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Musings on the Price of Oil

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By NorthCarolinaKen
May 12, 2008

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In April of last year, crude oil was $65 a barrel, about 50% of today's prices. What happened in one year to cause crude to double in price? On May 8th, 2008 The On-Line Wall Street Journal ran a poll of economists on the subject. 51% responded that the current price is due to supply/demand imbalances caused primarily by India and China. 11% suspected it is another bubble. Did China and India double their GDP over the past year? If so, I missed it. What I read was more like 10%. The visceral discomfort with what the experts are saying is similar to my feelings in 1998-2000 with the price of tech stocks or more recently, the price of houses. It is true that "they aren't making any more land" and "they aren't making any more oil either" but if a market gives me butterflies I avoid it and invest elsewhere. So far, that has worked well for me but recently the market and my investments have been moving inversely to the price of oil which has forced me to take a closer look at crude.

Historical Perspective
Actually, I am old enough to have been an investor during the late 1970s and early 1980s in the last big surge in the price of crude. Much of what is happening today is the same. The price of crude in 1980 in 2008 dollars was about $100/barrel, just a bit under where we are today. The rhetoric was also similar with the so called experts never more accurate with their predictions than a random number generator. "The End of The World is Near" people were out then as now as with all the angst over "peak oil" and running out of it. The real lesson out of the 1980s is that an investor had best not rely on the views of "experts." The size and sheer complexity of the situation defies simple answers and the hidden agendas of the respondents confounds their messages. I have no claim to expertise here except for having lived for a long time, having done some computer technology work with oil companies, investing in some of them and hopefully still having enough horse sense to tell the difference between a bread box and a barn.

In historical retrospect, the 1980 spike in oil pricing is well understood. It was a classic supply/demand imbalance. It started with the Yom Kippur war in 1973 when Syria and Egypt simultaneously attacked Israel. The American support for Israel drew massive anger from the Islamic peoples world wide as there were strong feelings about an Islamic nation transcending borders and boundaries as a single entity and a strong motive to recreate the golden age of Islam. The Islamic oil producing nations began withholding oil from the US and in the intervening years, they formed the OPEC cartel to enforce what they viewed as weapon to control American foreign policy. The second blow was the Iranian Revolution in 1980 that cut off the oil supply from one of our closest Middle East allies. Finally, our own government delivered the coup de grace with price controls in an attempt to cut off runaway inflation. This was a foolish error in all venues, but particularly with oil. The US is a major producer of oil. In terms of reserves we are number 11 worldwide but in terms of production, we are number 3 today behind Saudi Arabia, number 1 and Russia. We produce about 60% or so of our own consumption. Price controls in 1980 blocked investment in oil and in particular the application of new technology to pull more crude out of mature fields. As a result, US output dropped and the price of crude soared to its $100 peak.

Oil consumption is not flexible. If you drive 50 miles to work you have to do drastic things like sell your house, leave your job or downsize your car to have any effect on your gasoline consumption. Changes of this magnitude do not happen quickly and as a result, a price spike has little effect on demand, contrary to another band of "experts." In 1980, the result was catastrophic. Getting gas in your car was the most important thing and dominated your week. Gas lines could be two miles long. People pushed their cars to avoid losing gas idling. Gas was often rationed and the pumps cut off at 5 gallons. Gas stations often had no gasoline to sell anyway. In a situation of imbalance between oil production and consumption, there is no question about it. The effects are not subtle.
Paul Volker as Chairman of the Federal Reserve broke the back of inflation by raising overnight rates to 15% or so, throwing the country into a deep recession. With inflation subdued, price controls were lifted. Internationally, the OPEC cartel set quotas according to their hearts but pumped oil to satisfy their stomachs. Food on the table was more important than pan Islamic idealism and OPEC pumped oil to meet demand. Saudi Arabia, always the cool head in the oil business, worried about the long term effects of high prices forcing the kinds of fundamental sociological changes that reduce requirements. Whenever supply dropped below demand, they pumped to make up the difference. The result was oil prices that averaged $25 a barrel for 20 years to 2003, dipping as low as $11. Oil is and always has been a boom or bust business. At the low points, many exploration and service companies went bankrupt. The "windfall profits" are a reasonable reward for enduring the busts in my view. The booms are short and busts are long.

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