Thursday, September 4, 2008

Fair Value for Crude Oil?

I just found a fantastic op-ed article called  The Most Important Fact To Know About Oil Investing on the website Seeking Alpha.  I share it with my friends not because we are all invested in oil in our 401k, but rather because our professions necessitate us not only have a bias on crude and its constituent products, but to TRADE that bias by timing prebuys and by offering presales.   How unfair!!!  Especially on the Vomit Comet ride of 2008.  Let me draw out a few points for special emphasis:

"Only four months ago (May ’08), oil cleared $120 a barrel on its way to $145. Within a month, analysts were calling for $150, even $200 oil...Then Russia invaded Georgia, and oil took a nose dive falling more than 20 consecutive days from $145 down to $115 a barrel....So is oil going to go up or down?  The honest answer is that no one has a clue. We can talk all we want about worldwide supplies, Brazil’s latest discoveries, potential drilling in the US and other factors. But the reality is that an enormous slew of conflicting issues affect oil prices today..."

  1. Geopolitical Issues
  2. Speculation
  3. The Over-Leveraged Financial System

(The complete article goes into much more depth)

Personally, I agree with this analysis but would choose to go further. With crude oil, no one knows what price represents fair market value. In other commodities, things are just easier.  For example, if there is a shortage of corn, during the next planting cycle marginal acres of things like cotton (in North Carolina) and sugar beets (in North Dakota) move to corn.  High prices incentivize more production.  In that case, high price cures high price.  

But there isn't a place on earth that can produce an extra 300k barrels per day of oil within a period of time as short as a year (not since the days of Spindletop, anyway). That type of output costs billions of dollars and manifests itself in the form of a pipeline through Azerbaijan or a super-platform in the Deepwater Gulf of Mexico.  In each of these cases, today's high price creates incremental supply 10 years from now!  

Are we running out of crude?  I don’t know.  But I sincerely doubt it.  I am not a proponent of Hubbert's curve, and I do not think the hydrocarbon century is over.  But I DO know that recent large discoveries have come in challenging topographies (mountains and oceans) and inhospitable climates (the Arctic and the North Sea).  That can make people think that we are running out of crude - and THAT is all that matters.  

So if you are buying or selling a commodity that is finite in nature and the exact remaining quantity of that commodity also happens to be do you ascribe a fair market value to the barrel you are buying today?  Tomorrow?   It might be possible, but it is an estimation process fraught inaccuracy.  And when it feels like demand is growing uncontrollably or that supply is waning dangerously....well, price is off to the races. Price is the only rationalizing method that we have to rebalance these seemingly incongruous pieces of information.   

Previously in this blog, I have discussed how 15 foot corn isn't possible (but how - as we drive through the rearview mirror - it feels like it might be).   The market will trade from extreme to extreme again and again.  And the prevailing sentiment (however irrational) will carry the day. Dennis Gartman, the Canadian economist, says that "the market can stay irrational far longer than the individual investor can remain solvent."   Likewise, I have a Murphy's Laws for Commodity Traders on my desk that says "When the market is wrong, it doesn't pay to be right."   

Where's fair value for crude, you ask?  Today’s or minus $100 per barrel. 

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