Oil Debate Series - Part 1

One of the major sources behind the world’s current economic woes is soaring oil costs. While we have discussed this problem in recent weeks tangentially, my colleague John and I have agreed to more deeply explore this issue. John has graciously agreed to join me in debating several oil-related questions for the next few days. We hope you enjoy our discussions, and should you have any questions that you would like us to discuss, please do not hesitate to post a comment.

Question #1: When will oil hit $150/barrel? $200/barrel? $400/barrel?

Benjamin Beller: We actually have a bet going on this first one… remember when oil was near $100 and it flirted with that figure for while before crashing through? I think that the oil market will slow down before crossing this sentimentally-important mark, so I predict Monday, July 21, 2008 for $150/barrel.

John Kenderski: Oil closed today at 146.18 on the NYMEX a 1.92 % rise from yesterday. One of the golden rules of trading is not trading against the trend. If the market has appreciated over 40% since January, why would it stop? Regardless of speculation, demand supply, dollar weakness, or the factors moving the price of oil it has appreciated around 7% a month in 2008. Expect July to be no different with oil closing above $150, so I’m predicting $153.50/barrel by July 30, 2008. It is simple trend analysis which Ben cannot deny.

BB: In the words of Ari Gold, "Deny 'til you die." I think that unless there is a major event (attack on Iran, divine intervention, invention of cold fusion, etc.) within the next six months, the price of oil will reach $200/barrel by December 25, 2008. Merry Christmas.

JK: If you go by back tested data of 7% a month then by December 25, 2008 the price of oil will be $215.29. However this is too simplistic and is a ceteris paribus argument assuming the current trend continues. The current increase in the price of oil is a demand based increase, the trend will continue but the slope will abate. I agree with Ben that the price will be more around $200, at this point supply will satisfy demand.

BB: $400/barrel? If oil ever reaches this level, I don’t think (read: hope) that it will take place until 2012 or so. At this point, oil will have become too expensive for most consumers, and as a result, we will witness a major paradigm shift in how people utilize their automobiles. At the current ratio of oil price/barrel to gas price/gallon, it would cost over $11/gallon to fuel up. If you’re worried about stagflation now, you ain’t seen nothing yet.

JK: I disagree. Oil will never reach $400/ barrel because at this price demand would diminish. The current rise in oil prices is a globalization phenomenon, because increase transportation of goods across borders has increased the demand for oil. Once it becomes too expensive to produce goods in China and ship them, to the US production will be moved closer to the domestic market, decreasing the demand for oil. Look at the US automotive sector and observe the result of $4.00/gallon gas. Fuel efficient vehicles are becoming a necessity, and the extinction of the SUV is imminent.

Question #2: Is the problem due to supply and demand factors or speculation?

JK: The current spike in oil is a multi faceted issue that can be attributed to a variety of factors. Speculation, OPEC, Supply, Demand, or Dollar depreciation — they all have influenced the price. Principally this particular boom in price has been demand driven. The demand from BRIC countries and other emerging markets has outpaced the current supply of oil substantially. It is an undisputable fact that oil comes from bad, unstable places. This only increases the price of oil because there is a risk premium associated with the price. Iran and Nigeria are not nice places, not to mention Russia or Iraq. Obscene amounts of oil come from the third world; these countries can barely provide water to their people, let alone augment oil production. There is a world-wide shortage of engineers, and the engineers that exist are not products of the Saudi Arabian public school system. Thus augmenting production in these countries is not likely. Nationalization of oil industries are populist policies that in the long run lead to stagnant output. For example Russia’s state controlled Rosneft has not augmented production since it illegally took over Yukos. The reason, state assets don’t have to produce a profit, they just have the tax payer make up the difference. The result is no creative destruction, no technological leaps, and for the oil industry stagnant production. The above reasons demonstrate that the increase in the price of crude is a supply demand phenomenon. It is dry and boring but the combination of lack engineer’s, oil nationalization, and risk premium all have contributed to the recent price. These supply reasons, juxtaposed with the fact that China wants to become America. The Chinese infrastructure binge is anything but oil conserving, not to mention their manufacturing efficiency. I admit the argument of speculators sounds better because then we can blame a particular adversary, but it is not factual. The price of oil is headed in one direction because of supply and demand, not because of an evil gnome in the pits of Chicago that manipulates the price of crude oil.

BB: I’m not calling speculator evil gnomes… but I am holding them largely responsible for current oil prices. Since 2002, oil prices have increased by more than 500%... if you think that is primarily due to Chinese growth, OPEC supply, or a weak dollar, you’re not in the right ballpark. In psychology, we have a term describing these types of beliefs: denial. I am not saying that other factors aside from speculation have had an impact - they certainly have. But as figures such as Saudi King Abdullah or George Soros have explained, the reason for the explosion of prices is due primarily to speculators. Along with hedge funds, speculators have pushed prices higher and higher in their never-ending (and to be fair, totally justifiable) pursuit of profits. Some authorities, such as certain political leaders in Germany, have already proposed a worldwide ban of oil speculation. While such dramatic moves are unlikely in the near-term, it is likely that there will be moves against speculators in the future. Oil prices are simply rising too rapidly, and unless something is done to curb the influence of speculators, the outlook is grim for the future of oil.

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