Most of the decline in oil price from $147 down to about $100 was directly related to the strengthening of the dollar. So the oil price slide in July, August and the first part of September was mostly a monetary phenomenon.

Then we had the mid-September credit crunch and market meltdown. That dragged the price of oil from $100 or so per barrel down into the $70s (with price excursions down into the $60s). The demand weakness for oil has become clear in the past six weeks or so. Everybody just sort of woke up and figured out that the world was entering into a recession. The flip side is that inventories are building back up.

This has taken down all of the oil and oil-service companies. Among the latter, Superior Energy Services (SPN: NYSE), Halliburton (HAL: NYSE) and Baker Hughes (BHI: NYSE) have all tumbled. Even the perennially “too expensive” Schlumberger is way down.

The thing about the oil service companies, though, is that a lot of their business is all but recession proof. And much of the oil service business is immune even to wide swings in oil prices. That is, many oil company capital budgets are drawn up a couple of years ahead of time. So oil service companies should have work despite the macroeconomic situation. Not as much as in the boom times, maybe. But it’s not going to be as bad for the oil service companies as a lot of people seem to think.

There are many reasons for this. Sometimes an oil company has leases that are going to expire if it does not drill within a certain time frame. So the oil company has to drill. Or maybe the oil company has a rig under contract. So it has to drill before the contract expires and the rig moves on to other sites. Or maybe there is maintenance or a major workover on a well or field that just plain has to get done for reasons of safety or the environment. As I said, there can be a lot of reasons.

So keep an eye on the oil service companies. As Monty Python once said, they are “not dead yet.” The oil service companies are way down from previous high prices. I believe that this is a time to nibble. Don’t blow your whole wad of cash, but begin to accumulate a position while we watch how the larger economy unfolds. I think we’ll see stronger oil prices sooner, rather than later.

Oil Exporters Surprised, and Waiting at the Rope Line

Speaking of how the larger economy unfolds, some of the most surprised people on the planet are the folks who run oil-exporting countries. Hey, they believed their own press releases. They thought that oil prices would continue to rise upward, ever upward. All they had to do was figure out what to do with all the money that was going to pile up in their bank accounts. No waiting at the rope line for these worthies. But right now, demand destruction trumps even market manipulation by OPEC, not to mention the inexorable effects of depletion.

So what are the OPEC people thinking? They are hopping mad. The OPEC folks sure got used to high oil prices in a hurry. They don’t like these low oil prices. It costs money to run a petro-welfare state.

According to the International Monetary Fund, Iran, Venezuela and Nigeria need oil prices above $95 per barrel just to cover their respective national budgets. Saudi Arabia requires oil prices above $75 to cover its budget. Well over half of the revenues of the Russian Federation come from taxes on hydrocarbons. Mexico gets over 40% of its federal revenues from taxes on Petroleos Mexicanos (Pemex), the national oil company.

So low oil prices are causing problems for the oil-exporting states of the world. No major oil exporting country can long afford to see oil prices where they are now. Come what may, OPEC is going to turn valves and reduce supply. It’s just a question of how soon this will occur, how much oil OPEC will take off the market and what that will do to pricing. No less an authority than Hugo Chavez of Venezuela recently stated that “Venezuela can live with a price of $90 to $100 per barrel. But not less than that.”

“The Era of Cheap Oil Is Finished”

According to Iranian Oil Minister Gholamhossein Nozari, “The era of cheap oil is finished.” When a reporter from the New York Times asked Nozari what price Iran would want for its oil, Nozari declared, “The more the better.” Nozari stated that he is urging his fellow OPEC members to cut production by up to 2.5 million barrels per day.

How much oil is 2.5 million barrels? By comparison, the $6 billion BP (BP: NYSE) Thunder Horse Platform — 20 years in the making in deep water in the Gulf of Mexico — should produce 250,000 barrels per day by the end of 2009. So with one move by OPEC, there goes the equivalent of 10 Thunder Horses.

OPEC representatives are touring national capitals, urging non-OPEC oil producers, such as Russia, Mexico and Norway, to follow the cartel’s lead and cut production, according to Reuters news services. OPEC is trying to engineer a coordinated move to drive oil prices back up over $100 per barrel.

Most OPEC nations have already reached their own version of “Peak Oil.” Traditional oil-export powerhouses like Iran and Kuwait have admitted as much. Aside from Saudi Arabia, most OPEC exporters see a window of less than 20 years for significant international oil exports. By then, internal rising demand and falling output (due to depletion) will severely constrain the world oil markets. So all OPEC nations are interested in selling oil now for as much as they can get.

