Crude’s Still Overvalued By A Lot

I understand that I am playing the part of the broken record.  But bear with me, because I wouldn’t be doing it if I wasn’t convinced that I’m right.

I actually have a long track record of sucking up and admitting when I’m wrong.  I’ve taken plenty of losses on bad decision, with my chin up and looking those who follow me squarely in the eyes (my eyes see vicariously through my penmanship).

So rather than shouting over me, citing price action as your only reference, hear me out.

Those who are long oil have 5 basic arguments, that I’ve heard anyway:

1)      Supply of oil has never been this tight.

Counter: maybe.  That depends on how you define the purchases of oil that have been creating the perception of a constrained oil market.  While it’s very true that for the past 6 months, all oil that has arrived at market has been getting snapped up, the bigger issue is who’s buying?

The quantity of oil being purchases by non-industrial consumers (think GS storage facilities) has accounted for a large portion of these purchases.  I don’t have time to track down the exhibit, but in your free time, look up how much of recent oil sales have been by people who don’t actually use it for anything.

So we must ask ourselves; does oil that is being stored privately not count as stored oil?

I feel there’s probably a massive stock of shadow inventory of oil, which will likely hit the market should any significant selloff materialize.

2)      The Middle East is subject to instability

Counter: Pardon me, but when hasn’t the Middle East been in turmoil?  The only time that region seems to be devoid of violent uprisings is when its residents are being oppressed by a dictator.  We’ve had the same looming threat of violence for over fifty years now.  Yet, in all that time, we’ve managed to maintain our strategic interests.

You’d think we’d have some faith, by now, that we know what we’re doing and how to handle these people?

We’ve got more naval carriers in that region now than ever before.  And when they say “naval carriers”, what is actually being referred to is “a fleet of warships with a naval carrier amongst them.”  We’ve got nuclear warheads.  We’ve got battleships.  And, we have minesweepers.

At some point, you’ve got to trust that Iran isn’t going to put its head in the lion’s mouth and start slapping it in the eyes.  How could they close that channel, with its narrowest region of 30 miles wide anyway?  If they try, we’d be forced to enact a five mile deep “dead zone” along the entire length of Iran.

3)      Cheap oil is harder to find

Counter: True, but that in and of itself does not justify higher prices.  Just because the newer oils that are being extracted from tar sands and such are not feasible at prices below $70 (or so, I don’t know the specifics) doesn’t mean all oil needs to trade at those prices. 

Especially if demand for crude drops far enough to be fully satisfied without these newer, more expensive sources of oil, then competition will very likely force old fields to lower prices below where new fields can compete.  Why wouldn’t they?  The alternative is lower revenue from lower volumes anyway.  If lower prices enable higher sales, then there’s a range of volume that will give you more net revenue.

Net revenue is what really matters.  Profit margins are meaningless, if you’re laying off half your work force.  The cheaper oil will take the bids, the more expensive oil will be idled.  That’s the way it is.

The presence of a more expensive source of oil is no justification for higher prices on its own.  Case in point; electricity is much more expensive when generated from wind or solar than from coal or gas.  By any measure, energy costs significantly below $10 kW/hr makes the alternative energy sources unprofitable.

So electricity should be $10+ kW/hr to accommodate those production methods?  I didn’t think so.

4)      Big oil exporters need $100 oil to avoid running a budget deficit

Counter: Yeah, and I need a billion dollars to…you know…buy stuff.

I don’t care what oil exporters need to maintain their expenditures.  Greece needs debt/GDP below 100%, but how’s that working out for them?

This argument rests on assuming that oil producers, particularly the OPEC cartel, have some sort of mysterious power over pricing.  It’s superstitious, and naïve.

If anything, I’d argue that right now, oil producers have less control over the price of oil than ever before.  If oil drops below $100 a barrel, these nations will start bleeding deficits.  They will risk internal uprisings, sure.  Especially the Saudis, who are basically bribing their citizens to not rise up.

But the traditional mechanism for raising the price of oil is cutting production.

Tell me, if the Saudi’s need $100 oil at their current production targets just to meet their expenses, how can they afford to cut production to keep prices high?

This argument seems to hinge on assuming that if Saudi Arabia’s budget gets busted, then total anarchy will ensue and we’ll somehow lose the country.

But oil exporters have been running a surplus for, like, 30 fucking years.  Do you really think they’ll just cave?  Or maybe, just maybe, they’ll spend some of the hundreds of billions they have in sovereign wealth funds around the world to stave off judgment day…?

Yeah, I think they’ll be just fine for a while.  People are looking for safe fixed income investments anyway (Islam’s outlaw of interest aside, there are still ways to make set cash flow from investments in those places). 

Running a deficit (the first in practically ever) is not going to usher in the end times in the Middle East.

5)      Globally, central bankers are devaluing their currencies

Counter: And this is the final argument.  The big devaluation…

But it alone doesn’t add up.  Prices aren’t just a function of outstanding currency.  They’re more a function of credit.  And at these input costs, companies are going to be very reluctant to take on debt.

Credit has been contracting across the globe.  Savings continue to weaken.  These things are all interconnected.  The state of the consumer and business will in turn affect the amount of credit outstanding.  Lower credit, lower velocity of money, and thereby, probably, lower prices also.

Credit contraction is as much a function of higher prices as printing should be aiding credit expansion.

Besides, oil is priced in dollars, not euros or yen (for now).  Unless you’re all pricing in that changing sometime soon, the recent strength in the dollar should be very concerning for those of you who are long crude oil.  Foreign nations easing should actually be hindering your bets, not aiding them.

That about sums up the “higher oil” arguments I’ve heard.  And I just don’t see anything here to is going to give the push that some of the banks are using to call for $150 per barrel.

But what I still see, everywhere, is heavy demand destruction.  Assumptions about crude demand from emerging markets, and most recently the US, have been way off mark, to the high side. 

India and China were two of the earliest justifications for higher prices; yet I can’t help but notice that no one’s talking about them much lately.  On to bigger and better reasons to buy oil?

And, as I’ve consistently noted, Europe is getting sucked into a vortex.

On the back of foreign demand, US demand I would question.  We’ve now had two MASSIVE builds of crude inventory.  And remember, I believe the amount of real stored oil in the US is already being characteristically undercounted anyway.

Throw in continued export weakness and a sudden shift in sentiment could easily break oil markets, sending crude back into the $70’s (or lower) as a wave of shadow inventory comes to market.

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