$120 Oil Is Reasonable, Second Look

Jim Brown
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I wrote last week about the OPEC oil minister saying $120 is a reasonable price for oil. In hindsight I may have been looking at the comment entirely backwards. Maybe this is not greed but simply a defense mechanism.

Last week we had a JP Morgan analyst raise his target price to $120 to $130 on Brent for Q2. Not to be outdone a Bank of America analyst said Brent prices could average $122 and reach as high as $140. In his worst-case scenario if Libyan crude remains offline for the rest of 2011 he expects Brent to trade between $125 and $160 a barrel.

Those comments overshadowed the claim from the Iraqi oil minister that $120 was a reasonable price for crude. However, over $120 OPEC "might" meet to discuss production increases. I am sure everyone remembers the $85 to $90 fair price just a couple months ago and $100 would be a reason for OPEC to meet. There was no meeting when oil passed $100. Reportedly there was a conference call and everyone agreed to maintain their current levels.

If we consider the reasons behind the reasonable $120 oil comment we might find something to worry about. First, we all know, including OPEC, that oil at $120 would slow global economic growth and cause demand destruction. I think we can safely say that is a given truth.

So why would OPEC be ok with letting oil prices rise that high? There are two possible reasons. The first is greed. That is an easy excuse. Let the rest of the world suffer because we have billions in cash to float our yachts and furnish our palaces. Been there, done that. This has been a reason for OPEC to exist since it was created. However, they have always been careful to not let prices rise so high that demand trends were permanently changed.

In other words if oil shot up to $150 and held there the production of economical cars, hybrids and battery powered cars would surge. Gas guzzling SUVs would be scrapped and oil demand decline sharply like it did in 2008. In the past OPEC has made sure that permanent demand destruction never occurred. What is different this time?

One difference is the unrest in these producing nations. In Saudi Arabia the king has promised over $100 billion in stimulus, roughly 10% of its oil revenue, to pacify the masses and prevent a revolution. The same is true in a dozen other countries. The cost of being a dictator or lifelong monarch is rising and they need to raise cash to pay for these subsidies. In Saudi the king is hiring 60,000 additional security personnel to keep the peace. I think that is a make work program to get 60,000 unemployed and unhappy people off the streets rather than actual needed security.

OK, so OPEC nations need more money. However, they could make more money by raising production slightly. Instead of 30 mbpd maybe they produce 31 mbpd instead. That might lower prices by $5 but it would produce an extra $100 million a day in revenue for the producing countries. I think revenue is one factor in the refusal to produce more BUT I don't think that is the problem.

Picture this scenario. You control a commodity that the rest of the world cannot live without. Lets call it the Nirvana drug. It knocks 20 years off the age of any consumer and you live to 120 in perfect health. Unfortunately consumers have to take it every day or revert to their prior health and age. For years you have been telling the world not to worry there is plenty of this drug in inventory to last for decades. Don't worry be happy! Prices rise because of increasing demand and life is good.

Unfortunately for you the supplies of a rare component that goes into the manufacture of your Nirvana drug is becoming scarce and production is falling. All of your addicts will gladly pay the price for it up to a certain point. You always claim that $85 a month is a fair price. As supplies (known only to you) begin to shrink you have to come up with ways to ship less in order to keep the most people possible happy. You can have the Pfizers and Lilly's of the world buying big shipments and hogging supply so you short ship everybody and try to spread it around. Unfortunately the slowly shrinking supplies are met with the ever-increasing demand and the price keeps going up. $90, $100, $110. Your addicts are growing hostile at the rising price and continue to press you to release that decades of supply you have been claiming to have. Unfortunately you no longer have it and you are running your plants 24/7 but production continues to slow a little bit more every month and there is no hope of it ever growing again. What do you do?

In order to prevent millions of addicts from storming your factories and lynching you, a plan is hatched. You raise prices and claim that $120 is now a fair price and don't worry there will always be plenty available. There are thousands of people who cannot pay $120 so they quit ordering the drug and your demand problem is temporarily solved. Unfortunately there are others just finding out about it and they can afford the instant youth so within weeks the supply is no longer sufficient. Your have a flash of genius and proclaim $150 is now a fair price and the cycle repeats. This never-ending cycle has only one ending. Supply is finite and declining and demand is rising. You will eventually be found out and everyone will know you never had the supply you claimed but by then the remaining addicts will pay any price to get their daily supply.

I believe this is what is happening in OPEC. Supply is declining ever so steadily but they have promised us for decades that there are billions of barrels of oil to be produced "if needed." Don't worry, be happy, drive fast."

It is in their best interest to keep the production declines secret as long as possible. If they announced tomorrow that production had peaked and we need to learn to live on millions of barrels per day less every year in the future there would be panic. Car companies would ramp up production of hybrids and electric cars on the scale of ships, planes and tanks in WWII. Factories would be converted to car production and millions would be produced because there would be NO ALTERNATIVE.

Today we have the OPEC insurance policy of guaranteed production for decades to come. No rush to economize. Buy a Suburban. Unfortunately when it comes time to make a claim against that insurance policy we may find out the bank of OPEC was managed by Lehman clones. What they said in public had no relation to what they said in private.

Why else will OPEC countries not submit evidence of production and reserves even to each other? Why does OPEC have to resort to third party tanker trackers to get production info? Nobody in the group can document their reserves because they made them up. Literally. When OPEC went to the quota system based on reserves the claimed reserves doubled almost overnight without any additional exploration. Some countries continue to raise reserve claims even though they have produced billions of barrels since the first estimates 30 years ago.

This $120 is a fair price mystery is compounded by the light sweet crude story. Remember, OPEC has plenty of "OIL" but they don't have any material excess production of light, sweet crude, and the oil everyone wants.

When faced with oil prices going to $120 because of the loss of Libyan production they have no choice but to say that is a "fair" price because there is nothing they can do about it. They can't place a call to some OPEC field and say give me another 500,000 bpd. It does not exist.

That leaves them to perpetuate the myth of excess oil capacity and higher and higher fair prices because they can't produce it. The world press takes their claims at face value because they don't know any better. The world press works on a surface value basis. They hear comments and repeat them as gospel because that is their job. No research, no questions. CNN said it so it must be true.

I had an OPEC consultant email me a couple months ago and he said OPEC's official plan was to hope for a slow increase in demand destruction to reduce demand so that they would not have to come clean on their actual production capacity. As long as prices are rising slowly enough to keep demand right at or just below the current level of 88 mbpd then the lack of excess capacity would never have to be revealed. They were hoping they could balance that price-demand equation as long as possible to avoid the sudden rush to economical cars that forces oil prices lower on a permanent basis.

The $120 fair price claim is a leading indicator of further trouble ahead.

Jim Brown

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