Posted by: lentinman Date: Wednesday, August 22, 2007 7:16:55 AM In reply to: None Post # of 108880
MAJOR PREDICTION #3
Oil will drop below $40 (dollar-adjusted) sometime in the next 3 years.
Obviously, oil has been around $70 ($69.84 as I type this) for two years since Katrina. It has been over three years since oil was under $40. It has been under $50 just once in the past 2+ years and that was about 5 cents for about 5 seconds. And, of course, the world is entering a new era. And, let's not forget "peak oil" So, if my prediction were to come true, it would defy the odds – to put it mildly.
Of course, in order to make this prediction, I must factor in the value of a dollar. My prediction is based upon today’s dollar. If the dollar dropped 20% then oil prices per dollar would go up 20% to be equivalent. So, when all is said and done, the depreciation (or appreciation) of the dollar will have to be factored into this prediction. To value the dollar, I will base it 50% on the Yen and 50% on the Euro. At this moment, the Yen is 114.97 and the Euro is 1.3481.
However, if the dollar doesn’t change value, then $39.99 is my prediction. Why?
It is all about supply and demand. If it weren’t, I would be an even bigger fool to make this prediction than I probably am anyway. It’s clear to me that the event risk of some middle east crisis is very high. We (or Israel) could EASILY invade, or bomb the crap out of, Iran within the next three years – if not three months. Iran would likely attempt to cut off the Strait of Hormuz and oil could go to $150 bbl. It is a risk. It could happen. But, if it happens soon enough, oil could still get back to under $40 before three years is over.
We can all conjure up scenarios where oil prices explode. But, in the long run, it is all about supply and demand. My basic argument is that supply will increase and demand will decrease.
DEMAND SIDE OF THE EQUATION
Why do I think demand will be less? Well for starters, a U.S. recession (or something similar to it) - due to many factors that have been discussed numerous times on this board - will lead to lower demand. Last September, I explained what happens to demand during a major recession. Here is the post http://investorshub.advfn.com/boards/read_msg.asp?Message_id=13189434. The moral of the story is that I expect world wide demand to drop 4M bbls per day if the U.S. goes into a major recession. I’m making the assumption that the U.S. will drop 2M bbls per day and the rest of the world another 2M. Considering world oil demand is over 70M bbls a day it is easy to conceive demand losing 4M to a U.S. recession coupled with a slowdown in the rest of the world. If the US drops 2M, that would represent roughly the average percentage drops of other major US recessions.
It is a misconception that oil demand is increasing substantially – largely due to China. It isn’t. China has increased demand, but China's increased demand is still just a fraction of the world. Additionally, part of my prediction is predicated upon a retraction in China's growth beginning around next year's Olympics. Their present demand growth (small as it is in world-wide terms) could come to a screeching halt if this unprecedented double digit growth comes to a screeching halt. China is in an unsustainable bubble and it WILL come to halt at some point.
The US, Japan, Europe and China are the biggest users of oil in the world. Here is a table showing demand for the last 4 years.
2004 2005 2006 2007 US 20731 20802 20588 20722 Japan 5291 5305 5159 5260 China 6440 6720 7270 7530 Europe 15487 15592 15562 15601 47949 48419 48579 48573 Where is the increase in demand?? At best, it is barely perceptible. What’s more, this is during the greatest worldwide expansion in history. The U.S. not only hasn’t had a recession in quite a few years, but the markets have yet to have a meaningful correction. Employment in the U.S. is at historic lows. We have had a worldwide asset bubble, the likes of which the world has never seen! Yet, demand has barely budged. Imagine what demand will do when the world contracts!
SUPPLY SIDE OF THE EQUATION
This one is simple. The increase in price per barrel of oil has caused production to increase. That’s a no-brainer. It may be true that the average production per well is less than it used to be, but there are so many more wells being drilled that it more than makes up for it. World oil production has increased over the past four years (see below).
