Street Capitalist: Event Driven Value Investments

There are many oil bears who are expecting that Saudi Arabia’s new production plans will save us from the $150 oil plaguing our markets today. This is just wishful thinking. The Saudi plans are bold, there is no doubt about that. They are calling for 12.5 million bpd by next year and I believe they have the capacity for it. Even with such bold estimates, it wont be enough to bring oil back down to the $60 per barrel prices that the bears are longing for.The latest issue of The Economist sheds some light on why a production increase may not be enough:

The trouble is that it cannot manipulate markets as before. The kingdom has a fifth of known reserves. It supplies an eighth of the world’s oil and remains, crucially, the only producer with at least some spare capacity. A huge investment plan under way should raise its capacity from 11.3m barrels a day in 2007 to 12.5m by next year. Noting pleas from George Bush and Ban Ki-moon, the UN’s secretary-general, the Saudis have upped actual production twice in the past month, raising it by 500,000 barrels a day to its present level of 9.5m.

But much of that new output, and most of the reserve capacity, is in the form of heavier oils that are costlier to refine and for which there is less thirst. The Saudis are unlikely to bring new, lighter crude, or bigger refining capacity for their heavier oils, onto world markets until next year. Even then the incremental rise may not offset demand. So energy watchers hope the Jeddah conference will reveal something bolder than promises of more oil.

The puzzle of oil production (The Economist)

Currently, the excess capacity that the Saudis bring to the market will only serve to fill in the gaps left by decreases elsewhere. Specifically, in African nations like Nigeria and Angola where rebel activity is driving oil production down to 25 year lows. Recent attacks on a Chevron pipeline will be cutting its oil output by 120,000 bpd while Royal Dutch Shell is saying that they wont be able to make their previous 250,000 bpd delivery after a raid on their Bonga field.

Why are the Saudis even bothering to raise production? What do they really gain from more supply being brought to the market? There is a general worry that high oil prices will end up hampering economic growth and stem global demand for crude. Many emerging market nations employ fuel subsidies which drive their citizen’s consumption of crude upwards. China recently announced that they will be cutting some of their subsidies on gasoline and diesel, this will raise its public costs by 17% for gasoline and 18% for diesel which should help a little. If other nations follow suit, we should see a fall in the price of oil - but that hasn’t happened so far. Such a fall would be disastrous for Saudi Arabia because it would cut the value of their oil holdings by billions. This money is necessary to fund the kingdom’s bold economic city projects.

One possibility, that may drive prices down somewhat is if other OPEC nations follow suit and pump more oil as well. The problem with this is similar to the Saudi problem though. Iran has been trying to flood the market with heavy crude that it has kept in storage since mid-may, but this typically contains more metal and is harder to refine. The demand is less for this kind of crude partly because of a lack of refineries globally. Other nations are on the fence, debating whether or not our current oil troubles are a result of demand or speculation - this squabbling slows any kind of collective action by OPEC to address the problem that we’re facing right now.

My current belief has always been that speculation is not the cause of the price increases that we’re seeing. I will concede that there may be a slight speculative premium to oil, but not a large one. We wont go back to the $10 oil of 1999 by simply reducing the amount of speculation. As a result, lawmakers would be better off focusing on ways to promote the production of alternatives to oil so that crude is less of a problem to begin with. This kind of action has a definite future value, while conversely, the speculator witch hunts we’re seeing seem to be less based in facts and more grounded in manias and panics.