Soaring Oil Prices

By: David Chapman | Fri, Aug 20, 2004
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Oil is hitting record prices and the market seems to be treating it with a big yawn. We are not sure they should be so sanguine but then the market has a habit of doing the opposite of what everyone expects. Oil prices are at record levels and airlines will certainly be facing higher costs and drivers will inevitably be paying more at the pumps. But the stock market, at least for the moment, seems to be shaking it off and the oil stocks are well off of their highs.

But the record oil prices have been headlining the newspapers and the business shows. And every time the market does fall the prime reason given is high oil prices. The concern on high oil prices clearly should not be underestimated. Certainly OPEC has limited capability to pump any more, and there continues to be concerns about supplies from the Middle-East and their vulnerability to possible terrorist attacks and in Iraq where there has been numerous attempts to shut down pipelines and set fire to wells. But we are reminded that the headlines, particularly those now predicting $50, $60, $70 and even $100 are just as often tops as they are a continuance of the trend.

Our favourite headline has been the one seen on the business page of the Toronto Star "Pricey oil is positive for Canada, August 19, 2004". Why? Because it is not overly sensational and Canada with the world's largest untapped reserves in the Canadian oil sands in Alberta will certainly benefit. Higher oil prices are very positive for the oil sands as they require ongoing higher prices to extract the reserves. But if higher oil prices are favourable for Alberta, since energy resources are a provincial jurisdiction, it means that Ontario and Quebec are not doing as well as they have to pay for the higher prices without getting any of the benefit of the Alberta Petro-dollars.

Our favourite article was one on August 19, 2004 in the Globe and Mail entitled "Seven reasons why rising oil prices are a very good thing – Eric Reguly". Yes even the "Scoop" has little sympathy for those in the oversized gas guzzling SUV's.

The Toronto Star had a good chart of oil over the past 40 years in constant 2000 dollars. In 2000 dollars oil is currently at US$51.36 the highest level since the peak in 1980 near US$60. In real terms oil is of course now over US$49 but in 1980 it peaked near US$40, a level that was again seen at the time of the Gulf War 1 in 1990. In 2000 dollars the oil peak in 1990 was under US$30.

Oil prices are of course a function of supply and demand. In demand terms there has been little let up. The US remains the world's most prolific consumer of oil making up some 25% of global demand that approaches 82 million barrels per day. Trouble is demand from emerging markets particularly China and to a lesser extent the rest of Asia and Latin America is pushing demand through the roof. China for example consumes about 6% of global supplies but their share is growing. Currently with a fixed Yuan to the US Dollar if oil prices rise in US$ it is also rising in Yuan terms. But if the Chinese were to set the Yuan to float demand for oil could rise as the Yuan would rise against the US$ making oil in Yuan terms cheaper. If Chinese demand were comparable to US demand China would consume more than what is currently being produced. Obviously that won't happen.

Sharply rising oil prices have always been followed by recessions and rising unemployment. The first oil shock in the 1970's brought about the 1974-1975 recession. The 1982 recession followed on the heels of the peak in oil prices surrounding the Iranian hostage crisis in 1979-1980. And finally the early 1990's recession followed the peak in oil prices as a result of Gulf War 1. The recession thus far in the early years of the new millennium was shallow following the 9/11 attacks. But any spike in oil prices did not follow the attack as the attack itself was not on oil facilities nor did it involve oil. While oil prices have risen more than 4 fold since the lows in 1999 it is only now that oil prices are approaching the in inflation adjusted terms the potential impact of the Arab oil embargo shock in the 1970's, the Iranian hostage crisis spike and the Gulf War 1 spike.

While we do not know yet is at what level and when oil prices will peak. We have long called for oil to move to levels of $55-$58 once they broke out firmly over $40. By connecting the highs of 1996 and 2000 our weekly chart shows that resistance zone. The monthly chart calls for prices to rise to the $70 area. At levels around $55 we are approaching in 2000 terms the levels seen at the time of the Iranian hostage crisis in 1979/1980.

