Morgan Stanley: Oil prices may crash

[HenryTo]

Highly recommended article. Andy Xie from Morgan Stanley is an analyst I have followed and is one that I respect:

http://money.cnn.com/2005/06/16/news/international/outlook_morganstanley.reut/index.htm

The two commodities that have been confounding me have been crude oil and copper. The latter not so much because of declining inventory levels. However, crude oil inventory levels have been exceeding its high end of the last five-year range consistently over the last few months, and still oil prices continued to climb: http://tonto.eia.doe.gov/oog/info/twip/twip.asp

This is totally unprecedented. Sure, we have a lack of excess capacity - but we still have excess capacity. And the U.S. SPR is due to be filled to its limits by early August of this year. This will free up 75,000 barrels per day in supply. More important, we will finally have the full capacity (750 million barrels of oil) of the SPR at our disposal should a supply disruption occur in the Middle East, Nigeria, or Venezuela, etc.

My guess is that just like the long bond, some of the hedge funds who are short oil are being killed - which is fueling the continuing spike in oil as they are forced to cover their short positions. One of these days, we will find out for sure but when that day comes, oil will finally enjoy a substantial correction.

The Market Vane's Bullish Consensus on crude oil also surpassed the 70% level early last week - a level which we have historically seen at least a ST correction in the oil price. The CruDollar Index and the Oil-to-Gold Ratio are also at all-time highs. Caution should be exercised in the oil markets and oil stocks going forward.

[nodoodahs]

I like the EIA site, I used it to pull together the supply and demand data for my above post.

A world economic slowdown, if it happens (and if it could be measured properly), would result in a temporarily lower price as demand fell; temporarily because the producers would idle capacity until the price came up, and that idling would speed the increase in price.

Net impact would be that net oil consumers would draw down oil stocks, effectively burning oil they paid $50 for, because they can't find oil to buy at $40 even though that is effectively the market clearing price. IMO that is the 2002 situation played over. In the interim I will hold my oil stock, re-invest my divs, and look for other buying opps. It will take a major change in the long-term scenario to geld my oil bull. Like the Exxon guy said, "you have to wrap your head around a longer time frame."

The presentation you link to is interesting. Considering an "expert" put it together in Jan '05, it's interesting that we have already blown through the upper end of his volatility band for prices on slide 3.
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

Please note that I essentially said the increase in spare capacity will occur if the world economy slows down - which will cause world crude oil prices to fall as well. Spare capacity won't suddenly increase substantially because of new fields, but rather from a decrease in demand if the world slows down.

As far as world demand data goes, you can find it in the following presentation:

http://www.eia.doe.gov/pub/oil_gas/petroleum/presentations/2005/jetfuel/jetfuel_files/frame.html

[nodoodahs]

The increase in spare capacity in '02 coincided with demand outstripping supply by the biggest amount since 1970, demand increased but production shrank (primarily crude production). Price of crude fell to $20 in late '01 early '02 and capacity was idled because of the price; price didn't fall because of excess capacity. Cart before the horse IMO, I could be wrong.

In 1970, consumption (which includes oil subs like alcohol and coal products for the duration of this post) outpaced crude oil production (meaning exactly that, "crude oil" not including substitutes) worldwide by 2%. At that point in time, crude oil was 93.7% of total production (including substitutes).

By 1980: 5.9% outpace, 92.9% of total.
By 1990: 9.7%, 91.1%.
By 2000: 12.6%, 88.2%.
For 2004: 13.9%, 87.4%.

Two trends emerge. First, crude oil production has not, and apparently cannot, keep pace with demand for petroleum products. Secondly, and probably because of the first point, crude oil substitutes like syth oil, plant products, etc. take up an increasing share of the pie.

Now let's integrate both components of "supply."

In 1970: demand trailed supply by 4.4%.
By 1980: demand trailed supply by 1.6%.
By 1990: demand trailed supply by 0.04%. Note demand exceeded supply on average for 1981-1989.
Demand outstripped supply from 1991-1994. The nadir of this curve was 1998, when supply exceeded demand by a whopping 2%.

The 10-year moving average is for demand=supply, with crude supply falling and being replaced by less desirable substitutes. This makes me very bullish based on fiat currency depreciation.

The 5-year moving average is for demand>supply. Makes me more bullish.

The 15-year moving average has demand = total supply * 1.002 and demand = crude supply * 1.129.

Overall this picture makes me like crude oil, but be mindful of the replacements. Therefore it makes sense to grab the majors (not minors or drillers or explorations) because they have the capital to invest in replacements tech. They also have the free cash flow available for acquisitions.

