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OIL PRICES

OIL PRICES

Each year, we talk to many informed sources about oil and we attend many oil and energy conferences.  As a result of extensive research, we believe that oil prices have seen their low for 2009.

Some readers may be saying to themselves “how is this possible?”  The world economy is in a serious recession.  Major countries, such as the U.S., all major European countries, and many others are in what many observers are starting to call a depression.  The few growing countries like China and India are not growing fast enough to support the rest of the world.  How can oil prices be bottoming?

Let’s review a little history – As you all remember, oil peaked in July 2008 at $147/ barrel.  It then proceeded to fall, declining to the $34/barrel range last month, before rallying to the current level of about $45/barrel.  In January 2008, expert sources that we follow were saying that oil would peak in June 2008.  Although they were a little low on their estimate of the eventual peak price, these experts pointed out correctly that events in Russia in 2006 and 2007 were the main cause of oil’s rapid price rise in late 2007 and early 2008…and that the rise was likely to be short lived.

EVENTS IN RUSSIA?

Saudi Arabia is well known as being the world’s swing producer of oil, a role that they have undertaken for decades.  When world oil production is too low and prices too high, Saudi Arabia often lifts production to lower world prices.  This keeps the demand for their large, relatively inexpensive oil reserves strong, and it keeps nations from pursuing alternatives.  On the other hand, when oil prices are too low, Saudi Arabia will often cut production to buoy world prices so that oil trades in a more stable (but still quite profitable) range.

In 2006 and 2007, Russia repeatedly boasted that they could produce 2½ million barrels more oil per day than they were producing.  These production claims turned out to be a ploy.  This posturing was intended to make Russia look more powerful to Europe, which is a big consumer of Russian oil and gas, and to keep the Russians influential among the former Soviet states which were now independent.  In short, Russia was using their claim that they could produce more oil, as a foreign policy lever to keep former Soviet states in their realm of influence and to leverage their power with Europe.

Saudi Arabia was taken in by the Russian announcements, and began to cut production to stabilize prices.  The Saudis believed that the extra Russian production would create an oil surplus and a big price decline.

Of course Russia was unable to produce the extra 2 ½ million barrels a day.  Thus, world supply, instead of seeing the surplus that Saudi Arabia feared, started to see a substantial shortage of oil.  This drove the price of oil relentlessly higher.

By late 2007, our source says that Saudi Arabia realized their mistake and had begun to produce more oil.  The problem with oil production increases and decreases is that they are slow to manifest in the end markets.  It takes months to increase production, and it takes even longer for world inventories to be filled and speculators to realize that the shortage of oil has ended.

It was not until July 2008 that investors and oil consumers became aware that Saudi Arabia had increased production enough to fill much of the worlds’ oil storage capacity. Concurrently, a world economic decline was taking place and demand for oil in transportation, manufacturing, and other areas was falling…clearly oil was overpriced.  In just eight months, the price of oil fell dramatically to $34 / barrel.

This brings us to late 2008 and early 2009.  Since September 2008, OPEC, led by Saudi Arabia has cut daily production by about 4.2 million barrels per day.  During the same period, worldwide demand has only fallen by half as much.  The production cuts have removed much of the surplus of supply over demand.  Storage of oil has been drawn down, especially at major hubs such as Cushing, Oklahoma in the U.S.

Consumers of energy, such as transportation organizations, utilities, and manufacturers have once again begun to purchase energy for future delivery so that they will have available supply at an acceptable price.

In summary, we may be in a recession in some parts of the world, and a depression in other parts, but we still use energy…and current prices appear to be unacceptably low.

In our opinion, new oil cannot be discovered at a price where it can be delivered to consumers for less than about $50 per barrel.  If we are correct in our analysis, oil prices have to rise to the level where oil professionals will expend capital to search for more supplies.  By 2020, the U.S. Dept of Energy says oil production will go to 100 million barrels per day.  We believe this is an impossibly optimistic number. Unless world oil prices skyrocket to the level where very expensive oil resources like the oil sands of northern Canada can be mined, this target is grossly off the mark. Remember, depletion causes a decrease in global oil production from existing wells each year, and depletion is relentless. The oil market analysts that we respect believe that supply will go to about 75 million barrels per day by 2020. In 2020, we anticipate that world oil demand will be greater than production by about 4 million barrels per day. This implies that oil prices will go much higher over the next 11 years.

OUR BEST GUESS IS THAT OIL WILL AVERAGE $60 per barrel over the next two years.  It will fluctuate around this level to be sure, but we see $60 as an average.  We plan to buy oil stocks on declines over the net few months.

U.S. BUDGET

Mr. Obama’s budget puts federal government spending from 20% of GDP to almost 30% of GDP within 2009.  All we can say is WOW!

In February, the stock market collapsed when the budget was announced. By early March it had become extremely oversold.  It was set up for the welcome rally, which we are currently experiencing.  We will enjoy the rally while it lasts, it could easily lead to a 25-40% rally.  In our opinion, after the rally, we will return to the bear market environment which we have seen since late 2007.

FINANCIAL PROTECIONISM

This is a major problem that has recently been noted in the excellent publication The Institutional Strategist by its proprietor, Larry Jeddeloh.  The web site is:www.tisgroup.net

Why do people complain if U.S. banks make loans to Dubai?  It is a global world, and banks everywhere have long made loans to governments and companies outside of their own borders.  If financial protectionism continues and grows, it will be like trade protectionism, a result of poorly thought out legislation.  We guarantee that it will be devastating to world economic well being and will substantially extend the current economic malaise.

SUMMARY

The current stock market rally was expected, and we believe that it can carry stocks about 25% above their recent lows, which will still leave them down for 2009.  We recently did some bottom fishing in financial shares and energy shares, and have been enjoying the rally.  These are short term trading positions only because longer term, we expect the global markets will continue to struggle under the weight of weak economic activity.

For the long term we believe that gold, oil and agriculture investments will provide long term positive results.  We still see the U.S. dollar as a potential time bomb.  At some time, the buyers of the trillions of dollars of U.S. bonds being floated to finance the federal debt, will balk and demand a lower currency or higher interest rates before they buy any more bonds.  If the U.S. were to raise interest rates, the economy would be in danger of collapse, so the only option is a lower dollar.  The Chinese, who are nobody’s fools, are aware of this and nervous about it as well.  To read more, click this link: http://www.ft.com/cms/s/0/5240d9b0-1039-11de-a8ae-0000779fd2ac.html

REMINDER, FOR A LIMITED TIME…

For no charge, as a service to our readers, we will be happy to examine your current investment portfolio, and explain how we might restructure it to meet your needs for income and capital appreciation in the current environment.  In recent weeks, we have received a number of requests to review investment portfolios and have been responding to them as time permits.  In order to provide a more meaningful evaluation of your portfolio, we will need additional information about your overall financial picture.  Please give us a call if we can help you in this regard.  

Thanks for listening.


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