this time(or the next).

[zanzibar]

rcthweatt

Very good points!

With multiple billions required to bring a deepwater or tar sand project on stream there will be fewer until prices that make these projects viable are sustained.

Its this very reason that makes investing in the oil sector interesting as this works to constrain supply. There are many companies that generate decent free cash flow with current and even lower prices who have rock solid balance sheets. As prices rise in the next cycle these companies will have tremendous earnings leverage. The rising tide also takes up multiples. In the mean time investors are paid to wait as these companies can pay out a portion of their cash flows as dividends.

In my experience good investment returns can be obtained by finding the gems in sectors that are temporarily out of favor. Natural resources is such a sector today were investors should spend some time doing their homework and building long term positions. It will be couple decades at the least until we have commercially viable substitutes for oil, gas, coal, metals and lumber.

[curious]

http://www.dailykos.com/storyonly/2009/2/1/15245/35886/824/691763

Fine: Lehman Brother's, others drove oil barrel prices up

Expert blames speculation for price volatility, supports regulation

"Like real estate, the energy bubble was based on excessive, open credit that allowed big investment firms to instantly arrange contracts without putting anything up," Fine said. "No deposit or letter of credit was needed."

After Lehman Brothers folded in September, investigators found it held 10,000 oil contracts of 1,000 barrels each, Fine said.

Once speculative borrowing ended, oil prices plummeted to below $35 per barrel, which Fine said can’t be explained by supply and demand.

"At this point, total world demand for crude has fallen just two percent," Fine said. "U.S. demand since the peak is down less than five percent. I say it’s not supply or demand, it’s fall out of speculation and the relative absence of credit from the financial services industry."