Three Factors Point to Higher Oil Prices

Source: Kent Moors, Oil & Energy Investor  (9/18/12)

"The problem is that prices are not just reflective of new supplies, either too much or too little. By focusing only on how much is there, these analysts fundamentally provide a distorted view of the market."

Marina and I are leaving for London in a few hours. On this trip, I'll be giving two high-profile briefings on the Iranian oil sanctions — briefings that have had some significant revisions demanded by the recent unrest in front of American embassies and consulates in the region.

Friday's OEI will arrive the day after I finish briefing Persian Gulf ambassadors at a private dinner hosted by Khaled Al-Duwaisan, the Kuwaiti Ambassador in London and the dean of the diplomatic corps at the Court of St. James.

More on what happened when I write to you next time.

Today I want to focus again on oil prices. It seems that some TV pundits have never heard (with apologies to Alexander Pope) that a little knowledge is a dangerous thing.

Some people on Wall Street believe that by scaring the individual investor they stand to make a greater profit for themselves. Over the summer, there was a report issued by Credit Suisse that said that oil could hit $50 a barrel. We've seen predictions on CNBC saying $40 a barrel. Some people think that is could even go further.

What I am telling you now is that these views do not reflect the actual market, the new reality in which we now find ourselves.

A lot of this sentiment stems from the view that we have now increased our supplies here in the United States. Some political candidates said that they guaranteed "$2.50" per gallon gasoline if they were elected. "Drill, baby, drill" became a national catchphrase.

The problem is that prices are not just reflective of new supplies, either too much or too little. By focusing only on how much is there, these analysts fundamentally provide a distorted view of the market.

Yes, the rise of new sources has altered the prognosis. But so has the rise in demand globally, at a rate much faster than anticipated. In fact, the impact of the unconventional oil (like our huge sources of shale oil) is now projected to be less than expected, even with additional volume coming on line.

And one report issued last week reflects that fundamental view and explains why oil prices are set to rise, not fall in this age of expanded unconventional oil and gas.

The Fundamentals Are What Matter
I want to introduce you to a company called Bernstein Research.

They are regarded as the top energy research company in the world by their institutional investors. They're in 40 countries. They win awards every year for having the best analysts in the sectors they cover.

And they are very successful in their forward focus because they emphasize the fundamentals.

Last week, Bernstein Research released a detailed report reflecting the position I have been holding for some time. In the 180 pages, one of the best oil analysis teams in the business concludes oil prices will be rising to $158 on average for Brent in London, and about $153 for West Texas Intermediate (WTI) in New York before the end of the decade, with a concerted upward trajectory kicking in early next year.

And that's just the average price.

Spikes will carry it much higher. As an example, as I write this we are at more than $117 per barrel for Brent and more than $98 per barrel for WTI. Yet the annual averages for each are currently about $105 and $82.

The report also flatly dismisses the protracted effect some television pundits think is coming from shale oil. While it will have a much more pronounced result in North America, the unconventional will have a more subdued effect on prices elsewhere in the world. The estimate is that the overall impact of the "new oil" will comprise only 3.2% of worldwide supply at the beginning of the next decade, with most of that being in the U.S. market.
Remember, this is a global market.

Global demand and availability determines price, with that price translated to the market by the dominant benchmarks – Brent and West Texas Intermediate (WTI).

This is not simply a question of how much supply is available. Three more fundamental factors influencing an upward price move.

Three Factors Pointing to Higher Oil Prices
First, demand continues to rise in those parts of the world most directly effecting price. Those areas, as I have noted many times before, are not North America or Western Europe. They are also markets in which unconventional oil will not have an effect for some time.

Second, the presence of shale oil does offset supply concerns in North America. But is also does so by increasing the overall cost of production. The market effect per barrel of shale oil extracted will still increase the price of the crude. The cost of producing that barrel and the associated to-market costs is known as the marginal price of oil. In fact, Bernstein Research says that the average marginal cost of oil around the world today is $92 a barrel, and is set to rise because it is more expensive to lift, process, refine, and distribute these new sources of crude oil.

Finally, the pricing dynamic is also about the regionalization of supply for both crude and refined oil products. As we move toward 2015 and beyond, the demand curve will dictate pricing premiums for regions where imbalances of supply are present.

The prospect is there for new sources, but the costs being passed down the line are extraordinarily high.

Of course, it still makes sense to one way of looking at oil – the "simple is as simple does" approach.

Simply put, oil prices are on the rise, and one of the most reputable research firms in the world are backing up what you and I have known all along.