9/14

OILS WELL THAT ENDS WELL ?

Crude Awakening...First of all, please excuse our juvenile attempt at humor in the title of this piece.  Although it sounds like the name of a Popeye cartoon, we just couldn't help ourselves.  It's no grand revelation to anyone living in the modern hydrocarbon world that oil prices are pretty darn high at the current time.  High by absolute historical price standards.  Though not necessarily so on an inflation adjusted basis.  In fact for a very informative view of oil using our favorite price deflator (the stock market), have a look at the following:

Now tell us again, which asset looks expensive?  Crazily enough, if oil had stayed at about $25 per barrel as seen earlier this year as opposed to spiking to $35+ at the current time, the 2000 number in the above chart would be closer to 450 barrels.  One last fun fact.  Had oil held purchasing power equivalent to the Dow since 1980, the current price per barrel would approximate $410.  Maybe these are all unfair comparisons, but in a world of relativity in terms of asset prices, oil still looks pretty cheap.  In fact the paper wealth gains experienced in the US over the last two decades may be one of the reasons why politicians (up until now), central bankers and America in general has shrugged off the more than tripling seen in the price of crude since the Asian/Latin American/Russian crisis prompted the implosion bottom in price during late 1998.    

In reality, OPEC has not had a raise in decades.  As you know, the above chart is in absolute dollars, not inflation adjusted dollars.  At the all time highs, crude was only modestly higher in price than it is today.  Clearly over the last few decades, real estate, financial asset prices and the cost of living in general has escalated mightily.  Not so the price of crude oil in the global market.  We contend that complacency regarding the supply and price of oil had grown awfully thick as of a few years back.  Thick enough so that most  miscalculated the pro forma effects of a global economic upturn on the price of crude that has indeed transpired over the last few years.  As you know, this global economic upturn has been largely supported by the US consumer.  In our minds, this complacency has caused many to misjudge the real sensitivity of the American economy (and corporate earnings) to increasing oil prices.  A sensitivity we may only now be beginning to experience.

(Tangentially, the recent rise in the dollar price of oil in the global market is a bit of a humorous commentary on current society.  When asset values within our control such as real estate and financial asset prices zoom skyward, we are caught in the rapture of "wealth creation".  Supply demand imbalances are cheered.  When the price of a commodity/asset that is a good deal out of our control zooms skyward, it's just downright unfair.  How dare the global commodity supply/demand gods treat us this way!) 

You Walked Across My Heart Like It Was Texas And You Taught Me How To Say "I Just Don't Care"...You may have seen the current account balance number reported yesterday.  As you already guessed, another record.  The trade imbalance widens by the month.  The US continues to consume at a voracious pace.  Consuming foreign imports, an important component of which being oil.  It's not just us.  With global economies on the upswing, there is and has been a global concerted upswing in demand for crude.

Another social characteristic of the current market environment (the US, at least) that also prompts our fascination is the continual ability of the collective investment body to ignore bad news.  By nature, America's optimistic spirit has been responsible for sincerely great progress and prosperity over the last few centuries.  At times, though, that optimism has been an Achilles heal.  Admittedly, advances in US domestic energy complex technology have led to more efficient ways of finding and producing domestic crude (including offshore and Alaska).  But America has grown extremely complacent over the last few decades as the inflation adjusted price of crude has actually fallen significantly (yes even at today's price).  Here are a few graphic representations of complacency (all graphs constructed from DOE data):

The above graph pretty much speaks for itself.  Yes, US refiners have become more efficient and productive.  But, current capacity utilization in 2000 is running close to 96% on a much smaller base of refineries than that of two decades ago.  In 1981 at a major peak in oil prices, utilization was 69%.

Refinery production capacity in terms of absolute barrels of production possible has been stagnant over the last two decades.  Down a good amount from the peak in the early 1980's.  Have you tried to get a new refinery permitted lately?  Thanks to forward thinking folks like the "inventor of the Internet", you won't be receiving permits in the mail any time soon.  After all, it's so much easier to locate them offshore - in somebody else's backyard.

Clearly with the growth in Alaskan production and the push into deep water Gulf fields, crude production in the "lower 48" has trailed off significantly over the last three decades.  Unfortunately the inclusion of offshore and Alaska does not make up for the decline in lower 48 production.  Total domestic US production has been in decline for three decades. 

The one chart we regret we could not come up with for this discussion was total annual sales of SUV's over the last twenty to thirty years.  The same time period that domestic production and refining capacity were falling.  Complacency dictated that SUV's were allowable and logical, though, as the inflation adjusted price of global crude was dropping like a rock.  

Pump Up The Jam...When you get right down to it, there is no quick fix for the problem of globally escalating crude prices at the current time.  Blaming OPEC is ignorant.  We sincerely believe OPEC would much rather see mid-to-high $20's oil.  The risk in the current world is that global economies edge toward or actually fall into recession.  The very prescription for declining OPEC oil demand in the first place.  OPEC would makes oodles of petro-dollars between $25-30 per barrel.  The fact is that OPEC is not in control of global demand.  It is not in control of overheated demand and inventories that have been allowed to fall well below what would be considered normalized in many countries.

