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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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How Big is the Oil Supply Problem?

How big of a problem is the oil supply situation? The latest report from the International Energy Agency warns that the world will face an oil crunch in five years. IEA said that supply was falling faster than expected in major producing areas while consumption is accelerating thanks to strong economic growth in emerging countries.

To listen to some commentators, the world faces an impending economic cataclysm over what we are told is a major reduction in the available supply of oil. To others, the currently high oil price is a response not so much to actual supply as it is an inefficiency (whether contrived or accidental) in getting oil and its by-products to retail market channels. And yet another theory is that today's high oil price is a hidden "tax" on consumers to help pay for a long-term war effort in the Middle East (with its obvious benefits to the oil oligopoly).

Which of these theories seems to command the greatest attention from investors? To answer that question you need look no further than the leading financial web sites. Investors aren't shy about sharing their opinions on this matter to those who publicly comment on it. Here are some of the responses I've received lately concerning the oil conundrum:

"If you want to read about the future, start reading about peak oil. World oil production probably peaked in mid-2005, but time will tell. The next 5-year situation depends on whether the Saudis can produce more oil. Their production went down 2005 to 2006, but they still talk about raising production levels due to several billion dollars they are now spending to increase oil production. Their biggest producer, Ghawar, is dying. The next few years will tell us how fast it is dying. Do you believe these Arabs? I don't, and many experts on the subject don't either. So we are about to get hit with a major blow to the economy. It will also slow down the Chinese. If it slows down the Chinese enough, then we have an immediate depression."

Let's call the above sentiment the "Oil Depression Scenario." It's representative of much of the talk out there in Internet land and is a theory that's gaining increasing acceptance from many investors.

Another commonly held conception over the oil supply scenario is this:

"Expect all US commerce to start raising prices as they realize this is not just another short term spike in oil prices caused by Big Oil monopoly or OPEC conspiracy. The world doesn't have the conventional oil. The unconventional oil and renewable resources will take years to deliver in sufficient quantities. Look for 1970s type gas station lines and government emergency energy efficiency mandates starting maybe next summer, but certainly by 2010."

Let's call this one the "Oil Inflation Scenario." This theory holds that we're in for a repetition of hyper-inflation a' la 30 years ago. Its based on the assumption that global oil supply is extremely limited and diminishing fast. Keep in mind that there is an emotional bias and psychology behind the above sentiment from the individual investor's standpoint. This isn't simply a cold academic theory. It's part of the Emotional Belief System (EBS) of many individuals and as such it colors their investment decisions in many different market sectors.

We know from the classical rules governing commodity price analysis that "price cures price." Simply put this means that at some point along the curve of a rising price trend there is a point at which high prices evoke a reversal in demand and a period of falling prices follows. A sustained uptrend in any commodity also tends to stimulate greater production of that commodity, adding to the supply; rising prices also galvanize the search for lower-cost alternatives to that particular commodity. This process is already well underway in response to the long-term bull market in crude oil and we've already seen evidence of price curing price in the intermediate-term. Consider: since last July the oil price has essentially fluctuated in a range between the all-time high of $77/barrel and the yearly low of $50. One year may not seem like a long time to some, but for an essential commodity that is supposedly facing a major long-term supply problem, that year-long trading range doesn't speak very highly of the theory of a catastrophic supply shortage.

Do you remember the Hunt Brother's corner of the silver market from the late '70s? You may remember the hyperbole that was typical of the market talk of those days when wild-eyed commodity speculators spoke of a massive supply shortage and a limitless rise in the silver price. Basically every major spike in a commodity price throughout history has sparked the same kind of talk we're hearing about oil supply right now. And how does it always end? With a sudden (and quite unexpected) outpouring of supply onto the market that seemingly comes out of nowhere, and a corresponding fall in price. There has never in commodity price history been an exception to this rule.

The one thing we learn from history is that it always repeats. This also includes commodity price history and this shows us that every major bull market in any given commodity is always accompanied by its own supply crunch scenario. Remember the prospect of "beans in the teens" in the 1970s? Remember the sugar supply scare of 1980 when the price went skyrocketing from 7 cent/lb. to 45 cent/lb.? Remember the corn shock of 1995-96? Or more recently, the platinum price shock of 2000? All of these "crises" were eventually resolved as price cured price.

If you listen to the propaganda of the commodity exchanges you'll be told that commodity futures contracts can be likened to insurance policies that help producers hedge against market volatility. But there's another adage that says commodity futures were created so that producers and other vested interests could manipulate prices up and down to their advantage, as well as to put their smaller competitors out of business. I don't know about you but I strongly suspect the latter bromide comes closer to the truth. This could apply to the crude oil market in a number of ways.

Though it is speculation on my part, I have no doubt that there are supplies of oil and natural gas out there ready and waiting to come to market at such time as the market makers feel the need is right (by their standards). It is no speculation to note that there are massive natural gas wells within our own country that could be tapped in short order to relieve a high gas price. It's also no secret that there are many capped oil wells out there that could also be brought back into production if/when needed by the controllers. The oil supply conundrum is not an unsolvable one by any stretch, certainly not in the 10-20 year outlook.

Instead of fretting over the "peak oil" misconception and focusing attention on insufficient alternatives like solar, wind and ethanol, investors should instead look at the emerging technologies currently being developed that promise to relieve, in part, our dependence on oil. One example would include Pebble Bed Reactor technology (PBR). PBR involves nuclear technology that is far more efficient than classical nuclear reactors and much safer. PBR can also be used to produce hydrogen, which in turn can be used as vehicular fuel. It is being operated in the prototype phase in China and South Africa.

At every major turning point there is a time, just before the pivotal point, when everything looks hopeless. Some would call this the "darkness before dawn." We are now at a critical turning point in regard to our relationship with the industrial-petroleum complex. Things may look hopeless now, but what's to prevent the surprise introduction of an efficient and workable energy alternative? Revolutionary technologies always come about when they are needed most and we know that the technologies are there -- it's just a matter of getting them to market.

What the solution will be is anyone's guess and would be futile to even speculate. What we do know is that the oil problem has reached the point of maximum recognition, i.e. virtually everyone recognizes there is "no way out" regarding the oil problem. We know from history that when any crucial problem reaches the point of maximum recognition the reversal of the problem is imminent. It stands to reason therefore that the "solution" to the oil crisis (and there is always a solution to every manufactured crisis) has already been packaged behind the scenes. It's simply a matter of time before the solution is unwrapped for all eyes to behold.

If oil supply isn't the problem then why would the oil price be as high as it is? It's sometimes easy to forget that we're living in a war-time economy and in a war economy commodity prices tend to be high for prolonged periods. The oil price in particular will be influenced by the war for various reasons, not the least of which is the need for war financing. Because of the deeply vested interest the oil oligopoly has in the Middle East war, we can assume the oil price will remain buoyant for the duration of the war. The long-term uptrend will remain intact; however, there will be every effort made at preventing sustained run-ups in the oil price. We need look no further than the oil price trading history of the past year (see chart above) for an example of how this game is being played.


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