The Tycoon Report

Oil, Oligopoly and Inflating Your Tires

Editor's Note: In today's issue, we're featuring an article written by Tycoon Report reader "Merlin."  It's an exceptionally reasoned and professionally presented piece that we hope you enjoy.  Please feel free to let Merlin know how you feel about his article by leaving a comment or, better yet, write your own!  Enjoy.

Both the wife and I have been involved in oil and gas since 1978 in one way or another and I still struggle to create a reasonable equation to quantify an expected/appropriate crude price and the correlation of crude prices to traded production company stocks. However, when considering the US price of crude there are a number of components that must be understood separately from both short and long term perspectives.

Long term -

1) OPEC is an oligopoly. As such OPEC has a dominant impact on the world price of oil including the ability to substantially inflate and generally set the international price of oil.

2) Developing countries including China and India are becoming more mobile and current technology points to Crude derived sources of power for those needs.

3) Changing currency valuations impact the price of imported crude.

4) Trade imbalances contributed to by massive oil imports impacts US currency valuations creating a perfect storm.

5) As long as this Oligopoly exists supply and demand only impacts short term pricing as OPEC merely adjusts supply to support its price objectives!

6) Time, technology and capital are required to create, develop and implement alternative energies.

Short term—

1) Both Crude inventories and gasoline/diesel inventories do have separate supply and demand pricing impacts.

2) Short term supply and demand impacts on price are limited to the lag time required for processing and delivery of OPEC controlled crude.

3) Recent decreases in the price of crude futures and pump prices likely are only indicative of domestic inventory surpluses arising from recent consumption decreases.

4) It is probable that inventory decreases will occur as we realize an OPEC adjusted production transportation time line of imported crude planned to cause a return to recent price highs.

The important word is Oligopoly. For a real world concept of the impact this has on free markets I would suggest you review the Simplot Potato futures and Hunt Silver futures stories where effective control of a commodity was cornered. We however, lack legal means to break OPEC’s position in crude oil and must resort to supply demand methods.

A recent comment by an OPEC oil minister says volumes. The comment was that OPEC had adjusted the price of crude to allow for revenue they would not receive from Ethanol replacing gasoline in e-85. The power of an oligopoly is in its ability to both adjust price it will sell for and volumes to justify their desired price from a supply and demand perspective. To suggest that the current drop in crude oil prices is similar to the burst of dot com or tech bubbles of the past misses the fact that at least for now, OPEC not free markets determines the price of this commodity.

According to this link http://www.infoplease.com/ipa/A0922041.html total world production by major producing nations is 61.47 million BBL per day while total US consumption is 20.59 million BBL per day or roughly 33.5% of world production. But, OPEC controls 61% of the production other than US and Canada. These numbers show explicitly why OPEC has the power to dominate crude pricing.

The falling value of the dollar is a component of the increase in crude prices. Since January of 2007 the value of the dollar has declined about 16% relative to most currencies. It follows that about $20 or 30% of the increase in crude price in that time period ($52 to $125) has been from OPEC’s attempt to normalize exchange rates.

There are those that would blame the Speculator. If you’ve ever owned a futures contract on the 3rd business day before day 25 of the month prior to the out month you understand that supply and demand steps forward and sets the price you will deliver or pay for crude and you will accept the difference between that price and your contract as your gain or loss. The price that filters through to the consumer is market based!

Then there is the group that blame “Big Oil” for high crude prices simply because they reported big earnings. They would impose “Gotcha Taxes” on Big Oil or even nationalize Big Oil. But, if you actually read ExxonMobil’s 7/31/08 10K only 19.8% of the billions they earned in the last quarter is domestic and nationalizing a multinational oil company is a trick that not even the Messiah can accomplish!

Further, unlike McDonalds that orders food today for tomorrow’s customers, oil and gas investments are made today for returns years, even decades in the future. There is a resulting timing mismatch of revenue and true expense as proper accounting does not include factors such as the time value of money in those investments or the many indirect and corporate financing costs that are expensed as incurred.

While media is quick to report record ExxonMobil revenue numbers, I never recall hearing The New York Times or MSNBC reporting record Capex required to replace current production and consumed reserves. What makes this complaint laughable is that simply chopping “Big Oil” up into smaller chunks would seem to satisfy their complaint.

Because the Oligopoly controls the world oil price, domestic production and even e-85 pricing mirrors that price. If refiners attempted to pay Canadian and domestic producers less than world market crude oil prices, their products would simply migrate to other world markets. Unfortunately, those that argue the price of crude should be $80 or less, base their logic on a free market premise, not reality.

Brazil has established by example that the OPEC stranglehold can be broken. Since the early 90’s they have moved from 85% dependent on imported crude to 15% imported crude for their energy needs. In their case it was accomplished in large part by an Ethanol based solution. The result has been key in creating the vibrant economy they have today.

It is important for us to realize that decades would be required to adjust our infrastructure and transportation modes to a base that is not dependent on crude while only years are required to mitigate the OPEC grip by exploiting our own resources.

Media and other pessimists site data that the US has only 1.7% of the world’s oil reserves as grounds for returning us to cave man status. However, this number fails to include probable Bakken reserves of as much as 500 billion BBL and estimated Colorado/Wyoming shale reserves of 2 Trillion BBL. These two resources alone approximate the entire 1317 BBL world proved reserves without even considering the offshore and ANWAR reserves!

While the brain trust in DC stonewalls and pontificates on drilling off-shore and in ANWAR about a dozen small E&P companies are developing a long known field in ND/MT/SK with new technology. Today companies like EOG, BEXP, NOG, WLL, KOG and CLR are bringing wells with 2,000 BOD production on line. They are sitting on millions of acres of non-federal leases and are rapidly moving additional rigs into the area.

The pessimists argue that off shore and ANWR prospects wouldn’t be on line for 7 to 10 years as if to suggest that we’ll all die of global warming by then and it won’t matter. The facts are that production of new fields ramps up over an extended period depending on additional geological studies that are needed before selecting a location and drilling. ANWR would be producing at 60% of peak within 4 to 5 years and many off shore locations adjacent to existing production could be producing within 12 to 24 months.

The fact remains that while very long range solutions to our energy requirements point to alternative technologies many of which remain to be created, immediate solution lies in infrastructures already in place and the reserves we already have identified. We have the ability to return energy prices to free market control, but everyone parking their car for 7 years or everyone inflating their tires while the government mandates a solution accomplishes nothing.

While charts may tell us that the next out month (September) crude prices are down, it is the charts of inventories that say why they are down and are the trading cues. The long range picture is far more complex and absent actions in Washington to facilitate breaking OPEC's grip by increased production, higher crude prices with all its ramifications are a certainty.