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You Can’t Eat Oil

Sigma Investment Counselors

October 14, 2014

For most of the period following World War II, political and investment decisions have been predicated on the assumption that oil reserves were limited and that shortages and price increases were the most likely long-term risk to an increasingly energy dependent society.

Recent weakness in oil prices suggest that the expectation of shortages, particularly in the near term, should be revisited.  There is general agreement that weaker economies, particularly in Western Europe, and improving vehicle fuel economy may be moderating the growth in demand for oil. 

On the other hand, it would be logical to assume that disruptions in major oil producing areas, (fighting in the middle east, Ebola in western Africa, and politically driven management problems in countries such as Venezuela), would adversely affect supplies.  Historically, oil prices have quickly spiked at the first signs of any disruption in supplies.

This is not happening. Despite a wide range of actual and potential supply problems, the price of oil has been decreasing.  This is probably due to significant increases in production. 

Historically, the Saudis have been willing to stabilize prices; increasing production to prevent oil prices from reaching levels that would encourage more aggressive exploration and development of substitutes and, when appropriate, decreasing production to maintain the price level needed to balance the Kingdom’s budget.

It now appears that the Saudis are more concerned about maintaining market share than near-term pricing.  They seem to have recognized that, increased production from the United States, Russia and others is changing the supply/demand equation.

Most oil exporting countries currently need higher prices to balance their budgets and are hoping that someone else (Saudi Arabia) will curtail production to support prices.  In the absence of a price increase, some exporters may seek to improve revenues through production increases.

If you are looking for oil, finding costs compared to market prices is a key determinant.  If you already have significant reserves, lifting costs become the primary determinant of strategy.  Published estimates suggest that it costs the Saudis approximately $25-30 per barrel to pump oil out of the ground, well below similar costs for other major producers.  This would mean that the Saudis are in a better position to weather lower oil prices and less likely to cut production.

Budget pressures are likely to make it difficult to reduce production.  Investors should consider the implications of lower oil and gasoline prices.

You can’t eat oil.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA®

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