Stocks - August 2008

Those Evil Speculators It’s now quite stylish to blame speculators for the rise in oil prices. That sure lets everybody else off the hook, doesn’t it? Well, speculators may have a minor role on short-term price moves, but to blame today’s high oil prices entirely on speculators holds no water. It may be a beautiful theory, but it’s about to get mugged by a gang of brutal facts.

If you’ve paid any attention at all to the recent circus in Washington that posed for hearings on energy, you witnessed a case of finger pointing second to none. What a bunch of fools they must believe we are — and to some degree, they’re right. The average American really doesn’t know too much about the dynamics of the oil and gas business. And they apparently don’t want to know too much, as they are very busy watching such things as Dancing With The Stars! or keeping up with Brad and Angelina. That level of ignorance and apathy has set the stage to allow our elected politicians in Washington to hose the American public when it comes to energy policies. We’ve been sold down the river and to make matters worse, we’ve idly sat by and watched it happen.  Going back to the very first oil embargo of 1973, the oil and gas industry has been warning — no, make that screaming — that our energy policy was short-sighted, not comprehensive and would lead to an extreme day of reckoning. The chickens have come home to roost.

Don’t ask Washington the obvious questions regarding the prohibitions against further offshore drilling, exploring ANWR, or the extreme difficulties of building new refineries or nuclear power facilities. (Do you know that France generates 80 percent of its electricity from nuclear power? France!) In the parallel universe of The Beltway, the energy hole that we now find ourselves in is not the result of the extreme and almost criminal mismanagement of our energy policy over the last 35 years. High energy prices — are you ready for this — are the result of a conspiracy of oil speculators who buy oil contracts on the futures markets. That’s about the best that the recent congressional hearings could surmise.

Maybe, but here’s a fact. For every speculator that buys an oil futures contract there’s someone on the opposite side of the trade who’s sold it. It’s a zero sum game. One winner, one loser. Period. But even if you ignore that most basic truth about the futures market, there’s still just one more problem out there for those who want to believe in a conspiracy of speculators. And that problem is supply and demand.

Worldwide production (supply) is about 85 million barrels of oil per day. It’s been flat for three years now. In the face of a tripling of prices over the last three years, the producers of the world haven’t been able to increase supply. And it’s not for lack of trying; at these prices, there’s not a producer anywhere who isn’t trying to sell all that he can.

The other side of the ledger is demand. It continues to rise. While demand was roughly 85 million barrels of oil per day three years ago (supply and demand were then in balance), demand climbed to 86 million barrels per day two years ago, and last year demand climbed to 87 million barrels per day. According to a recently released report by the International Energy Agency, demand by the end of this year will rise once again to roughly 88 million barrels of oil per day. Feed the machine!

It’s really no more complicated than that. Supply: 85 million barrels of oil per day. Demand: 87 million barrels of oil per day — and climbing. What would you expect prices to do in such a situation?

Worldwide (except of course here, where in much of the United States it is still politically incorrect to drill for oil), everyone is trying to increase supply. Aside from the obvious problems of finding a new field that is materially significant, it also takes time and money to develop a newly discovered field before production can begin.  Sometimes a lot.

Take the discovery of the Kashagan field in Kazakhstan. This field, discovered in 2000, is expected to produce 1.5 million barrels of oil per day when it finally comes on line. That would make it the third largest producer in the world. That’s significant and the world could really use that additional production right about now. When will it come on line? It was estimated that it would produce by 2005, but that didn’t happen. Now here we are in 2008, and still not close — the startup date was once again moved to 2013. We’ll know in five years if that is a good guess. After an expenditure exceeding $17 billion dollars to date, not one drop has yet been produced.

Oil companies are running against the clock. The time from discovery to production is taking longer and longer and costing more and more, while the speed at which existing fields are declining is increasing. While the IEA predicts a gain of roughly 16 million barrels of oil per day from non-OPEC producers from new discoveries and development over the next five years, it also predicts that depletion from these very same non-OPEC producers will decrease production by some 14.8 million barrels of oil per day over the same period. So, the net gain is estimated to be only 1.2 million barrels per day. And that’ll happen only if the expected discoveries pan out and if producers can bring this new production to market on schedule.

The speculators are at best the tail, not the dog. Without the fundamental truth that demand has exceeded supply for three years, speculators would no more be able to keep prices in the triple-digit level today than they would have been able to lift prices from the single-digit levels 20 years ago. After all the huffing and puffing, speculators are not at the heart of the problem; it’s simply no more complicated than supply and demand.

At this point, if you believe as I do that supply will not be able to be materially increased in the years to come, there is only one way to try and rein in these high prices: Lower demand. Conservation and a move toward non-oil based energy sources (coal, nuclear, natural gas and wind) are currently gaining great currency. A worldwide economic slowdown would also have an effect on demand (nothing like a good old fashioned global recession to knock down the price of everything). While this is not an outcome to hope for, current economic evidence seems to be pointing in just that direction. Should a recession actually materialize, we may well get a bit of price relief.

Yes, we have a problem, but it results directly from the abdication of responsibility that our elected officials have repeatedly demonstrated over the last 35 years.  They have pandered to the short-term easy fixes rather than making the hard — and politically unpopular — choices needed to get our energy house in order. Get mad. But don’t blame the speculators.

Bo Billeaud is president of Lafayette-based money management firm Billeaud Capital Management.