2004 2005 2006 2007 72224 73791 73546 73282 Don't be misled by 2007. The most recent months available (April and May, 2007) were both higher than the same two months in 2006. Clearly, world oil production is not in decline. Additionally, more and more effort has gone into production that will pay off in the years ahead. Oil production, especially deep sea drilling, yields the highest production, but it is something that takes years to develop. The world has not yet, IMO, felt the benefit of increased oil production from deep-sea exploration due to $70 oil.
In the months after Katrina, I bet Bobwins that the U.S. would increase oil production month over month beginning with January 2006 versus January 2005. The actual bet was that the U.S. would increase oil production at least 10 of the 12 months of 2006 from the same month of 2005. I lost that quickly as the first three months of 2006 were below the first three months of 2005. But, I was just early. U.S. oil production has increased over the previous year’s same month for 10 of the last 11 months. That is a trend I don’t expect to see end anytime soon.
One other issue to look at is Canada. This is critical for two reasons – 1) They are our neighbor and the best place to get oil if we can’t get it elsewhere and 2) Oil sands. The oil sands have more potential oil than the middle east. Better technologies are being developed to bring more of it to the market than ever before. There are many potential pitfalls, but the fact remains that Canada INCREASED their production of oil in the most recent 12 months by 6% over the previous 12 months. At some point, this could have a significant effect on total world production.
Lastly, Russia - the big dog on the block. Russia has passed Saudi Arabia as the world’s largest oil producer. Russia has massive oil reserves and they continue to grow their production at extremely fast rates. In slightly less than 10 years, Russia has increased their production a staggering +63%! Here is their decade of production (2007 is seasonally adjusted).
The other aspect of supply is the issue of reserves. The U.S. has roughly 700 million barrels in the Strategic Oil Reserve at all times. Capacity is 727. The U.S. wants to increase capacity to 1 Billion, but that takes years. In the meantime, apart from modest increases from time to time, the U.S. is at full capacity – a goal established when GWB took office. Japan, owner of the world’s second largest reserves are also at virtual capacity.
In 30+ years, the total amount of oil drawn from the SOR is 60 million barrels – 1/10 of the existing reserve. The ability of the SOR to compensate for any unexpected shortfalls is substantial. That doesn’t mean oil prices won’t go up in an "emergency", but just as the last time there was a draw down (Katrina, 11 million bbls) the price of oil went from $70 to $55 just 3 months later.
Even beyond the Strategic Oil Reserves, the DOE stated on August 10 “at 335.2 million barrels, the U.S. crude oil inventories remain ABOVE the upper end of the average range for this time of year.” It’s a simple fact. We’re swimming in oil and the present price of oil is artificial.
I’m not completely sure what is propping up the price of oil, but I don’t believe it can last. The biggest issue is the world economy – most specifically the U.S. economy. The second biggest issue is the dismissal of the widespread belief that even with the world economic boom that oil demand has been increasing substantially. The third biggest issue is that world production is increasing and likely to increase at a faster pace over the next few years as $70 oil investments come to fruition - especially in Russia and Canada. And, the fourth biggest issue are the large reserves.
Should the U.S. economy slip into a recession, oil prices will begin to drop precipitously IMO. Saudi Arabia may be used to $70 prices, but they will not be able to decrease production to increase the price for political reasons. If the U.S. economy is suffering, the pressure on Saudi Arabia to maintain production will be enormous. In fact, pressure may be on them to actually increase production to lower the price enough to help pull the U.S. out of recession - the carrot being future $70 prices.
This is a difficult prediction because 1) nobody (or almost nobody) believes oil will drop to $40 (or below) ever again. 2) both supply and demand are moving targets. 3) geopolitical risk is extreme.
Nevertheless, the fundamentals are simply not there to justify prices anywhere near this high. I would not be surprised to see oil settle around $50 sometime in the next three years and have some spike down of under $40. Thus, my prediction.
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