Monitor Oil Prices in the Months Ahead

Joan E. Lappin, CFA

Physician's Money Digest, February15 2005, Volume 12, Issue 3

Figuring out what oil prices will do in thecoming months is no longer just about supplyand demand; the picture has become farmore complicated. As usual, the talkingheads on financial TV shows are extrapolating recentprices into infinity and concluding oil prices are onlygoing higher. Now that we're at nearly $50 per barrel(as of mid-January), they're debating if the right numberis $60 or $70. Most oil stocks increased by double-digit percentages at the end of 2004, and nowthey're telling you to buy them. You want to be aheadof the mob, not chasing it.

High prices at the gas pump place a particularlyheavy burden on those who live on a tight budget.That means you have less to spend elsewhere. That'swhy retailers and restaurant chains have felt thepinch. Airlines have been squeezed mercilessly byhigher prices for jet fuel.

Oil Sources Explored

That said, eventually the law of supply anddemand prevails in a free economy. New techniquesfor exploring and recovering resources from fieldspreviously considered depleted are increasing reservesaround the globe. The new methods facilitate faster,cheaper, safer drilling.

The Saudis have issued successive statements ofintent to increase supply, and they seem to be doingso. Russia is using the current high oil prices toincrease its output. You might be shocked to learnthat in 2003, Russia produced more oil than SaudiArabia. Russia uses about 33% at home and sells therest of its production abroad.

Over the past several months, Russian PresidentVladimir Putin has used a variety of tactics to reclaimcontrol of some of the privatized oil assets of Yukos.Russian oil output reached a new post-Soviet high of9.42 million barrels per day in September. Many ofthe European countries that didn't join our invasionof Iraq refused because they had been exploring for oilin Iraq ever since the Gulf War. Our Department ofEnergy (DOE) says that Iraq's oil reserves, once fullyexplored and developed, may equal or exceed thereserves of Saudi Arabia.

Consumption and Terrorism

All of this is additive to supply; however, globalconsumption has been rising faster than discovery anddevelopment of new fields. The rapid industrialexpansion in China is resulting in a dramatic increasein its consumption of oil, and Chinese workers areabandoning their bicycles in favor of automobiles, thenew status symbol. An up-tick in the global economyhas also sparked increased use of fossil fuels.

It is a sad fact for Americans that we use far moreoil (20 million barrels per day) than weproduce (5.5 million). We also use morethan any other nation and consume25% of the world's daily usage. YoungerAmericans who don't remember gaslines in 1975 have been migrating toSUVs and trucks. The US governmentoffers tax incentives to business purchasersof large, gas-guzzling SUVs. Weoften fail to turn off electric lights andappliances when we leave a roombecause we have been spoiled by lowcost energy. Electrical usage is soaringwith the growth of computers.

Added to that growing demand, theBush administration decided in November2001 to fill the Strategic PetroleumReserve (SPR) to its capacity of morethan 700 million barrels. Even as oilprices have spiked in recent months, theflow of oil into these storage facilitieshas continued unabated at the rate ofabout 1 million barrels per week.

National Geographic

Terrorism is threatening the supplyof oil to industrialized nations. TheJune 2004 issue of pointed out that in 1973,almost two thirds of the world's knownoil supply came from the Middle East.The DOE predicts that by 2025, onceagain, the Middle East will source 50%to 65% of the world's supply. In 2002,our oil imports came from Saudi Arabia(17%), Mexico (16%), Canada (16%),Venezuela (13%), Nigeria (6%), Iraq(5%), and others (27%).

Price Predictions

Oil has become quite a vehicle forspeculation this year by commoditytraders. Every global disruption of supply,concern over hurricanes, temporarydowntime on oil drilling platforms, orriots in Riyadh against the Saudi royalfamily, has been enough to send pricessoaring. If you balance the actual inventorieson hand, softening demand resultingfrom higher prices and the increasedsupplies expected to come on the marketin 2005, oil should be selling at around$35 per barrel. The difference betweenthat number and current prices around$50 must be attributed to speculativepressures and the terrorism premium.

Remember:

The probability that prices will dropis much greater than that they will soarto $70. When the Nasdaqwas at 5000 in March 2000, stock marketexperts were projecting furthergains to 6000, 7000, and 10,000 beforeits collapse by fall 2002 to 1300. At1300, they gloomily predicted 1000; ithas now rallied near 2000.

It's always easiest to extrapolate theunlimited continuation of a trend thanto call for a change in direction.However, very smart managers at smalloil exploration companies are now sellingfutures contracts to deliver gas in2005 at today's prices. They have decidedthey would rather lock in today'smid-$50 prices when planning theirbudgets for next year. They know that ifprices decline, their revenues will bewell protected. Hopefully, at this timenext year, oil prices will be trading inthe $30s and adequate supplies willovercome the terrorism premium.

is the chairman and chief investment

officer of Gramercy Capital Management

Corp, a NYC-based registered investment advisor.

Gramercy develops personally managed

portfolios tailored to your investment goals.

Ms. Lappin has been featured in several prominent

publications, including BusinessWeek. She

welcomes questions or comments at 212-935-6909.

Joan E. Lappin