Keep in mind I like to research, buy, and forget. If you like to play more short term this analysis may not interest you.

There are also lots of tax credits available for synthetic fuel producers. The IRS is currently auditing boatloads of them, because several are in it just for the tax credits and not for real production. However, if you could find one that was selling at a discount and really engaging in the business of synthetic oil production the prospects would be nice. RSC I believe is the ticker for Rex Stores Corp, they are an electronics retailer that owns their properties and is selling fairly cheap. One of their side businesses is a partnership in some synfuel operations. I found their effective income tax rate was low, and did some DD. I didn't purchase RSC however.
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[Dubious]

P/Es of major oils are rather attractive.

I invest in OIH ETF. Buy when crude is trending down and sell when it is trending up. I sold when crude broke 58. Will wait for a pullback. I hope we have a pullback because if we don't this economy is in the dumper - recession upcoming. Depending on the Petro report at 1030 I may go long or short at that time no matter what the price. Those that are playing the indexes are getting ground to powder.

Good luck all. Great thread.

[HenryTo]

World Spare Capacity from the EIA website:

http://www.eia.doe.gov/emeu/steo/pub/gifs/Slide5.gif

I appreciate all the comments that have been made on this thread. Bill has a great point - in that a lot of outsized returns have been made some of these companies like the integreted oils such as Exxon Mobil and ChevronTexaco over the years.

I have been long-term bullish on energy prices over the last year or so since we began writing our commentaries on a regular basis but I just feel the recent price rise has definitely been overdone. Note the rise in world spare capacity in oil from 2000 to 2002. It is not inconceivable that such an increase in spare capacity will occur again during the next few years - especially if the U.S. falters or if the housing bubble pops (which will severely impact the prospects of China, Japan, and India, and so forth). If that's the case, then an oil price that is below <$40 again would quickly come to fruition. That being said, $40 is still a very profitable price level for many oil companies, so if you're a great stock picker like Bill R. (who is going to be our guest commentator tomorrow evening, by the way), then by all means go for it!

Best,

Henry

[nodoodahs]

Actually I think “time is my enemy” when I’m buying tech. After all, I have no guarantee that their products will be marketable a year from now. I-Pods and Athlons and MP3’s, oh my. When I buy commodities or energy, I think “time is my friend.”

Whether $38.50 or $58.50 is the “right” price today, in two or three years we will be wishing for oil to break $60 to the downside. In five to seven years we will be wistfully thinking about how nice it was to buy gasoline for less than $3. Key to this is the fact that all fiat currencies sink, sometimes at different rates, but no fiat currency ever floats.

Any item with intrinsic value becomes more expensive over time as measured by fiat currency. Interesting thing is, the demand/supply relationship won’t be constant. Demand is growing, and whether there’s a blip here or there, month to month, in two, five, seven years from now the demand will be higher than it has been over the last year.

Supply is composed of immediately marketable supply, inventories or reserves, and excess capacity.

There is little excess capacity and what there is, is shrinking relative to demand with each passing year. When was the last refinery built? How many refineries are there in the world, per capita? How does this number compare to the per capita figure from, say, 1980? How long does it take to build a refinery?

What’s the U.S. demand for oil daily? How long would the SPR hold out if it had to replace just 10% of the daily U.S. demand for oil? Would the government deplete the SPR to help the markets (more than just the token amount they typically do), or would they save their oil for the tanks and jets?

When was the last “elephant” find of reserves made? We’re awash in oil, but most of it can’t be gotten for a profit (EROEI = energy returned on energy invested) at today’s prices. How many years will it take to deploy the technology to get this oil?

Hydrogen is a pipe dream. Solar and nuclear are viable but again, how long to wean the world away from oil? Coal is a better alternative over the next decade or so, and can be used to make artificial oil. Still, the time to structure the transition insures that demand growth will outstrip supply growth.

There will be wars for oil over the next decade. Nothing like a war to increase demand and depress supply. Especially considering that oil is priced in dollars that are printed by the warmongers. We are already at war with Iran, engaging in violations of sovereign airspace and funding of insurgencies that were considered to be, in a more naïve time (like, last century!), acts of war. We may well take action against Venezuela (again! – after all, we’ve already backed one attempted coup/assassination).

