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Tuesday, August 05, 2008

Oil! Texas Tea!

One of the things I have been doing during this interval of blogging silence is trying to figure out where a stable crude oil price might be over the next couple of years. I've worked very hard on this using four different methods, but I can't find a stable price I'm comfortable with. The interval looks like $70-$105, but the top ten dollars just won't settle so it probably should be thrown out, making the range $70-$95. A demand-stabilizing price (taking into account likely currency moves of the major players) appears to be more around $85, but I'm not comfortable with that price either because of political and country issues.

Even though this turned out to be unsuccessful, it wasn't unfruitful. One of the clear patterns that emerged was that diesel prices are major factor here, and this was a surprise to MoM-The-Spam-Blogger. That's so for a number of reasons, such as diesel's higher correlation with transport costs and consumer prices (and even with the net price of other energy), diesel's higher usage in countries in which the power infrastructure is poor and/or it gets a higher subsidy (see India), and the amount of diesel one gets from a barrel of crude. (See this EIA page about the refining process.) You can eke some more out, but not tons. It is at least theoretically possible to have dropping gasoline prices and rising diesel prices depending on demand differential.

It is not until diesel fuel drops substantially that the cost add-ons in a vast range of products drop, and until those cost pressures diminish, demand for crude should continue to decline due to pricing pressures reducing consumption. Therefore gas prices are a misleading index. Another very important lever moving prices, economies and demand is ag chemicals, many of which are made at least partly from petroleum! Demand for ag chemicals is being stoked by biofuel production, and ag chemicals will continue to be an inflating component for food prices for some time to come.

The last major component of this is that spot prices are not contract prices, and a lot of refining is done on contracts. So overall import oil prices for the US, for example, have substantially lagged the spot market and will continue to lag it. July crude import prices won't be released until August 13th, but over the year ended June, crude import prices had risen a staggering 86.2%. As contracts expire, they are rewritten at higher prices. Refiner crude acquisition prices reported by the EIA were $127 a barrel in June, which is an increase of about 96% over the year. The reason that these two measures differ is that transportation costs are jacked higher too, so actual acquisition costs make the effective price increase higher than the nominal increase.

India was experiencing similar increases, as Indian crude import prices crossed into the $100+ territory in April. Further, the rupee is still stuck on a downward trend, so world oil prices are hitting them harder. Their other problem is that diesel demand is rising around 25% a year, whereas gasoline demand is only increasing 10-11%. Here is where their lack of energy infrastructure is just killing them - many private residences and most businesses have private generators to kick in when the electricity supply fails to meet demand, and in many places this is happening every day!

So if I calculate a stable US price, I am overshooting for India. Indeed, one wonders what in the heck is going to happen in India, because their energy subsidies are causing diesel shortages. Read the article - they are experiencing their own Jimmy Carter episode.

There is some theoretical price cP of crude oil that would allow the emerging countries to continue to grow at a slower rate but sufficient to maintain the supply of petroleum products they use, but it does not look to me like that price can be found under current circumstances, partly due to problems with infrastructure and subsidies which have distorted markets. If I am correct in that surmise, the result should be an end price skewed toward the lower bound of my range, but my surmise also implies a slower approach to that range.

Rolling my eyes and cursing my incompetence, I finally decided to use a target price of $85-$90 at 6-8 months and a target price of $70 at 14-16 months. I then paused to laugh hysterically at Obama's theory that gas prices are going to be $12 a gallon. Not likely, because consumption would plummet. I am afraid that he has been hanging in the wrong salons to learn much about fuel prices; gasoline is a consumer-skewed product. Diesel is a commercial-skewed product, and is less immediately susceptible to demand changes.

I am not pleased with my level of uncertainty in these calculations, and if anyone has helpful insights, I'd love to have them. If you just want to hurl invective, try to make it at least as balanced and objective as the truck drivers. Note that they are very good at checking facts and quite effective at researching and rebutting lies.

Even though gasoline can't go to $12, I can conceive of circumstances in which a temporary shock could push diesel to $5.50 or so, and that would be a crushing blow to the world economy. I think the US population is taking energy independence much more seriously than Washington is. See Carl's post and the really bizarre first response in the comments. Neither McCain nor Obama really seem up on the topic, and although McCain talked about drilling first, he is also a recent convert.

The bottom line is that economies which have heavily subsidized energy have also starved their energy companies of capital to provide infrastructure, and that is now posing a limit to growth. It's not just India. In Indonesia relatively recently, there was a near rebellion among many companies in response to utility outages: The Indonesian government's plan had been to tell companies to rotate shifts into weekends, and one of the stories I read said that a group of the foreign companies threatened to pull out. The only recourse for the Indonesian government is to price electricity far closer to the generation cost, which will undercut its attractiveness in siting:
Unlike the prices of oil for industrial users which have been floated on international market prices, PLN is required to sell electricity to all categories of users at government-fixed prices. These electricity rates cannot be changed without approval from the parliament, while the prices of the diesel and coal that fire most PLN power stations have been rising steadily and steeply over the past 18 months. Things could become even worse for PLN before they start to improve. The sharp increases in diesel prices have prompted many companies to stop operating their own captive power units, relying instead on power supply from PLN.
In one case, the outgage occurred because PLN simply didn't have coal. The price of coal has since dropped, so we are reaching limits on all major energy categories.

The current situation is unstable and becoming rapidly more so.

