The Contrarian Case for $50 Oil
Just a few weeks ago traders were taking for granted that the price of oil would shoot through $80 a barrel. Economic forecasters and pundits were talking about the consequences of $100 oil, which might have cut 50 basis points from gross domestic product growth, according to some (see BusinessWeek.com, 7/26/06, "Would $100 Slam the Global Economy?"). Perhaps they should have been contemplating the prospect of $50 oil instead.
Yes, $100 oil is still possible and in the long term maybe inevitable. A geopolitical crisis, in Iran or elsewhere, or events like 2005's double whammy of Hurricanes Rita and Katrina, could bring it on sooner.
But for the next year or two, the chances are beginning to look a lot better for $50 oil than $100. One argument for this contrarian view is the way the oil market has acted over the past few months. Despite BP's bombshell announcement that it would have to shut down the Prudhoe Bay pipeline, a key source for the U.S., and the flareup of Israeli-Hezbollah fighting and its possible implications for Iran's oil production, the price of crude never got all that close to $80.
It topped out at around $78 before beating a hasty retreat all the way down to $70 the week of Aug. 14, as the news from BP (BP) and the Middle East got better (see BusinessWeek.com, 8/10/06, "Prudhoe Bay and $100 Oil"). And as Ed Yardeni, chief investment strategist at Oak Associates, and other Wall Street gurus have noticed, energy issues seems to be surrendering their multiyear leadership of the stock markets to technology and other groups.
Veteran oil analyst Charles Maxwell of Weedon & Co. notes that there is also a fundamental reason to expect stagnant-to-lower prices. Demand in the biggest energy-consuming nation, the U.S., seems to be moderating.
Overall economic growth is getting dialed back at a time when plenty of oil and refined products are sloshing around. With the heavy driving season almost over, the American Petroleum Institute reported on Aug. 16 that the highest-ever crude oil and product imports for July had left inventories at unusually high levels. Crude inventories were at 335 million barrels, up almost 5% from a year earlier, and gasoline stocks, which almost always fall in July, actually rose.
Of course, the price of oil for the past several years hasn't been determined strictly by the forces of supply and demand. The price has also been ratcheted up by a perfect storm of geopolitical shocks, including the Iraq war, North Korea's and Iran's nuclear buildups, and hostilities in Venezuela and Nigeria.
All this scary stuff, plus hurricane-related and other disruptions such as the BP pipeline fiasco, brought the energy speculators out of the woodwork. Some Wall Street sources reckon that $75 billion to $100 billion in speculative money—up perhaps 1,500% from a few years ago—has piled into energy markets.
If the world regains even a little political stability after the remarkable chaos of recent years, a lot of this money could move out of energy and into other plays. Says Maxwell, only a bit tongue-in-cheek: "You look at all the geopolitical things that could go wrong for oil, and we're running out of them at a rapid pace. The events of the last few years are an anomaly and have put the price of oil in the stratosphere—at a level that is not sustainable."
Today's prices even seem to anticipate that last year's extraordinary storm season will now be the norm, even though so far the hurricane season looks to be tame, he adds. "Speculation [in energy commodities] is getting more expensive and more dangerous," says Maxwell.
LOTS OF DISSENTERS.
In the near term, what happens to those speculative bets may have the biggest impact on whether oil prices just flatten for awhile or plunge to $50 or so—the level some industry experts believe is justified by supply and demand. A sudden change in psychology could cause a landslide of selling in a mad attempt to close out long positions that were essentially bets on higher prices.
Speculators wouldn't be the only ones caught in the crossfire. If prices do move sharply lower, that would put a strain on the major oil producers, including ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP). The majors' share prices have roughly an 80% correlation with the underlying commodity prices, according to Maxwell at Weedon.
There are plenty of dissenters to the view that oil prices are more likely to fall than rise. T. Boone Pickens, founder of BP Capital Management, has been one of the most prescient in the industry with his price predictions, and he's still bullish. "If you're ready to make a bet, I'll take $100 over $50, but you have to give me a year," he says.
Pickens was right a few years back when oil was in the thirties and he predicted it would soar to $50, and later when he predicted $60 and $70 oil. But he was a contrarian back then. Now he's one of the thundering herd predicting higher prices. It doesn't mean he's wrong. Yet he must be a little nervous having so much company in the bullish camp.