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Why Prices Will not Fall Under $60 Again

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By madamebutterfly1
September 1, 2006

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retiredb4age55 asked whether there are strong arguments to believe that prices will not fall below $60/B again.

First and foremost, I don't think anyone can answer that question with absolute certainty, because "again" implies "never", and "never" is a long time.

However, if you were to ask me do I think prices will fall under $60/B this year or next year, I will tell you with a high degree of certainty that it is not likely that prices will fall under $60 this or next year, or even the year after that. In fact, in all probability prices will move above $70/B again by the end of this year, and may likely stay there at least throug 1Q07, especially if we have a harsher winter.

But even without a harsher winter, world wide demand for oil continues to grow even at prices which have averaged this year well above $60/B.

Do I think prices are likely to fall under $60/B in the next five years? I doubt it. I think that when you look at the supply/demand balance down the road one has to conclude that there are likely more chances for prices to move up than to fall under $60/B.

One has to realize that much of the production that is coming onstream in the next five years was developed at a time when prices were much lower and with a vision of future demand where the growth profile was anticipated to be much less than it has been in the last five years.

In other words, the idea that there was going to be hardly any spare crude capacity left eas not in the minds nor in the radar scope of most oil executives. No one expected the brutal demand increase that has occured in China, India and in developing countries in Asia.

If one looks back over the last 20 years one will notice, I believe, that there is not one year where net production increases have exceeded demand, and definitely not one single year has shown net production increases above 1.5 million barrels of oil per day. And why is this important?

Because demand over the past 5 years has been increasing at an average rate well above the average new net production -- which has been less than 1 million barrels. This event alone caused the comfortable crude spare in existance just a few years back to dwindle to under 1 million barrels per day last year. Price increases have been the only mechanism available for the markets to bring supply and demand into a semblance of balance. We have been operating at over 98% of capacity. At such level any little interruption of supply gets magnified as evidenced by the spikes in prices we've seen lately.

So unless, there is a significant ramp up in net production capacity, it is difficult to foresee how sufficient crude spare capacity can be re-stored to return the markets to a lower price plateau.

Unlike the price collapses of the past that occurred once artificially imposed constraints in supplies were removed, today, the price hikes have been caused not by artifical constraints but rather because of very strong demand pull effects-- effect caused by a booming world wide economy.

So unless someone can assure me with certainty that we will enter into a steep recession in the next five years, I just don't see significant price reductions to the end of the decade.

It is true that some argue that through 2013 a series of new production fields and LNG fascilities are "supposed" to come on stream which theoretically will expand energy supplies substantially.

I used the qualifier "supposed" because while on paper everything looks good, there are a number of issues that need to be considered. First among which is the likelihood of "delays". Delays that will occur for a multiplicity of reasons; lack of spare parts, equipment and skilled personnel just to name a few of the least serious causes.

But on the more serious and dangerous side for the longer term prospects of expanding supplies is the likelihood that there will be many other delays because of disputes with hosts governments regarding contractual issues and expanding access to resources.

This very thing is happening today with many projects in Russia, kazakhstan, Venezuela, Chad, Nigeria, Ecuador, Bolivia and others. For crying out loud it is happening in our country, also. We are not giving access to the oil companies to explore in our continental shelf nor in Alaska. And even the issue of bringing known gas reserves to the lower 48 states through the building of a pipeline, is being delayed in Alaska because of disputes between the governor and the legislature regarding the appropriate incentives to grant the builders of the pipeline.

So while many projects being developed in these countries look "good" on paper and assume a continuing expansion of already known discoveries, the crude reality is that these very projects may get significantly delayed or scrapped as a result of geopolitical difficulties.

If one just scans recent news items one will notice a resurgence of nationalism among producing countries which are demanding re-negotiation of old contracts, and is threatening the legal framework under which companies committed huge amounts of capital. If this legal structure is shaken, it is anyone's guess what will happen to future project expansions that were already in the planning stage.

I predict that all of this legal uncertainty that is being created is going to cause many companies to have second thoughts about pouring significant capital into these less friendly regions. And these events suggests that there will be significant delays down the road in expanding production in some of these places-- this will impact production growth after 2013.

In addition to these realities one needs to consider and even harsher realy and that is that large producing provinces like the North Sea, Alaska and Mexico are in steep declines -- and there is no way to reverse it.

On average the world is ineluctably losing between 3 to 5 million barrels every year of producing capacity because many of the large fields have already reached maturity, and are in irreversible decline. And as the production base increases, so will the losses due to production declines.

All of this suggests that we cannot expect a world where there will be ample supplies of spare capacity in the foreseeable future.

Consider also other factors. Aside from some of the geopolitical factors that I have mentioned, there is indeed a very near term factor that may cause the world a lot of headache. It is called Iran.

Iran has threatened some kind of retaliatory action if sanctions are imposed to prevent it from acquiring nuclear enrichment technology. The next few days or weeks are going to be interesting. This alone suggests that prices may go through the roof and so will oil company stock values.

Then you have a second order problem.... Iraq. If we stay, there is no guarantee that we will see positive results soon. If we leave, I think it is going to be disastrous and we don't know who will take over the government and the current production of 1.8 million barrels per day.

So if I were you, I would see whether stock prices of oil companies, and specifically xom, will fall a little more, but I would not more than a few weeks to decide.

I think investing in xom is an unbeatable combination of growth and security. If you look at a few statistics you will become convince.

I will mention just a few to give you an idea of the superiority of xom's performance vs other oil majors.

2005 net profit margins for the top 5.

10.6% ExxonMobil
8.6% Shell
8.1% Conoco-Phillips
8.0% BP
7.4% Chevron

Return on Equity

37.8% ExxonMobil
27.9% Chevron
26.9% Shell
26.6% BP
25.8% ConocoPhillips

If you want to further educate yourself go into xom's web page and look at the presentations they made to both the analysts in March and to the Shareholders in May. You will clearly see how in various peformance indeces xom gap between its competitors rather than diminishing, it is growing. Exxon has developed a set of competitive advantages that are difficult to emulate, and you can see it in its superior returns vs all its major competitors.

One final thought. I have worked in xom for over 23 years. I have worked in their planning group. I will tell you that the care and in-depth analysis they perform in every project is just short of amazing. Exxon is a very careful investor. If you look at they way they invest they invest using risk analysis and portfolio theory to ensure that no single event would damage the company significantly.

They are the only company I know that has had a triple A rating from Moody for the past 85 years. No other oil company has had a record like that. This tell you that investing in xom is as secure as investing in bonds with the added advantage that you also gain the upside of owning a stock. Just thought I would metion this also.

Hope all of this helps.

Madame Butterfly


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