I add it all up and come out very bullish on oil, for at least the next decade. I’m currently long in CVX, two shippers, and an industrial chemical manufacturer that services the oil companies. I will re-invest my dividends from those stocks, in those stocks. I’m patient and can wait out any short-term shakeouts. I invest money I don’t need this year, or even next. I will use serious drops as buying opportunities. I may add COP next as I like it’s valuations right now.

Henry, maybe I am a little late to the party. But the way I see it, no one’s passed out yet; the SWAT team has yet to be called; the furniture is intact; the lampshades are still on the lamps; the floor has yet to be stained with either blood, vomit, or urine; in short, there is a lot of partying yet to be done.
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[pete richardson]

I have oil worth $38.50 per barrel with a reasonable supply cushion. But,
there does not appear to be much of a supply cushion, based on what
I see and hear. So, I figure you have a healthy fear premium coupled with
a speculative premium that, combined, has oil in the upper $50s.

The market is supposedly well supplied with no short outs. So, time is your enemy if you are long oil, because if the production process continues to supply the market smoothly, folks will start drawing inventory here and there and the market should weaken. But, I think
smooth transfer needs to continue for a while to settle fears down.

I would like to put a time on it but cannot. But from a technical perspective, crude is primed to blow through $60. If it does not soon,
that speculative premium will fade.

[Dubious]

Another point on this matter. Wonder why were still filling up the strategic oil reserve with oil over $40 plus? Even thou Greenspan was stating over and over and over crude over $30 was temporary. I call it noise and fact. Noise was crude under 30 was temporary and the fact was 40 is cheap.

Another point. USD was spiking and so was crude and the pms sold off heavy. Yet crude did not. PMs are not the store house of wealth anymore. Times have changes - as the tobacco reference above shows a perfect example. So must we as investors.

No worries Henry. I could be wrong but I have put a lot of research into this and I do not think so.

All of this outsourcing of jobs has helped the villagers become city dwellers is part of my thesis on this.

[nodoodahs]

A little history.

In North Carolina, at one point warehouse receipts for tobacco were in wide usage as currency, to pay for goods and services and facilitate trade. The warehouse backed the "currency" with goods, making them essentially "specie" and every receipt was a "demand deposit." Of course today's legal tender laws and fiat currency make something like this less likely to happen amongst us commoners.

However, there is no reason whatsoever that foreign governments or multinational corporations couldn't be using the same strategy as part of a currency hedge operation. Oil would be a likely place ... since the current "reserve currency" only has tradable value due to oil purchase.
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

Dubious,

Thanks, that was an interesting discussion and the concept of "storage of wealth" is a concept that is well-worth discussing and which I will think more about in the future. There is still a lot that I need to learn!

Take care and good trading!

Henry

[Dubious]

Point taken and well said Henry.

Who said we were average? Just kidding.

Sooner or later Joe Public is going to get out of the "just send it to the mutual fund" company and forget about it mentality they have been trained to do. We are starting to see that with the increase in ETFs.

If you look at the PM side of the house - the rage right now is is paper contracts. The PMCP is the poster boy for this that all are starting to copy.

Once again. Thank you for the reply.

[HenryTo]

Futures: Not for the average investor or even high net worth individuals. Futures contracts is not an easy thing to manage for most investors - even financially-savy ones. In theory, it can work but given the ability to leverage one's position, one will inevitably do something stupid with it. If one is seeking insurance against a financial calamity, then holding a paper contract with no intent to take delivery of (and no ability to store) your 1,000 barrels of WTI crude oil is hardly the way to go.

I have some gold coins as insurance and it helps me sleep soundly at night. Conversely, holding 1000 barrels of oil via a futures contract will not have the same effect. It is all psychological - in fact, this will further add to the stress if all I was interested in is a store of wealth.

Henry

[Dubious]

Sure beats the spread to sell pms, storage fees, insurance and security needs.



Some of these fleece outfits have 30% spreads.

Mr No you understood my thought process - thanks.

[nodoodahs]

Henry,

Wouldn't a futures contract for the oil be both easy to store and liquid?
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

Dubious,

That's an interesting concept but a concept which I have a hard time envisioning. Sure, in terms of industrial and commercial uses, oil is much more valuable than gold but what about as a store of wealth for retail investors? Not too great mainly because it is both too hazardous and too difficult to store. For a wealthy family, 1000 gold coins is easily storeable, while the same equivalent value of oil would be nearly 7,500 barrels - or over 300,000 gallons. This wealthy family could also buy an oil well out here in Texas but the liquidity of such an asset is questionable - especially if oil prices plunge from here and oil prices subsequently decline below recovery costs.

Henry