Current Oil Price Justification

Jim Brown
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We have heard every conceivable reason for high oil prices as a result of Libya and the unrest in other Arab countries. Officials are talking about no-fly zones, donating weapons to Libyans and releasing oil from the strategic petroleum reserve. Will any of this help?

The Libyan problem is going to be a long-term problem and we need to get used to this fact. Half the country is now controlled by the opposition and half by Qaddafi. The government is in the strongest position because they have fighter jets and attack helicopters to project force over a wider area. The opposition groups have a deep-seated hatred of Qaddafi for decades of arrest, torture and oppression. Never underestimate the power of emotion but realize it has to cope with the power of modern fighting machines.

Libya has been a lose collection of dozens of tribes for decades. Qaddafi kept them under control through a harsh and brutal reign. He kept the tribes separated from each other by fostering decades of hostility between them. As long as the tribes did not want to unite, the Qaddafi government was safe from organized rebellion.

That concept is falling apart today as the tribes come together to fight the oppressor. Whether they win or lose is unknown but the outcome for oil prices will be the same.

If Qaddafi believes the opposition is benefiting from the $150 million a day in oil revenue he will not hesitate to bomb the oil facilities and prevent them from selling oil. He has bombed positions in those facilities daily for the last week. How much damage, if any, won't be known for months to come. So even if Qaddafi wins the conflict we will not see full production resume for months into the future.

Let's assume the opposition finally overcomes Qaddafi and gains control of the country. Because Qaddafi is not going down without an all out effort he will probably become even more violent against the oil facilities in his final days. His own people have said he would bomb the pipelines and producing facilities if it appear he was losing.

If the opposition wins they 12-20 major tribes will inherit a nightmare of production problems left over from the war. On top of that those major tribes will want to be assured a cut from the oil fields they control. Getting all these normally hostile factions together to settle the problem of who gets how much of the $150 million a day in oil revenue will be a major problem. If the opposition wins we should not expect any material increase in oil production for months to come. It will probably take them longer to restart than it would take Qaddafi.

Many analysts have suggested implementing a no-fly zone in Libya to "protect the opposition from being massacred by the government." At least that is the stated claim. The real reason is probably to prevent the Qaddafi government from bombing the oil fields.

This no-fly zone is not likely to happen. In order to have a no-fly zone you have to be able to prevent people from flying there. This requires planes in Libyan airspace to challenge Libyan aircraft and force them down. Libya has antiaircraft defenses. In order to protect the planes of the no-fly force those defenses would have to be attacked in advance. That is the equivalent of declaring war on Libya. Secondly, the opposition is shooting at every plane they see and they do have captured anti-air missiles so it would be a dicey proposition at best.

Libyan oil is not coming back in the near future. However, Saudi Arabia, Kuwait, Nigeria and the UAE have all said they would step up production by April to offset the losses from Libya. It will be interesting to see just how much light sweet crude they can produce over their current levels.

If we assume the Libyan oil is not coming back but OPEC nations are going to pickup at least some of the slack then the current price of oil should have all those factors already priced in. The only one still a factor is the unknown about Saudi Arabia's Day of Rage protest scheduled for Friday. We heard today that 21 clerics have now said it would be illegal to take part in this protest. I am sure they were helped to their decision by some sharp prodding by the government. Another group of "influential academics" has also come out against the protest. The government of Saudi Arabia has also warned that anyone showing up to protest will be dealt with harshly. In Saudi when they say "harshly" they actually mean it.

Today I believe this Friday protest is going to fail. Unless we see an outpouring of support between now and Friday this event is going to evaporate along with high oil prices.

Brent crude will probably remain high because Europe depends on Brent and oil indexed to Brent for their fuel supplies. Until Libya returns to full production the Brent price will remain elevated.

U.S. WTI prices are facing multiple threats. First there is plenty of oil in the U.S. and there is no reason for WTI prices to be at this level. Inventory levels at Cushing Ok. Hit record levels at 38.6 million barrels last week. There is so much oil there is no place to put it. Demand has not recovered to prior levels and the $3.50 price for gasoline is going to depress it even further. Refiners are not buying oil at this price unless they have to. They have plenty on hand and they are only running at 80% refining capacity because of the slow demand. This period on the calendar where heating oil use is declining and gasoline use has not yet begun to rise for the summer driving season is normally a period where prices moderate ahead of their summer rally.

To further complicate this the USO has to sell 18,000 crude futures contracts over the next four days and roll over to the next month futures. This could present just enough selling pressure to create a break in crude prices. April futures don't expire until March 22nd but anyone thinking about owning a long contract and taking delivery is scrambling to find a place to store it. Without available storage there is a very limited arbitrage trader where traders buy a cheap front month, sell a higher priced distant month and then store it until time for delivery. There is no place to store the oil without moving it from the pipeline at Cushing into storage somewhere else. Transporting oil is expensive and time consuming. This suggests we should soon begin to see weakness in the WTI contract.

The kickback the administration got today for suggesting the strategic petroleum reserve could be opened to keep gasoline prices low was quick and pointed. Commentators pointed out that there was no place to store any oil removed from the SPR and nobody needed any oil of they would be buying it from Cushing supplies. The proposal was immediately crushed for the publicity ploy it really was as an effort to drive prices lower.

While I don't expect crude prices to go much higher without another event somewhere in the Middle East there is always that possibility. Once crude prices moved over $100 they began a series of short attempts and short covering that always promotes more of the same. The higher it goes without a meaningful reason the more traders will try to short it. Eventually they will see a long ride lower but it may be from a higher level.

Jim Brown

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