Over the past number of weeks as oil prices have surged relentlessly towards $50 a number of reasons have been given for the rise. Amongst them has been the ongoing conflict in Iraq where pipelines have been sabotaged and oil wells set on fire and as a result oil exports remain well below potential; the Yukos bankruptcy where Yukos is a major supplier of upwards of 2% of the world's oil supply and there has been threats to cut exports; and, the Chavez recall vote in unstable Venezuela where the popular leader has been under constant attack from the moneyed classes and the Bush Administration. The Yukos situation currently seems to be under control and Chavez won his recall vote taking away Venezuela as possible area of destabilization.

While these have been reasons that oil supplies have been threatened there is very little ability to pump more oil as even Saudi Arabia, the only one that could expand supplies, is near capacity. As well reserve supplies in the USA have been lower than expected and that has added to the supply concerns. But a reason often overlooked is refining capacity that has actually shrunk in the past twenty years or so. In the early 1980's capacity was over 18 million barrels/day while today it stands at only around 17 million barrels/day. Investment in building infrastructure to obtain and deliver oil has shrunk. In the 1990's investments averaged a $100 billion a year and while it has risen to the $150 billion area it needs to rise further to $250 billion per year.

Around the world there are currently at least a half dozen hot spots where oil is either at the centre of the conflict or while not appearing to be the centre of attraction it is in reality one of the prime reasons behind the conflict. The first half of the new millennium is going to be dominated by conflicts over oil and indeed it could lead to clashes between competing economic interests given the world's insatiable appetite for oil and the reality of dwindling supplies. The world is now divided into three main Economic zones. North/South America centred almost exclusively on the USA; the European Union and by extension Russia; and, Asia centred primarily around China and Japan and to a lesser extent India. While all have a strategic economic interest in oil, only the USA has been actively seen as in the process of protecting strategic oil interests. Indeed oil is a strategic commodity for the US and they have stated unequivocally that they will protect their interests. Inevitably this may lead to potential major clashes amongst the economic power blocs.

We have divided the hot spots into really hot spots and hot spots that don't necessarily appear to be hot spots but they could turn into hot spots. First the "don't necessarily appear to be hot spots".

· The former Russian satellite of Georgia has become a potential battleground between the USA and Russia. The US backed a coup in Georgia under the auspices of the war on terrorism. Georgia is strategically located. The prize here is a pipeline that would connect the oil fields of Baku in Azerbaijan to Western markets through the Mediterranean. But the Russians were long established in Georgia and continue to maintain a military presence much to the chagrin of the now US government and the US backed Georgian government. Russia's hands are being seen in the ongoing conflict with the breakaway provinces of Abkhazia and South Ossetia where rebels are fighting US backed Georgian forces. They stand in the way of the pipeline.

· There is a strong US military presence in the former Russian satellites of Kyrgyzstan, Kazakhstan and other states in the "arc of instability" in the Caucasus. Again at stake here are the oil interests surrounding the Caspian Sea. Russia has become increasingly concerned about the growing US military presence so close to their borders and it may help explain the tightening of controls in Russia including the takeover and forced bankruptcy of Yukos who were contemplating selling to US interests. Oil is a strategic commodity as much to the Russians as it is to the US.

· The situation in Darfur is not what it seems to be. While there is no doubt that thousands are dying and are caught between Darfur's rebels and supposedly Khartoum backed militias the real prize is the oil wealth of the Sudan. It is almost no secret that the Sudan's 30-year war has been spurred by the US to destabilize the unfavourable Islamic government. (See Eric Margolis - Tread Softly in Sudan, August 15, 2004, Toronto Sun). The Darfur rebels have been backed by arms brought in through Chad another poverty stricken African country where there is oil and gas and a growing US military presence and the CIA. Historically Darfur was the home of the Dervishes and the "Mahdi" that defeated the British imperialists under General Gordon in the 1880's and immortalized in the Victorian novel "The Four Feathers".

