With Global Demand Rising, Oil Production Remains Flat

Economics clearly support the notion that in a functioning market economy, increases in revenue are likely to lead to investment in the industry, expansion of supply, and ultimately moderating prices for consumers in the longer term. If this self-correcting process is not working, as seems to be the case with oil lately, then – this could be a rather strong indication, that factors other than profit and investment incentives are at work. This unavoidably, as we have experienced with crude, will result in additional long term increases in price and profit for the industry.

The international conference of oil producers, which was held in Jeddah , Saudi Arabia on June 23, kept as its focal point not only the unprecedented hike in oil prices, but also the role of speculators in shooting up prices in world markets. Now, and quite honestly here – this game of “let’s blame the speculators” has gotta stop. Speculators are not the driving force behind rising demand for oil in the emerging economies and they are certainly not the reason the current Saudi production of 970K barrels a day is not an all-time high. Oil producers are the ones that ultimately determine the long-term price trend, not speculators.

Frankly, not only is the speculator-argument unrealistic and without base, but it’s outright – laughable.

Even U.S. energy secretary Bodman last week said “There is no evidence that we can find that speculators are driving futures prices” for oil. I agree with energy secretary’s assessment. All we have to do is look at commodities such as iron ore or coal which are not traded on the futures exchange and are not influenced by speculation. Both of these commodities have risen at a higher rate than oil since the end of fiscal ’02. And it’s not just oil, prices are up across the board and that’s a fact.

Another interesting aspect is OPEC’s constant claim that there is significant speculative premium in oil prices. Well, let’s take a look at some data. – Our imports from Mexico, and Venezuela are running more than 30% below year-over-year basis. Libya keeps threatening to cut back on their production. Nigerian exports are way off due to political instability. Saudi exports are running below fiscal ’05 levels, (true – the Saudis pledged to add 200K barrels a day to the market, but let’s face it – that’s just a drop in the bucket in the context of global consumption), and Russian production is starting to fall.

Furthermore, the U.S. Congress has convened at least 40 hearings on the issue of skyrocketing energy prices in the first half of fiscal ’08. At least 160 witnesses have been sworn-in and questioned and yet nothing has been done, in terms of effectively addressing energy issues let alone finding solutions. In fact, many of the experts called to testify were rather misinformed about how the markets realistically function.

Meanwhile, more than 73 million new cars hit the road last year.

It is a persisting and irrefutable fact – world demand continues to rise while the production has remained flat since fiscal ’05. With output at several major oil exporters in decline and no big fields slated to come on steam anytime soon. Let’s face it. This is not about speculation, it’s just good old supply versus demand. Whether we like it or not, price will function to equalize the quantity demanded by consumers.

Interestingly, after OPEC President Chakib Khelil predicted on June 28, that the price of oil will climb to $170 p/b before the end of the year, several analysts came out saying that they expected the ‘oil bubble’ to burst soon. In fact, they called for a 25%-30% drop in oil prices over the next six months.

While, this would certainly help return oil prices to more practical levels, a 25%-30% drop in oil prices is only a correction. A 30% correction in a commodity or even a blue chip stock is not uncommon. That’s why we don’t understand the ‘bubble’ analogy used by different analysts, including an article published by Barron’s recently where oil was analyzed in bubble terms.

The essence of a bubble is that it involves a sharp rise in the value of an asset that inevitably destroys the reason behind the rise. Tech was a classic example. That’s not the case however, with oil. We don’t have a scenario in which newly issued shares are diluting earnings and funding capital investment that could lead to vast overcapacity and ultimately earnings collapse. Many energy stocks are cheap by any measure, whether relative or absolute.

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