The Price of Oil
Special Edition: The Smart Profits Report Oil Forum
The Smart Profits Report: Issue #310
Friday, May 19, 2006
The Price of Oil: “There Is No Oil Shortage”
by Karim Rahemtulla
Chairman, Mt. Vernon Research
With oil prices rising, remember that oil is a self-limiting commodity in the long term. That means it has to compete with demand… and demand is a result of a healthy consumer.
But right now, consumers across the world are enduring the early phases of an upward inflationary spiral. Prices are going up for everything but staples. That means less disposable income.
Consumers do not have an endless supply of money, and when this comes home to roost, demand will begin to fall and we could enter a period of stagflation (high inflation and higher interest rates). That would spell recession for the U.S., and a slowdown for the rest of the world.
Pointing Towards The West
Many people point to the “new growth” of China and India. And while China is a factor, it will only remain that way if the U.S. is healthy enough to buy Chinese goods. However, India is a non-factor when it comes to production or consumption, as it’s still more than a decade behind China.
High oil prices will cause a slowdown in the U.S., hence the China play will be less attractive. Less oil demand from the U.S. and China will lead to a lower price for oil.
The second reason for lower oil prices is actually higher oil prices. As you’ll see in Steve McDonald’s notes below, higher prices will force a speedier search for alternative and more efficient energy sources.
This “substitution” is a basic law of economics: When prices rise above equilibrium, the market searches for substitutes. The worst thing for oil producers is competition from alternative energy, and those fears are hitting home.
The wild card, of course, is the short-term geopolitical climate. This is the main reason that oil is at $70, not $40 or $30 - and it’s the reason oil could reach $100 or more (remember Goldman Sachs’ infamous “super spike” prediction?).
Oil: Shortage Or Surplus?
But, there is no oil shortage. In fact, we’re arguably close to a huge crude oil surplus right now, as the world oil producers are pumping a higher amount of crude today than in the past when oil was half its current price.
As oil goes, so does the exploration and production industry. Aside from taking a short position in oil futures, there is no real way to short oil in the stock market. The oil ETF is not shortable and has no option yet. However, the Energy Select Sector SPDR (AMEX: XLE) does have LEAPS options available for consideration. That way, you can take a nice, limited-risk short position that could bring you huge returns if oil prices return to “normal” levels over the next two years. If not, then your risk is limited and small.
At the end of the day, the number that bears watching the most is U.S. consumer spending. If that slows, no amount of geopolitics will keep the price of oil high. Picture tanker after tanker offloading oil at U.S. ports, with nowhere to go but into storage. It could be a frightening correction.
Good Trading,
Karim
The March To $100 A Barrel
by Steve McDonald
Advisory Panelist, Mt. Vernon Research
Whenever I consider the current mayhem in the oil markets, I can’t help but think back to 1974. Gas lines everywhere, oil prices soaring to what was then thought to be stratospheric levels, the U.S. government doing its best to convince the public that the world was running out of oil, and the feeling that maybe the joy ride of cheap oil was over.
Thirty-plus years later, we seem to have learned nothing - and done nothing - to create a more stable environment where we are not subject to the crazy politics of the Middle East. We are now even more vulnerable to the whims of some of the most unstable governments in the world than we were in the ’70s.
Every aspect of our economy, and the potential of the two largest emerging economies - China and India - is all tied to oil. Just about everything in our lives - essentials and luxury items - require oil. Oil is not optional in our culture. It is as much a necessity as electricity and fresh water.
So, the question isn’t whether oil prices will continue to go up, but how far up they will go, and how much we can stand before we do something about the spiral we are in again.
Reasons For Oil Prices To Jump
I believe oil will soon experience another quantum leap in price - to around $100 a barrel - thanks to three probable reasons:
- The most obvious reason is the geopolitical situation we find ourselves in. Despite the lessons taught in the ’70s, we have continued to rely almost exclusively on the Middle East for our imported oil.
- Unfortunately, oil is an absolute necessity. We cannot function without it. We can’t just give up oil the way we could with other products where we can make do without if the price rises too high. Although oil is not completely free of the usual supply and demand market forces, it does seem to be able to run up in price almost at will. Do you really think we should all be paying $3 a gallon for gasoline?
- Realistically, one has to consider the possibility of another major terrorist strike in America. If that attack were directed at the lifeblood of our economy - oil - it would be devastating. After all, one hurricane shut down a huge percentage of U.S. oil refining capacity for several weeks, so imagine what impact a concerted terrorist effort would have on our ability to refine, transport and deliver oil.
If oil doesn’t break the $100 mark, it will only be because the federal government will have realized the horrible position it has allowed this country to be placed in, and make energy independence a national priority. Not likely.
But you can bet that when oil rumbles close to $100 per barrel, the stakes will be high enough that all the stops will be pulled out, and you’ll see a gigantic effort to push oil alternatives. Even Big Oil’s influence in Washington won’t be able to stop it.
Alternative Fuels vs. Big Oil
Look at a couple of the most popular energy ETFs - the Energy Select Sector SPDR (AMEX: XLE) and PowerShares WilderHill Clean Energy (AMEX: PBW). The alternative fuels in PBW have enjoyed a bigger ride than the big oil companies in the XLE.
Above is a one-year comparison of the XLE (containing large oil companies) and the PBW (described as including clean energy companies, or alternatives to petroleum). The alternatives are having quite a ride!
In the short term, I expect crude prices to pull back, but then, as I said earlier, start heading up to the $100 area. So, consider short-term put options on energy-related investments, and LEAPS plays for the long run.
Good Trading,
Steve
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