May

14

Turmoil in Nigeria adds to oil uncertainty, but behind the scenes the big oil question keeping prices up seems to be Ghawar. This one massive Saudi oil field produces five million barrels a day, 60% of Saudi production and 7% of world oil production (more than all U.S. wells combined, says the WSJ). Matt Simmons and other peak oil advocates claim this 20 by 175 mile field is in significant decline. The secretive Saudis won't say, but a recent Sanford Bernstein study cites satellite data to claim Ghawar is okay. "Junk science!" says Matt Simmons of the satellite data. Saudi mismanagement of Ghawar in the past–perhaps when oil prices were very low–may be causing severe problems today (NYT 2004 article). Many new wells are now being drilled, but with steeply higher prices, that is to be expected.

With so many oil "experts" issuing reports on oil development and production around the world, it is hard to tell whether new oil finds and production will over-balance declining production in old wells, turmoil in countries like Nigeria, and industrial and transportation expansion in China, India, Mexico, Brazil, and Eastern Europe.

Delta Airlines faced similar problems some years ago researching airline data on seat availability. How could Delta determine when competitors were selling lots of seat on particular routes? What data could they trust regarding ticket sales for future flights? The answer came from economist F.A. Hayek. Prices reveal information about supply and demand and a Delta executive well-versed in Hayek realized he could judge competitor's seat availability by watching changing prices. As ticket prices rose for a particular route and flight, that meant the seats were filling up.

Similarly, though oil experts don't have perfect or even partial data on the Ghawar field, recent rising prices might reveal the reality of serious problems. Saudi Aramco may be secretive regarding Saudi oil production, but hundreds of oil field workers and consultants have detailed information. It is unlikely that the best information about Ghawar will come from satellite observations 22,000 miles out when hundreds of oil field workers and petroleum engineers are right on top of Ghawar wrestling daily with production issues. Is there a pathway for their inside knowledge and information to reach oil market and influence prices?

The key problem, as a recent Forbes article ("Give Oil a Future") notes, is the lack of long-term futures market in oil. If major oil companies could lock in even $50 a barrel for oil over 20 years, they would pour funds into developing many more fields than are now active.

Perhaps the Strategic Petroleum Reserve could provide this service. The Federal government should privatize the reserve, selling up to 500 million barrels (leaving far more in the reserve than has ever drawn down in crises, according to recent NYT op-ed). Income from oil sales could be set aside to guarantee purchase of 500 million barrels at $50. That would allow companies to lock in that minimum price now.

Of course the Federal Government has a poor track record speculating in commodities. For example, in the 1980s, the the Dept. of Agriculture had millions of pounds of cheese stuffed in Kansas City area caves (an expensive Strategic Cheese Reserve). ["In the limestone caves and above-ground storage space of the Kansas City area is the largest single share of the nation's dairy surplus. According to the Department of Agriculture, the area stores about 25 percent of the country's 473 million pounds of surplus butter and about 20 percent of its 876 million pounds of surplus cheese." NYT, July 1983.]

[Forbes offers a nifty chart of nominal and real oil prices from 1868 to the present here. Of course the prices are misleading as they are not adjusted for true cost (hours of average labor per barrel), or for much increased automotive miles per gallon of gas/barrel of oil.]

So, is the high price of oil a distillation of hundreds of experts thousands of investors, and millions of consumers, or are market prices distorted by fear and wishful thinking? A problem is that everybody except one group enjoys high oil prices. Environmentalists cheer as people buy fewer SUVs and drive less. Urban transit folks like it as more ride their mismanaged mass transit. National Defense people welcome high prices that improve "energy security" by leading to billions invested in traditional and alternative energy production in the U.S. And the energy industry and energy investors are happy with higher prices and profits.

The only group not gaining are everyday consumers who pay more and have to cut back other expenses and adjust their travel plans to cope with high prices.


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1 Comment so far

  1. Rocky on May 15, 2008 2:05 pm

    Some rhetorical questions/observations:
    (1) The NYMEX Crude oil contract currently goes all the way out to 2016. There is almost no open interest past 5 years, suggesting that there is little or no demand for a 30 year hedging vehicle. And even if there was a hedging vehicle out 30 years, there is a mark-to-market problem for both longs and shorts: Remember Metalgesselshaft (?1990) was “perfectly” hedged on their crude strip, but because they couldn’t meet margin calls between various longs and shorts, they went bankrupt.
    (2) Forbes is only looking at one side of the equation. Exactly who would be a speculative BUYER of oil for the year 2038? If oil continues to rise at a parabolic rate, at some point, won’t we remember crude the way we remember Whale Oil … which is of course was why Drake et al drilled the first crude oil wells in Pennsylvania!!
    (3) From 1996 to 2000, some stock p/e’s rose dramatically…and these valuations (hayek price signals?) were, with 20-20 hindsight, predictive of nothing more than eventual reversion to the mean. When Pfizer released Viagra in 1999, the book value was $3.62, the p/e was 65 and the stock traded at $50.(This despite the fact that even if every man took viagra, the market cap was not “rationally” explainable using any dividend discount model.) Today, the book value of pfizer is $9.60, the p/e is 8.5 and the stock is at 20. So much for the collective wisdom of markets!
    (4) In free, efficient markets, must commodity prices EVENTUALLY revert towards their marginal cost of production? Are there any long term (30 year) examples of this not happening?

    p.s. I am currently long crude and natural gas futures; and even though I am (so far) making money, I am very nervous. It’s those words “this time is different” that send shivers up my spine.

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