Lower Oil Prices Become Just a Memory

A review of the factors that affect crude's cost shows that $40/barrel is here to stay -- or headed for an increase.
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Where next, crude oil?

After all the ink put toward this topic in recent months on these pages, queries about my thoughts on the direction of crude continue to be the No. 1 question I receive every day. With prognosticators such as T. Boone Pickens suggesting "$60 before $30" and others suggesting that $20 isn't far away as we approach the less-demanding springtime season, the question remains the topic of sometimes heated conversation among the pundits.

While my view is just that -- my opinion -- it seems like a good time to set forth the factors that could affect the oil markets in the coming months. I believe they indicate that energy prices are not likely to head lower anytime soon.

Energy Economics 101: Rational Markets

Let's start with the premise that supply and demand for crude oil are roughly in balance today. If that is true (and if we ignore the frequent headlines that suggest too much supply or too much demand), then basic economics provides the presumption that current prices are rational. After all, markets clear at a price at which supply and demand are in balance. As such, if supply goes down or demand goes up, price is likely to move higher. Conversely, if supply goes up or demand goes down, price is almost sure to slip.

That may seem obvious, but for many, it isn't. Six months ago an argument that the oil markets were irrational and that price would come down was somewhat palatable, but that argument should hold very little sway today if you believe longer-term markets are generally rational.

In other words, over the last six months or more, the markets have provided a clear message: The "clearing" price for crude oil, for now, is no longer $20 or $30 a barrel. It is much closer to $40 or $50.

That doesn't mean that price won't fluctuate. In fact, oil prices should move lower as winter turns to spring, during the interlude between winter heating season and summer driving season. That is a seasonal fluctuation in which demand shows seasonal declines, and as a result, crude inventories build. However, absent some major shift in supply fundamentals or demand characteristics, the move is likely to be along the

current

price curve rather than a shift downward in the entire price curve. That's economic-speak suggesting that price fluctuation is likely to be incremental, not a step-function change in prices at all levels of supply and demand.

And if seasonal patterns hold, prices will rally into summer as consumers step up demand during summer vacation and travel seasons, meaning more demand with little change in overall supply. Again, we'll see a move consistent with the current pricing environment.

Without some major shift in either supply or demand fundamentals, the market is telling those who are listening that oil prices should remain in the $40 range in the coming months. Now, I don't know if that means $38 or $45 a barrel on any given day, nor do I need to predict an exact price. As an energy investor, I am comfortable with a general belief that oil prices around the $40-a-barrel level are sustainable.

Supply and Demand

Certainly, there are items that could change my outlook, and with prices in ranges that are not historically proven over time, I am constantly playing skeptic and looking for errors in my analysis. In the commodity markets, the best way to go about such self-reflection is to compose "what-if" lists or a list of the reasons prices moved to these levels last year. If those tenets are challenged, you know it's time to reassess your position. So, here's a quick list:

On the demand side, there are two primary drivers: a global economic recovery and the acceleration of energy demand growth in China and, to a lesser extent, India. A quick listen to

Federal Reserve

Chairman Alan Greenspan this week suggests that the U.S. economy appears to continue its steady growth profile, and a look at other developed nations suggests the same, with some unevenness and lumpiness. More importantly, there are no major warning signs on the developed-nation front that suggest we are about to hit a brick wall. As a result, no big demand shocks -- absent an exogenous event -- are likely on the developed-nation front.

China is a slightly different story. It is difficult to read, let alone predict, the growth pattern in China. It is likely to be lumpy for several years to come as a rapidly developing economy grapples with ways to manage growth without stifling economic expansion. However, the trend appears to continue "up and to the right," and that, even with its erratic nature, will make for continued incremental growth in energy demand. In fact, Don Straszheim, in my view one of the premier China gurus around, recently suggested that the need for additional energy supplies in China will remain a primary issue for that developing nation for several years to come.

On the supply side, the issues are somewhat easier to measure. After all, there must be two dozen organizations that measure production runs around the world, tanker loadings in every port on earth and receipts of crude in places as diverse as Port Fourchon, La., to pipeline terminals across Europe.

There are plenty of signs that supply growth continues to be challenged around the globe. In general, it has been well over 10 years (maybe 20) since the last mega-oil discovery was made, and the big fields of our past are aging just like the American populace, meaning less production and higher costs per produced barrel.

If you don't believe prolific producers are facing high decline rates, take a look at the news that Saudi Arabia is looking to double the number of rigs drilling new oil wells in attempt just to keep production near current levels. It is becoming more difficult to find new sources of oil, and that trend will only continue.

It also is becoming more expensive to find new oil sources. A small exploration company that has appeared in these pages many times,

Energy Partners

(EPL)

-- to which my firm has provided corporate finance services in the past year -- announced that finding and development costs in 2004 were nearly $16 a barrel, well up from the historic average closer to $12 per barrel. While a portion of that increase is due to a harsh hurricane season in the Gulf of Mexico that led to expensive remediation and lower production, it also is a sign that the low-hanging fruit in the oil patch is all picked.

The trend of increasing costs is important, because it means higher sustained crude prices will be needed to create the economic incentives for exploration companies to explore. Given the increasing costs of each new well and the growing risks of drilling unsuccessful exploratory wells -- dry holes -- in more difficult exploration plays, companies will demand higher prices for the oil they do find. That will create a bias toward higher, not lower, oil prices.

The 'Risk' Premium

A final cause of higher crude prices is what many pundits call the "risk premium" in crude. Whether it is Iraq or Russia, there is a belief that geopolitical events have been a primary cause of higher crude prices, and that belief gained much more traction after the invasion of Iraq.

There is little question that a number of geopolitical events have affected the price of crude oil:

  • Instability in the Middle East.
  • Civil strife in Nigeria and Venezuela.
  • Budget issues in Mexico.
  • Government policies that have created significant uncertainty as to the viability of private energy investment in Russia.
  • Strikes and social policy in Norway.

However, as I have argued before, too many people are trying to predict how large this so-called "risk premium" is rather than focusing on the more fundamental question: When will it go away?

We live in a world that has become much more uncertain than it was even three or five years ago, and much of that uncertainty is directly or indirectly related to or associated with regions of the world that are rich with oil reserves. As a result, until certainty and stability pervade those regions, the risk premium, however large or small, is likely to remain in the price of crude oil.

Next Chapter

Many of us sit here today and say it's hard to imagine a scenario where oil prices go to $60 or even higher, as suggested by T. Boone Pickens. But a year ago, most of us would have found it hard to imagine a scenario where oil prices soared to $50 a barrel in six months and settled into a pattern that suggests mid-$40 oil for the foreseeable future.

Here are the expensive facts: Demand for crude oil is growing, crude oil is becoming harder and more expensive to find, and there are few alternatives for the pervasive nature of energy in nearly every facet of our lives.

While that may sound as much like sociology as economics, the economic and market realities seem to suggest that lower energy prices are a dream of our past and not likely a part of our foreseeable future.

As consumers and investors, that is something we may need to learn to live with.

Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

cedmonds@thestreet.com.