What is a very apparent problem is that the US simply does not have enough refining capacity to meet demand, no matter how much OPEC crude supply is released in the global market.  It's a bottleneck problem.  A log jam.  As we have shown in the refining capacity chart above, current total US daily production capability is roughly 16 million barrels.  At the moment, one million barrels a day in capacity is scheduled for maintenance in October alone.  That's right, 6% of total US refining capacity will be taken down next month.  Just what do you think that will do to domestic supply/demand pressures?  Modest hint: It's won't improve things.

The US supply/demand and refining capacity situation is further exacerbated by global demand.  You've seen the headlines out of the UK, France and Germany.  It's not a pretty picture.  It's a picture of mild to not so mild panic.  Can you imagine the domestic reaction if food were disappearing from grocery shelves in America?  Can you picture Manhattan devoid of vehicles?  Very quietly, and seemingly out of the news, Asian demand has also been very strong.  Have a peak at the following chart (to which we are indebted to UBS Warburg for the data):

China is not unique in this pattern.  Japan is also importing more oil than in prior years.  Many of the large Asian nations have been building inventory for some time.   US investors may believe that Greenspan can fine tune the domestic economy and financial markets with his magic monetary wand.  Unfortunately when it comes to effecting the price of global commodities, he's just not quite as slick.  It's no wonder why Clinton has been globe hopping lately, wearing his crude oil production lobbying grin.  As of now, to very little avail.

Are You Ready?...For a potential spike to $40 or $50 per barrel?  It's a possibility, though no sure bet by any means.  What could take us there?

   A global economy that heats up from here.

   A hard spike in winter demand due to abnormally cold weather.

   The current domestic inventory situation.

   The sheer fact that OPEC just doesn't have a lot more to give.

By definition, higher oil prices are an interest rate increase.  They are a tax increase.  They should and ultimately will act to slow global economic activity.  Because global crude is priced in dollars and because the dollar has soared relative to foreign currencies, the negative price impact in foreign countries is much worse than in the US.  Is it any wonder why Europeans are screaming so loudly.  The Euro has imploded roughly thirty percent from the highs and the price of global crude has more than doubled since the floating of the Euro.  A recipe for pain if we have ever seen one.  The UK is in a similar boat as Sterling has dropped over 15% relative to the dollar since last October.  If memory serves us, just about every time crude has spiked to these levels in the past three decades, an economic downturn/recession has followed closely on its heels.  Will it be different this time?  Possibly.  This time the recession, if it comes, will be a concerted global effort.

As a last few comments, we can't help but relate crude to the current credit bubble in the US.  (C'mon now.  Don't kid yourself.  You knew this was coming at some point.)  We see the expansionist monetary policy in the US as aiding and abetting the pressures crude is bringing on the US as well as the global economy.  First, we have already discussed with you too many times why credit creation in the US has exacerbated the trade deficit, propped up the financial markets and, in turn, underpinned a good portion of the spike in the dollar relative to foreign currencies.  The imbalance of US dollar strength has really put pressure on the global economic community in terms of crude pricing.  It is clearly translating into inflationary and economic pressure.  In essence, here we have imported deflation into the US vis-a-vis the trade imbalance and are paying back our benefactors with upward inflationary pressure on their economies via the strong dollar effect in global crude prices.

Secondly, current abnormal credit expansion in the US has most assuredly driven domestic GDP to levels higher than may have been realized under historical average credit growth rates.  The wealth effect driven by financial asset and real estate asset gains is an offspring of this credit mechanism further supporting the most important domestic GDP driver - consumption.  We're not saying here that Fed policy has caused higher oil prices.  What we are saying is that under the law of unintended consequences, excessive money and credit expansion in the US was ultimately destined to spill over into commodity price inflation (despite today's energy component in the PPI report) vis-a-vis the circular relationship between financial markets, real estate assets, domestic consumption, the trade deficit and dollar strength.

As long as crude prices stay high, the Fed is in a dilemma.  Does the Fed lower rates to offset the negative effects of higher oil on overall domestic economic growth?  Does the Fed hike rates to forestall price and wage gains that may result from clearly inflationary energy price pressures?  Does the Fed do nothing and just hope for the best?  If consumer confidence begins to wane and inflationary expectations begin to build from here, the Fed may just find themselves is a black, gooey, sticky mess.

On The Firing Line...It's been a weird few weeks of market activity.  Once again in the schizophrenic topping process we believe is occurring, mild euphoria has given way to mild exhaustion.  The yin and yang forces of the market play havoc with the thoughts and emotions of the bulls and the bears alike.  Overowned NASDAQ leaders have been softening significantly.  NAZ sector favorites appear to be at some critical junctures.  It's either up, up and away very soon....or something else.  Time to line 'em up:

 A break in these favored sectors would be a real telling sign of fatigue.  Keep an eye out for potentially failing favorites.