The 'Experts' Are Wrong About Oil Prices

Source: Kent Moors, Oil & Energy Investor  (9/4/12)

"Their argument is deceptively simple—with all of shale oil coming on the market, there will be an oil glut in the U.S. Gluts naturally depress prices. And those pounded-down prices will force companies to fold. Unfortunately, the argument is both simplistic and wrong."

Last week, I began pointing out the flaws in the latest "doomsday" predictions about oil.

There is a more serious, genuinely misguided, and dangerous element to what has been masquerading as "analysis" out there.

Those more than likely fronting for another short run on the oil market have been preaching an explosive misconception. These pundits once again preach that an oil pricing collapse is coming.

And with the crash supposedly comes the demise of many oil companies.

Their emphasis is on newfound unconventional oil reserves. Their argument is deceptively simple—with all of shale oil coming on the market, there will be an oil glut (oversupply) around the United States.

Gluts naturally depress prices.

And those pounded-down prices will force companies to fold.

Seems straightforward enough. Right?

After all, there appears to be a kernel of supply and demand in there somewhere.

Unfortunately, the argument is both simplistic and wrong for three fundamental reasons.

Reason 1: Capital Investment Isn't Driven by Market Volume

First, the volume side of the equation does not determine investment and company capital applications. That there may be large reserves in the ground means absolutely nothing if oil and gas are not extracted.

The lifting rates are determined by the market balance between supply and demand.

That balance essentially gives us the market price, not the amount of black gold in a conventional deposit. . .or shale, or sandstone (tight oil), or an oil sands field. What all knee-jerk reactions to the oil market always miss is this single overriding principle.

Capital investment actually determines the market volume of a raw material.

Now, when this is applied to oil, the next statement follows. The availability of reserves is only one aspect in determining price; however, it is not even the most important factor in the equation.

The balance between supply and demand is determined by the decision to produce. Absent a spike in demand, operators will restrain additional production to maintain price levels.

That has absolutely nothing to do with how much could be lifted. Profit motives determine extraction rates, not Mother Nature. . .or deliberate manmade gluts.

Reason 2: Unconventional Sources Are Replacing Conventional Reserves

Second, much of the domestic unconventional oil production is replacing conventional imports, not supplementing the existing oil flow.

There are two aspects here. One is a "national security" argument—by relying more on domestic production, the U.S. reduces the need to be dependent upon outsiders. That several of these producers also don't particularly like us makes reliance on importers a riskier prospect.

The other, however, goes in a quite different direction.

This speaks to fueling an economic recovery. The main reason we became dependent upon imports was a direct one—price. It provided cheaper oil and cheaper energy remains a primary ingredient in strengthening an economy.

This latter aspect is decisive in the matter we are currently considering. Reliance upon domestic shale and other unconventional production is more expensive. It costs more to produce, uplift (this is heavier oil on average and requires synthesizing), move and process.

In addition, the bulk of the infrastructure required to increase the domestic reliance is not there yet. An expansion of that infrastructure is a multiyear series of expenses that will be passed on in the price at the pump.

Now, to be clear about this, there is a prospect (a good one) that the U.S. market will become less dependent upon imports. Within the next decade, we are likely to see that market move toward self-sufficiency. What imports are required (perhaps as little as 30% of what is consumed daily) will come from Canada.

But none of this will result in cheaper oil products for the end user. The essential premise of the "Chicken Little" approach must rely upon the glut + overproduction = price collapse equation. That is not going to be the environment as we move toward greater reliance of new oil sources.

Reason 3: Prices are Determined Globally. . .Not Just by U.S. Production

Finally, every TV pundit predicting a price collapse regards the U.S. market as somehow a closed system, one for which a "Fortress America" solution is required.

Trying to build walls is a waste of time, energy and money. This is a worldwide market, prices are determined globally, and the primary ingredients in that pricing are neither American nor European.

We cannot insulate the U.S. oil market from what occurs abroad, even if we increase the domestic component.

To argue that companies are too stupid to regulate their own production, which might lead to a market collapse, is both simplistic and dangerous.

It is also based upon a patently false scare tactic.

Their argument centers on this notion that the U.S. government does not allow the export of domestically produced crude. That means oil company profits would somehow become hostages to their own production. Forgetting all that we have touched upon above, the misconception of the argument profoundly misleads investors.

But this is how the export situation will really play out.

Currently, federal regulations allow the export of heavy California crude production. It requires that a company demonstrate the production could only be sold domestically at deep discount.

That is already taking place. In addition, "tolling" is now allowed. This is a system where crude is exported in return for the import of processed oil products. Both of these practices will be extended early next year.

This does not mean we will avoid cycles of price declines (such as the most recent 21% decline between early May and late June). When this happens, however, especially in the overreaction experienced this summer, it expresses concerns on the demand side and not the supply side.

And it certainly was an overreaction, an emotional misreading of headlines. The price went down because of recessionary fears on the horizon (once again, overreaction), not because of a glut in the oil market.

Kent Moors
Oil & Energy Investor