For base data, see the BP Statistical Review (pdf).

A U.S. centric view should allow for the seasonal production trade off between diesel and home heating oil, the two being essentially the same stuff.
Interesting commodity discussion linked to at Big Picture regarding commodities. The commodity analyst is predicting a $100-$120 range for oil and $10-12 for natural gas.

In response to Fred's comment, I don't see diesel prices moderating. We may get a spike in fall depending on home heating oil demand. I don't have a good feel for how much home heating oil demand is shifting to coal, etc. It will also depend on how cold the winter is, and the sunspot and solar flux numbers don't make me optomistic about that.
Well, Fred, diesel prices should stay up because of trend on the the world market. That's why I see a relatively high floor for home heating oil. Wholesale, it's oscillating between $3.25 and $3.35 in recent days. At that price, consumption will drop significantly.

John - I honestly considered first posting on the sun and temperature trends, because that is the counter argument to my argument in this post. However, the bottom line is that people don't pay for what they can't afford, so something's got to break regardless.

Almost all of US home heating oil consumption (app 80%) is in the NE. But costs on other forms of space heating are also going to be very high this winter. Nor can the federal government afford to subsidize this cost as some Dems appear to be proposing. The best option is to provide some heating assistance for the lower income families, but I'll be darned if I can see how this is going to shake out.

Analysts who predict a $100-120 range remind me of the NAR's forecasts for home prices over the last few years. There comes a point when people just can't pay, and then demand drops.
One thing that might need to get factored in is bunker fuel, as used in ships. I understand that various international regulatory agencies are going to require ocean carriers to either (a)switch to distillates, or (b)put desulpherizing scrubbers on their vessels. Option A, whichs seems more likely, would change the product mix at refineries, though I don't know by how much.
It's happened exactly as i predicted. There are/were no consumers willing/able to pay $140 equivalents. Right now I think we are processing something like $90 products and that's showing up as unprecedented demand destruction.
MoM - my intuition is that when the market corrects it will overcorrect. If the political situation in several oil producers stabilizes and the winter is mild, I think the price could break down to the lower end of your range. But as long as people have to hedge against a chain of events like "Israel strikes Iran in November, Iran tries to close the Straits of Hormuz, and the USN does a replay of Operation Praying Mantis", the uncertainty is going to help prop the price up.
John - it's got to pull back sharply, because people are getting shorter of money all the time. In a sense, it has to overcorrect to restore demand at the previous level. Pulling back to $80 would still leave demand about 1% below where it was then.
Nice post, MOM. Very informative links.

If you can find a way of predicting oil prices, well back up the truck and start buying futures. You'll make millions!! (LOLs)

So far none of our politicians want to look at more than the next election cycle. The scale of what needs to be done and the time frame involved does not seem to impact on their thinking. Had we actually done something starting during the Carter administration, many of the solutions would be in hand.

I saw a guest on Kudlow's show today who claims to have a process for turning natural gas or coal into diesel and jet fuel for about half the present cost of refining it from oil. He also claims the process sequesters CO2. If he's right, this could be a very big thing in the future.
Jimmy - laugh until you cry. I am really trying to figure out where banks have to be to maintain their NIM (net interest margin) in 2009, and for that I need to know the Fed rate. Okay, the Fed rate is going to be dependent on the economy. The major driver down on the economy is inflation, and the major cause of inflation is energy.

I also want to predict the real inflation rate for tiered demographics (bottom 20%, next 20%, etc), because that is going to affect default rates and cure options.

So I end up digging through Asian papers to figure out what it will take to maintain NIM for a cb in the US.
A negative FFR won't be enough to keep the banks liquid because it is a solvency problem. We've seen the margins exploding twixt borrowing and lending but that is self defeating in a deleveraging world. Maybe we'll see reverse buydowns. I trade my sub 5% mortgage for a no redemption for 5 years 18% mortgage with the same monthly payment via a balance adjustment. Think about it.
Rob - I'm not dealing with the insolvent ones. I'm dealing with the conservative banks that cut way back around 2005. A lot of them now have money to lend, but obviously the environment is a very risky one. Of particular importance is that FF rates will rise as we come out of this; predicting the low and the curve out is of some strategic importance.
MOM, you are way out of my league with your means of divining the future. If you can do it with some degree of certainty, more power to you.

One reason I read your blog. I often learn something.
I'm dealing with the conservative banks that cut way back around 2005.

Both of them? Wow.

Anyway did you notice that no one has denied a speculative oil bubble or mentioned peak oil for ohhhh I don't know at least the last $30/bbl?
Rob - there are a lot of them. Not every banker is nuts. Drive around to some community banks and walk in the lobby. You'll notice a lot of them have signs up for home equity loans at nicely low APRs. It's not like this is rocket science.

Jimmy - well, really this is a theoretical construct. It's not that I care what the price of crude is in any one month - I just need to get somewhat in the ballpark quarter by quarter. Nor can anyone predict the oddities - the industrial accidents, wars, earthquakes, etc. Over time, however, economic balances do control the outer parameters of the price of a commodity like oil. What's extraordinary about the current situation is that we are way outside the economic parameters; one can then safely say that this situation will correct. In normal circumstances one cannot apply the same reasoning, because a broadly traded commodity will be within a 20% or so mesh that conforms to economic circumstances.

This has turned into a very disturbing exercise, because a lot of vectors remind me of those WWII clips of the fighter planes falling out of the skies.
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