“We Want the Money Now”

Last May, I attended the Offshore Technology Conference in Houston. I had a revealing discussion with an oil manager who works for the national oil company of an African country. He told me this:

“The Saudis think there is an ‘optimum’ price for oil. They don’t want to raise prices too much, too fast. They say it will kill the economies of the West. But for my nation, we disagree. There is no ‘optimum’ price for oil. We don’t care about the economic effects on Western consumers. If Western consumers want to drive, they will pay. Or they can walk, like millions of people do where I come from. So we pump oil every day. We want to get as much as we can for the oil. We want the money now so we can fund the priorities of our national government. We cannot tell the people that they have to live in poverty for another generation because we are afraid that Westerners will not be able to drive their Mercedes-Benzes.”

So you can see why the odds favor rising oil prices within a few months.

That’s all for now. Until we meet again,
Byron W. King

November 06, 2008

P.S.: Oil is truly going to be a lot more expensive and the price will be driven by fundamentals — diminishing supply versus growing demand — rather than any speculative actions. In short, next time don’t count on a huge price pullback like the one we saw this time around.

Oil Prices Down…for Now was originally featured on Whiskey and Gunpowder

In the 1980s boom his neighborhood boasted not one but two commercial real-estate developers, both of whom were building shopping malls.

The one developer was cautious. He’d already built two malls successfully, and by re-investing some of his profits as equity in his new project he’d reduced his leverage and his risk.

Further along the avenue, however, was a more aggressive developer. He’d borrowed 98 percent of his construction costs on artificially cheap credit; money which had been pumped into the banking system by the Fed to keep the economy steaming along.

Anyway, the experienced developer was earlier into his construction project and completed it ahead of schedule — and he got his mall nearly fully occupied. His competitor, as well as being more highly geared, was slower to build and later to complete, so you can guess what happened next.

As the early ‘80s boom in Texan oil projects and real estate turned into bust, the new mall couldn’t get any tenants, which meant there was no revenue to pay down the debt. The aggressive developer went bust, and with the local economy sagging, the near worthless debts on his empty mall were sold by the bank at just $.18 on the dollar.

That allowed the new owners to slash the asking rents. They charged $.04 on the original construction dollar, making a yield of 4/18 — a healthy 22 percent yield on their outlay. But that rent deeply undercut the other, more cautiously built shopping mall. It was charging $.12 on its construction-cost dollar, fully three times as much.

Naturally, as the recession wore on, the cautious developer watched his tenants quit his mall for those cheaper rents down the freeway. So now the cautious developer failed too.

Why? Because overcapacity — first of credit, then of malls — had driven the local price of rented retail space down to third of its reasonable rate of return. The total rent that could be earned on two malls was significantly less than what could have been earned on one.

I have always found it difficult to make the logical step from cheap credit — which sounds so helpful — to financial collapse, which seems so regularly to follow it. This story shows how the route passes through overcapacity. Yet even overcapacity was not bad news for those investors who bought the distressed mall at 18 percent of its construction cost.

How were they able to get such a bargain? Simple. They could raise cash when almost no one else could. That probably meant they were debt free at the end of the expansion, and had found a reliable store of ready value as the credit liquidation played itself out.

I like to think that lots of readers will one day be the opportunists in stories like this, though I also believe the credit crunch has a long way to go, which means it will not be for some considerable time. Gold certainly doesn’t offer a 22 percent yield, but when other asset classes do, perhaps sellers of gold will contribute the capital which kick-starts our economies from the bottom of the coming slump.

Until then debtors, politicians, and central bankers will call us hoarders, and accuse us of destroying the economy. It’s not a label that makes me feel particularly proud, but I think I can live with it.

Regards,
Paul Tustain
September 3, 2008
BullionVault

The Trouble with Cheap Credit was originally featured on Whiskey and Gunpowder

“In a credit crunch, it’s often said, cash is king. In which case, gold’s just been crowned emperor.”

AT LEAST THE weather here in London suits the markets. More like October than August, the constant drizzle is broken only by chill gusts of wind, rattling the windows like a late autumn gale.

Unseasonable? Yes — even for a British summer! But it’s perfect weather for losing your shirt as yet another bubble turns to bust.

Just like the Bankers’ Panic of 1907, the Great Crash of 1929…Black Monday in 1987…and the “mini-crash” triggered 10 years later by the Asian Crisis…any trader bored of tanning his hide on the Cote d’Azur can now come home to find October in full swing. And if he’s seeking a snow-white pallor for autumn, he can turn white as a sheet within minutes in Mayfair, watching his funds under management shrink with each breath.

Wednesday, Aug.15 marked the deadline for hedge fund investors to withdraw what’s left of their money before the third quarter ends. Tuesday saw one fund, Sentinel Management Group, ask the U.S. Commodity Futures Trading Commission if it could “allow it to halt client redemptions until it can conduct them in an orderly fashion.” No dice, said the CFTC to the puny $1.6 billion fund. A disorderly fire sale might now be expected — which is just what the markets seem to be suffering.