· While Chavez won the recall referendum the opponents have screamed fraud even though by all accounts monitors under former US President Jimmy Carter said the referendum was fair. It is unknown at this time what the next move will be. Already there have been two attempts to oust Chavez through a US backed military coup. Venezuela is a major supplier of oil to the US.

· Saudi Arabia remains a hot bed of opponents to the Saudi regime. The supposed original terrorists who attacked the WTC were primarily from Saudi Arabia. While there have been no attacks thus far on oil facilities that does not mean that it couldn't happen. Numerous attacks have been made on Westerners who are key to maintaining the Saudi oil facilities.

· The ongoing conflict in Afghanistan. What everyone forgets or didn't even know is that there were plans to oust the Taliban even before 9/11 happened. The Taliban were increasingly uncooperative with the US with regards to the building of a pipeline to ship oil from the Caspian Sea through Afghanistan to the Indian Ocean. The Taliban were former US clients

Now for the really hot spots.

· Iraq is a given where the country is descending into chaos with attacks on pipelines and oil wells. Whether Shia cleric Muqtada al-Sadr leaves the Imam shrine or not is not relevant as the insurgency will continue and the destabilization of Iraq will continue. The only question is will things escalate and deepen further.

· The war of words between Iran, the US and Israel is becoming increasingly bellicose. Each has threatened pre-emptive strikes against each other. The issue of course is Iran's alleged WMD and nuclear facilities. The words coming from the US sound similar to those that preceded the invasion of Iraq including linking Iran to the alleged terrorists of 9/11 and Al Qaeda. This has the potential to become the next big crisis although it may just be a lot of words, gestures and threats that goes nowhere. But with a US election coming up and increasingly the polls indicating that Bush will lose Iran would be a major distraction. Iran was one of the original members of the axis of evil, borders on the Caspian Sea, is surrounded by US forces in Iraq and Afghanistan and has been increasingly seen as having a hand supporting the Shia uprising in Iraq. Iran has significant oil production and reserves. A conflict centering on Iran could send oil to a $100/barrel.

Oil it would appear has not as yet peaked. There has been talk of releasing oil from the US's strategic reserves. That would have a dampening impact on the price of oil. It may be amongst these reasons that the oil stocks appear to be lagging the oil price move of late. They don't believe that this price gain is sustainable and fear a sudden drop. Still since the lows of oil in 1999 while oil has increased in value more than 4 fold the TSX Energy Index is about 3.5 times and the Philadelphia Oil Index (XOI) is up around 1.7 times. Both indices remain in major long term up trends and are above the key 40-week moving average and 4 year moving average.

Gold and oil are often inextricably linked. If oil rises then gold rises as well. Over the years though this indicator has been mixed where there has been periods where oil is favoured over gold and others where it is gold that is favoured. But generally they tend to go up together. Our chart of the oil/gold ratio shows that oil is rising faster in relation to gold but we are approaching the highs that were seen back in 2000. The large symmetrical triangle suggests a move to a ratio of .174. That could occur if oil rose to the $75-$80 area while gold rose to $430-$450.

In 2000 gold was favoured over oil. This suggests to us that the best move in gold may come either after oil peaks or certainly while the oil gains are slowing. Of course it could suggest that if oil falls but gold just doesn't fall as much. Gold too remains in a long-term uptrend and today's big move suggests a breakout and a move underway back to the highs near $430.

Oil has been soaring and is increasingly headlining the news. We continue to hold to our targets of $55 to $58 for a possible peak on this move. But if we break through $60 then there may be little stopping a run away move to $70 or higher. Oil is a strategic commodity and is at the heart of most of the major conflicts currently going on where the US is being seen increasingly as protecting its interests.


 

David Chapman

Author: David Chapman

DavidChapman.com
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David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

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