EIS Idea — August 14, 2007: Perspective on Near Term Oil and Gas Prices

Since 7/31 the price of oil has dropped about $6 or 7.6% while the price of natural gas has risen about 50 cents or roughly 8%. Both moves are counter to their longer term trends which seem to be well justified by the fundamentals. That is, there was no new supply or reduced demand for oil that would account for a drop in its price since month end. Nor was there any interesting drawdown of the gargantuan gas storage numbers or adverse weather that would have raised the price of gas in the face of what seems to be a fairly clear glut.

Instead of fundamental facts, there were chaotic markets for credit instruments and stocks. Some observers think the unsettled markets account for the countertrend moves in oil and gas because certain hedge funds that employ a strategy of leveraging diverse and "unrelated" sets of trades (see Morgenson’s NYT Sunday piece) have experienced losses from the unusual conditions in the credit and equity markets. They have therefore needed to sell whatever positions they could to raise liquidity. Some funds have had to liquidate their oil and gas commodity positions, the theory goes. This concept seems to make sense because prior to the market turmoil there was a widely remarked upon and substantial short bet in natural gas and long bet in oil made by certain hedge funds. Liquidating these bets would cause gas and oil to move the way they have in the past two weeks.

Of course, I don’t know all this for sure — I am not a commodity trader nor an insider in the trading world. But it is a theory that is being widely posited, seems to make sense, and if correct has an interesting corollary: when the debt and equity markets return to stability, the oil and gas markets will most likely get back to their primary and fundamentally justified trends. When? As the saying goes, if I knew that I wouldn’t be writing letters.

A reader recently raised the following question:

"What are the shorter term risks to your [my] assumption that the price of oil is likely to rise?"

Hedge fund influences aside, the factor(s) that would cause oil to fall are either economic weakness causing diminished oil demand or some form of peace and free-market efficiency returning to any or all of Iraq, Nigeria or Venezuela that would increase oil supply. Those three countries taken together could raise their oil production by 6 – 8 mb/d (over a few years) if a stable, free-market business environment pertained in all of them. Anyone who thinks that "Peak Oil" has already arrived simply because oil production has not increased over the past 18 months or so is clearly not correct. Peak Oil is a geological concept saying the rate of global oil extraction can no longer be increased. Geologically speaking the world is clearly capable of producing 6 – 8 mb/d more than it presently does, so we are a number of years (3 – 6 I would guess) away from Peak Oil.

Of course, it is very possible to have insufficient oil supply to meet demand without having Peak Oil, as we have seen over the past few years. That is the condition I believe will be exacerbated over the next 18 months. I do not believe, for what it’s worth, that either increased oil supply or reduced oil demand are likely to occur and thereby keep oil form heading north. In my view oil is likely to go higher because it is unlikely that oil production in Iraq, Nigeria and/or Venezuela will increase substantially given the present political realities in those countries, nor is it likely that there will be substantial recessions in the global economy given the enormous winds of growth blowing out of Asia. But those realities could change, and they constitute, in my view, the primary risks that oil bulls should keep in mind.