Oils Well That Ends Well

May 4, 2006

In case you’ve missed the nonstop media coverage, gasoline prices are again approaching $3 a gallon. Does this “crisis” situation offer any investment opportunities? Can it derail the economy and stock market? And why is gas so expensive anyway?

Last year's price increase was in the aftermath of Katrina, which damaged U.S. oil production (drilling) and refining (converting crude oil to gasoline and other consumable fuels). Because a natural disaster was the culprit, finger pointing and political haymaking was kept to a minimum.

Today, the “why” behind the jump in gas prices is not so clear. Gas prices are up (no surprise here) largely because oil prices are up – crude recently hit $75 a barrel, up from a low of around $10 less than a decade ago.

Here are the top ten causes of currently high oil prices:

1) <b>Strong world economy</b>. As countries get richer, they consume more energy. In this way, high oil prices are a good thing in that they are a measure of global wealth – sort of like how a fat population is a sign of economic well-being. Want to see oil prices fall with a thud? If a few major economies go into deep recession, we could see oil at $20 a barrel again. While the U.S. is still by far the largest consumer of oil, fast growing economies like China and India are increasing their oil consumption at a faster rate. All this growth in demand puts pressure on prices. 

2) <b>Limited growth in supply</b>. While the demand for oil can jump and fall dramatically in a short period of time, developing new production takes years. Since oil was cheap just a few years ago, many oil companies put off new development projects since the cost of extracting oil from these faraway locales would exceed the price they could charge for the production effort. Even today, many major oil companies think oil is temporarily overpriced and are hesitant to drill for more, lest prices fall after they start an expensive project. 

3) <b>Speculation</b>. Possibly the single biggest reason oil prices have remained above $50 a barrel is rampant speculation in the marketplace. Today, investors from giant hedge funds to mutual funds to Joe E*Trade bet on oil prices. The recent launch of an oil-focused exchange-traded fund is just one symptom. These wagers on oil going ever higher help to drive oil prices up, just as rampant speculation on everything from tulip bulbs to beanie babies increased prices in those markets. 

4) <b>Price-insensitive consumers</b>. Economists call it “inelastic demand”, but what it means is that, as prices rise, consumption doesn’t fall off. If the ticket price to a movie jumped from $10 to $20, ticket sales would plummet, perhaps by 50% or more. We’ve seen the same doubling of gas prices in just a few years and there has been no measurable change in buying behavior. Over the last year alone gas prices have jumped around 30%. Today, one in four new cars sold has an eight-cylinder engine, the same as a year ago. Gasoline consumption has not dropped from last year's levels. Pretty strange considering how we get a daily blast of news reports about how consumers can’t stand the high gas prices. If U.S. gasoline consumption fell even 10% we’d likely see such a glut of oil forming that prices would fall precipitously.

5) <b>Iraq</b>. The Iraq war and resulting insurgency has damaged oil production in Iraq. Today, Iraq is still pumping about 800,000 barrels of oil a day less than they did before the war started. Moreover, the levels of Iraqi oil output before the war was reduced from previous levels because of international sanctions. Global oil consumption is around 80 million barrels, but in a tight market, 800k barrels makes a big difference in prices. 

6) <b>Iran/Nigeria</b>. While Iran still pumps oil, the fact that their nuclear ambitions may lead to military action makes oil speculators nervous. Oil markets, like stock markets, try to predict future prices. If there is even a 5% chance of a cutoff in Iranian oil exports, current oil prices jump to reflect that possibility. Nigeria, the world's eighth-leading oil exporter, has seen its production reduced by sabotage and corruption.

7) <b>Consolidation in oil business</b>. In recent years major oil companies have merged, consolidating power and oil reserves into a few hands. While the oil companies do not get together like OPEC and set production levels and try to fix prices, they are less likely to go for more oil when they can sell off their existing production at elevated levels. 

8) <b>Energy Waste</b>. As there are limited supplies of fossil fuels that become increasingly more expensive to extract from the earth, wasteful behavior adds to the upward pressure on prices. Blame giant SUVs and limited use of public transportation. Large, energy-consuming homes and suburbs farther away from work are big factors as well. 

9) <b>Home boom</b>. Building new homes consumes energy – from bulldozers to lumberjacking to shipping new sinks around the country. New, large homes consume energy. Most of all, appreciating home prices create a wealth effect that boosts consumer spending on other items, increasing the demand for energy.

10) <b>Strategic reserves</b>. From time to time, the president has been filling our strategic oil reserves – the giant storage facilities for crude oil, which the country maintains in case of a major supply disruption like we saw when OPEC cut off oil exports in the 1970s. The U.S. imports about half our oil. Ideally, such filling would take place when prices are low. Besides being expensive, filling reserves extracts oil from the market at the worst time. President Bush recently decided to suspend deposits to the strategic reserves, and prices eased slightly.

Price gouging by oil companies makes for easy political fingerprinting, but it doesn’t really make much sense. Gouging as a concept doesn’t hold much water. Gouging means taking advantage of a supply and demand imbalance by charging far more than your own costs. Most businesses try to charge as much as possible over their own costs without affecting demand. Without “gouging” there may be shortages, but also lower prices for those who can get fuel.

Today, gas prices are much higher than oil companies’ own costs, resulting in massive profits. But drug companies charge far more for drugs than their own cost of manufacturing. A near monopoly like Microsoft sets prices for their Windows operating system wherever they want with almost no marginal cost to them for each additional sale. 

Will high oil prices drive the economy into a deep recession and hurt non-oil related stocks? Keep in mind that the strong economy drove oil high, so it’s unlikely the tail will start wagging the dog and derail the economy – though high prices will limit economic growth. In past oil price-induced recessions we saw a major cut off in the supply of oil. That is different than prices rising from strong demand.

One reason artificially boosting an economy with low interest rates and government spending and tax cuts can be a bad idea is supply of basic commodities can’t keep up with the accelerating demand. You can give somebody $100 and they will buy something the next day, but producing the extra oil to produce the goods takes longer. Prices rocket and eventually the economy cools (partially from the high prices but largely because the stimulus runs out), and then prices fall back to earth.

So are oil-related investments a good idea? No. The opportunity to make easy money here is over, which is why we have downgraded the natural resources fund category and do not recommend energy-related funds. Energy as an investment is just about to run out of gas.