Further north, in Canada, two trusts said that they’d failed to sell new securities needed to refinance loans that are due for repayment. A bank had also refused to provide liquidity, according to news reports, making August ‘07 a real crunch for those trusts, if not yet for all of their peers.

“Everyone always waits until the last second to get out, and [Wednesday] is the last second,” said Mike Hennessy of Morgan Creek Capital to Reuters Tuesday. But in fact, redemption notices began “piling up weeks ago,” said the newswire. The proximate cause remains the collapse of Bear Stearns’ two highly geared mortgage bond hedge funds in June. Those wipeouts sparked the current turmoil in world financial markets.

“The longer this credit crunch goes on, the more likely that gold will attract safe haven buying,” reckons John Reade, head of metals trading at UBS in London. In the short term, “we do not expect institutional buying of gold to trigger any sharp move higher; we suspect that position closing and deleveraging will be the focus of these investors’ attention…

“[But] any move to gold will probably come from private investors, and as such, the listed exchange-traded funds in gold will signal this interest.”

Confirming the move into gold by a growing number of anxious private investors, the StreetTRACKS gold ETF reported a record holding of more than 510 tonnes on Tuesday. In London, the gold fund run by ETF Securities saw a trebling of holdings last week alone. According to AFX News, some 200,000 ounces of gold were bought in one day!

(Here at BullionVault — the world’s fastest-growing route to outright gold ownership between April and June — gold sales are also markedly higher. As ever, gold stored securely in Zurich, Switzerland is proving the most popular choice with new gold owners.)

But it’s not only private investors who are choosing solid gold bullion over paper promises right now. The last two weeks have seen a huge surge in gold leasing rates — the price charged by the major members of the London Bullion Market Association to lend out their gold. Put in plain English, the banks of ScotiaMocatta, Barclays, Deutsche, HSBC, J. Aron & Co, J.P. Morgan Chase, the Royal Bank of Canada, Société Générale, and UBS have become less likely to put their gold at risk by lending it out.

After all, in a credit crunch, cash is deemed to be king. In which case, gold owned outright has just been crowned emperor.

The move in gold lease rates, spiking inside two weeks from 0.15% to a 33-month high of 0.32% above dollar lending fees, would also contradict claims that the U.S. Fed and its fellow central bankers are dumping fresh gold loans onto the market. Such a forced increase in gold-for-hire would have pushed gold leasing rates down, not up. But whether or not you hold with the theory that central banks are wantonly quashing the gold price — despite it doubling since 2002 — it’s clear that the Fed and its friends have plenty to fret about besides bullion right now. The U.S. dollar, after all, is up versus the euro. It’s everything else that is down, besides gold, Treasury bonds, and the Japanese yen.

Last Friday’s open market operations by the Federal Reserve saw it accept mostly mortgage-backed bonds — precisely those unsellable “assets” undermining faith in the financial system today. That left the big houses free to trade their outstanding positions in both Treasury bonds and the more secure agency-backed notes, a gift from the Fed that points to how serious this credit crunch is beginning to prove.

To date, the quarter of a trillion in central bank cash lent to the world’s biggest investment houses has failed to prevent the asset-price bubble — way up there in the stratosphere of new or near all-time highs — from hitting a series of air pockets, bid free. The ECB’s money on Tuesday failed to save Europe’s 300 largest stocks from losing an average of 1.2% of their value. The S&P closed the day 1.8% lower, while the Nikkei dropped 2.2% by the close in Tokyo on Wednesday. Here in London, the FTSE 100 has now dropped nearly 650 points — bang on that 10% slump deemed to mark a “correction” — inside one month.

No wonder, then, that lower interest rates are now priced into bonds. Traders foresee an 88% chance the Fed will cut rates to 5.0% at its September meeting, says Bloomberg, followed by odds of 47% for a further cut by December.

There’s no risk of monetary policy allowing the bubble to burst, in short. Or at least, that’s what everyone thinks…even as the bubble bursts despite super-fast action in central bank policy. “My worry is the Fed will cut too little, too late,” said Nouriel Roubini, NYU professor and a former adviser to Bill Clinton, in an interview this week. And besides, if the money markets are freezing up with dollar rates at 5.25%, will anyone become more likely to lend money at just 5% or 4.75% this Christmas…?

Now that cash is once again king — and the dollar has seized the throne with its twisted sidekick the yen playing court jester — we think you might do well to keep an eye on the gold price. Even with spot prices ticking sideways amid the sell-off in paper, that’s still a sharp break from the strong correlation between stocks and gold bullion seen between 2003 and early ‘07. Plainly put, the smart money looks keen to keep hold of its bullion.

Versus the resurgent dollar, the price of gold remains little changed right now from a week or even a month ago. Indeed, it’s risen against sterling and euros — a little-reported fact that U.S. investors wanting to take advantage of this spike in the greenback may like to note.

Regards,

Adrian Ash
August 22, 2007

Autumn in August? was originally featured on Whiskey and Gunpowder