Saturday, August 28, 2004

A Contrarian View on Oil Prices

August 28, 2004 - Street Insight Consensus oil price forecasts are too aggressive, and are not sustainable in the long run. The usual bullish argument sounds among the lines: Production capacity is maxed out (Saudis are pumping all the oil they can, Russia is a mess), demand in China, India, and South Korea is growing very fast -- far outpacing the supply available.
As compelling as the argument for higher oil prices is, it suffers from a major problem: the fallacy of composition. Fallacy of composition is an economic concept referring to the mistaken assumption that what applies to the part applies to the whole. The fallacy of composition ignores the interaction between multitudes of factors that are built into the assumptions. Most analysis that predicts sustainable high oil prices assume caeteris paribus -- a Latin term for "other things being equal;" in real life all things are not equal.
Demand side: At high oil prices, consumption of gasoline should decline as consumers drive less and drive less gas consuming hybrid vehicles.
It is assumed that demand will be either rising or staying the same. The erroneous belief here is that it ignores the impact that the rising oil prices have on demand. High oil prices have not yet translated into a proportional increase of gas prices at the pump (though oil price correlation with oil prices is not perfect since oil is about 43-45% of the total gasoline cost, the rest are taxes, marketing and distribution, and refining costs). Thus consumer demand has yet to readjust to higher oil prices. For example, in Europe gas prices are several times higher than in United States (mostly due to high government taxation). European consumers have adjusted their driving habits and the type of vehicles they drive accordingly. They drive smaller vehicles and drive less.
CNBC recently reported that a small hybrid car, Toyota Prius, is one of the fast-selling vehicles in the U.S. Major car manufactures have announced that they will be coming out with more hybrid vehicles in the next couple of years. U.S. car manufactures are very sensitive to losing the lead to Toyota (or other Japanese manufactures for that matter). In addition, they don't want to make the mistake that they made in 80s, when high oil prices gave an open invitation to Japanese manufactures, who produced less gas-hungry cars to win the hearts of the U.S. consumers.
As slow as U.S. auto manufacturers are, hybrids are likely to become a very important part of their business, since their cash cow SUVs will not be flying off the lots when gas prices are high. Ford's (F:NYSE) introduction of a light, hybrid SUV Ford Escape is the first indication of that. Though hybrids cost more money than traditional cars, U.S. consumers are already used to paying up for SUVs, therefore they are likely to be willing to pay higher prices for hybrids. Also, increased scale in production and improvement in technology is likely to narrow the price gap between the traditional and hybrid vehicles in the future. As I was writing this article, FedEx (FDX:NYSE) announced that they will begin beta testing hybrid trucks.
High oil prices make a very good political campaign issue as well, because of the simplicity of the argument. The argument is us -- honest, hardworking Americans against them -- large oil companies or unfriendly, self-serving cartels. Politicians will try to jump out of their skin to create incentives for automakers to produce more fuel-efficient cars and if needed to subsidize an alternative fuel infrastructure (i.e. hydrogen gas stations).
Another factor that may decrease future demand for gasoline is China. The growth of demand that will come from China may not materialize. China is living through a tremendous economic bubble which is about to burst, thus demand may actually decline, not increase.
Supply Side: High oil prices will have wide range ramifications on oil producers causing a significant increase in supply.
High oil prices make many uneconomical (high cost) oil wells economical again, thus spurring oil exploration in harder to reach places. However, high oil prices by themselves don't cause an increase of oil production, since an increase requires a large commitment of capital. An expectation of high oil prices staying high is a must for exploration efforts to intensify. Fortunately, that expectation is forming fairly rapidly, which provides another reason to believe that though it is unexpected, oil supply will likely increase from the unexpected places.
Contrary to common wisdom, OPEC doesn't want high oil prices. OPEC understands that high oil prices will lead to the above mentioned structural changes in demand and supply. That is why the recent announcement by Saudis of an increase in oil production is not surprising. As much as it is tempting to enjoy high oil prices, OPEC's objective is to maximize present value of their oil reserves and ironically high oil prices don't do that.
I believe that it is crucial to be able to read obvious but often ignored signs, since they are a good barometer of investors'emotions. For example, when a top business magazine features a company on a front page with a title "How (fill in the blank) transformed the industry." Usually that is a good sign that the emotions are at their peak, and so is the stock.
Washington Mutual (WM:NYSE) was a great example of that, a front page article in a top business magazine marked a top for the stock. The same is true for oil. A couple of days ago, CNBC started to show oil price in the low right hand corner bar on top of the Nasdaq index. Oil is appearing in the headlines more and more everyday (even I wrote three articles about it and I don't even own an oil stock!). Those are good indicators that emotions are heading towards their peak, though I don't think they have peaked yet -- since oil has to start appearing on the covers on the non-business magazines or become a subject on a sitcom.
It takes time for the structural changes to take place, thus it is impossible to predict how high oil will rise before it declines to its historical averages or even below them. However, the market has a good track record serving as a discounting mechanism, factoring events that are yet to occur. Thus oil prices are likely to head lower sooner than the structural changes take place. As always, the obvious answer to why the oil prices have returned to their historical average will stare at us in the face, though unfortunately after the fact.
This bearish case may or may not have all the answers to where the oil prices will go in the short run, and it is possible that the truth lies somewhere in the middle between the bull and the bear. However, the hidden risk that oil companies' revenues may fall of the cliff when oil prices decline is so great that we believe risk/reward of most oil stocks is unfavorable. As a result, we are keeping them out of our portfolios. Though a more short-term oriented investor may find them to be a good trade, that is not what we do. Vitaliy Katsenelson, CFA Copyright 2004


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