Tuesday, May 13, 2008

Is Oil the New Globe.com?

Here is why Oil shouldn't go to $200 a barrel. Notice I didn't say won't go to $200, as betting against a commodity in this market is tantamount to financial suicide.

1) The fundamentals don't support an accelerating price for Oil. While the U.S is not officially in a recession, growth has slowed down here as well as in the rest of the world. Less economic growth means less demand for Energy. Has supply changed in the last month? Only in the minds of those bulls who believe any time a gun is fired in an oil exporting nation, supply is threatened.

2) The elasticity of demand for Oil may not be linear - that is to say that each 1% increase in the price reduces demand to a different extent. Is it possible that the higher the price, the more demand impact occurs? It is not inconceivable that demand for oil worldwide could flatten out for several years - it has happened before.

3) Many countries subsidize the price of refined products to its citizens to promote social stability. As the price of Oil moves up, the cost of these subsidies increases to the point where it is no longer economically feasible to do so. Once these subsidies are reduced or eliminated, the impact on demand may be tangible. Turkmenistan recently ended subsidized gasoline for its citizens, and others will follow suit as the price of Oil goes higher. While demand from Turkmenistan is negligible in the world market, many countries use subsidies, including China. China, is in effect, hurting itself by shielding its people from increasing prices. Since demand doesn't fall internally as prices rise, this leads to even higher prices.

4) Although demand for Oil is inelastic in the short term due to a lack of substitution, there is a "crowding out effect" as consumers pay up more for gasoline, they will cut back on purchases of consumer items and other discretionary purchases. This will cause a further decrease in demand for Oil since many products use Oil in the manufacturing process. Many of these products and items are made in China, which still relies heavily on exports. So won't this "crowding out effect" eventually reach the end of the supply chain, and cut demand for Oil?

5) The price of Oil is firmly in the hands of speculators and financial players as everyone knows. This is difficult to prove, but it is clear that technical reasons and momentum are keeping the price elevated. As a trader on the floor said this morning on Bloomberg, the market wants to go up. And we all know that what the market wants, the market gets, at least in the short term. When this momentum ends, the impact will be staggering.

6) Much is made of the growth in demand for Energy from emerging economies, but the United States still uses 30% of the world's oil, and lack of growth here will eventually have an important effect on the market. In other words, a 5% growth in demand in the U.S. is worth 1.1 million barrels a day, while China's much hyped up growth of 7% was only worth 600,000 barrels a day. What if demand in the U.S declined 5%? Could China make that up?

7) Another important reason is less analytical - take a look at the people that are telling you that everything will be OK with Oil in particular, but also with Commodities in general. That prices will stay high. Do they look familiar? They should, as they are the same ones who told you that everything would be OK in the housing market and the Homebuilders. Remember that crap? They didn't buy land any more, they "optioned" the land. They had access to capital, etc. None of these reasons stopped Homebuilders from going down 75% from the peak. Consider your source.

8) Another non analytical reason is this - eventually someone in OPEC will stand up at a closed door meeting and say this: is it really wise for us to have oil so high for so long? Won't this eventually lead to permanent long term changes to demand as countries adjust their economies? Won't it stimulate the growth of alternative fuel sources? Or might it cause so much inflation that it will crash the world economy?

What could end the momentum play? Here are a few scenarios:

1) A Democrat in the White House releases oil from the Strategic Petroleum Reserve to bring prices down. The government has twice as much Oil in its inventory as the entire commercial market does. Sure, OPEC might cut production to balance the market, but then there goes the spare capacity argument.

2) A Democrat in the White House pushes a Windfall profit tax through during the first 100 days. This tax is not on Oil companies but on commodity traders and speculators. Or they could push up margin requirements for futures trading on certain commodities.

For those of you who don't remember, the Globe.com, was the poster child for the start of the Internet boom in the late 1990's. It soared way above its true value as money piled into a speculative play. The company is now long gone, and I am not saying that Oil will one day be "long gone," but might there be some lessons we can learn from our past mistakes.

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