Once the issue with Iran resolves itself, will oil prices crash? Many are saying “yes.” I think they are wrong.
Certainly oil prices are higher than they normally might be because of the ongoing conflict with Iran. And if war breaks out, oil prices will spike even higher.
On the other hand, I have to completely disagree with the position that oil prices will crash.
According to the International Energy Agency (IEA), the world supply of oil is just under 90 million barrels per day…about the same level as daily world consumption.
While some point to the fact that oil inventories in the U.S. are high (which is one of the factors why some point to a crash in oil prices), they are forgetting to note that oil inventories in other parts of the world are falling.
Most experts in the oil industry, including the IEA, agree that the oil wells supplying the world with oil are declining at a rate of three percent to five percent per year.
That means that if there is no economic growth in the world, we still need to find roughly 3.6 million barrels a day more of oil to replace the wells that are running dry.
If worldwide economic growth is 1.5%, this is another 1.35 million barrels per day needed to meet demand, bringing the total supply required to roughly five million barrels a day. To put this into perspective, Saudi Arabia exports about six million to six and a half million barrels per day. Five million barrels a day is a significant amount of oil that needs to be replaced.
In a recent interview, the CEO of Royal Dutch Shell plc (NYSE/RDS-B) stated that the era of cheap oil is over, which will mean sustained higher oil prices (source: Forbes, Apr. 23, 2012).
As oil wells deplete, we need to drill 6,000-7,000 feet below the ocean’s floor to find replacement oil or we have to visit our friends north of the border to extract oil from the oil sands—both expensive propositions. An oil stock can only make money for investors if oil prices are above the price of extracting that oil from the ocean or the oil sands or another expensive source.
Shell estimates that worldwide demand will double by 2050, with most of the new demand coming from emerging economies. It is estimated that China could overtake the U.S. to become the largest consumer of oil over the next few years even if China’s economy is slowing!
Although a number is hard to come up with, most experts place the higher cost of extracting oil from the ocean floor or the oil sands at approximately $70.00-$80.00 dollars a barrel. This doesn’t mean that oil prices cannot drop below $70.00 a barrel.
My contention is that if oil prices drop below $70.00, oil companies will simply stop extracting the more expensive oils out of the ocean or the oil sands, because oil companies will lose money on these ventures.
It may be that the world has not reached peak oil, dear reader, but it certainly seems to have reached cheap peak oil, which means those higher oil prices are, unfortunately, here to stay. This is bad news for consumers, bad news for the inflation numbers, but good news for the oil companies.
Over 80% of the S&P 500 companies that have reported earnings so far for the first quarter of 2012 have beaten analyst earnings expectations. But the rest of the year doesn’t look that rosy…
The Coca-Cola Company (NYSE/KO), an S&P 500 company, beat first-quarter analyst earnings expectations, but stated that prices for aluminum, juice and plastic—commodity prices—increased its costs by 10% over last year, decreasing their profit margins.
The company stated that the U.S. market seemed fine and certainly much better than Europe, which will continue to be an issue in 2012. The company also cited a slowdown in its business in China.
Kellogg Company (NYSE/K), an S&P 500 company, did not meet analyst earnings expectations because of its European business. It foresees a difficult 2012 with commodity prices remaining high. Although the company cited higher commodity prices as impacting its current earnings, the company stated that, at least to this point, they have been able to raise prices to offset higher commodity prices.
WD-40 Company (NASDAQ/WDFC) reported better earnings, but noted that Europe was still a major concern. The company mentioned how high oil prices were reducing its margins, while higher commodity prices in general impacted its business.
Nestle S.A. (Pink Sheets/NSRGF) warned that 2012 would be a difficult year, as its U.S. and European businesses remain challenging. The company has experienced higher commodity prices, which impacted their business by 10%-11%, but partially offset this by raising prices.
PACCAR Inc. (NASDAQ/PCAR), also an S&P 500 company, is the second-largest maker of large trucks in North America. The company is viewed as an economic indicator. If large truck demand is high, it means that more goods are moving across this country, which translates to a strong U.S. economy.
In the past two years, the company hired people to build trucks, as it ramped up production in anticipation of demand in the U.S. economy, in spite of higher commodity prices. Now the company is planning to reduce the number of workers it employs by 10%. This seems to suggest that the demand the company was expecting from a stronger U.S. economy has not developed.
Watch out for that stock market rally, dear reader. Commodity prices were an issue in the first quarter of 2012 and could continue to be a problem.
Where the Market Stands; Where it’s Headed:
I remain steadfast in my opinion: We have simply been in a bear market rally (often referred to as a bounce) since March of 2009.
The rally has been supported by artificially low interest rates, record government debt and a record increase in the money supply. There have been structure improvements to the economy. The lifespan of the rally is limited.
What He Said:
“Why Google stock will go higher: Most investors in Google, surprisingly, are retail investors. And that’s why the stock can go higher—because only 20% of the stock is owned by institutions. If the institutions jump in and buy Google, the stock will certainly move higher.” Michael Lombardi in PROFIT CONFIDENTIAL, June 2, 2005. Michael recommended Google stock as a buy on June 2, 2005 when the stock was trading at $288.00. On November 5, 2007, when Google reached $700.00 U.S. per share, Michael advised his readers to sell their Google stock and to put the proceeds into gold-related investments. Coincidentally, gold bullion was also trading at about $700.00 per ounce in November 2007. Michael’s message was to trade each $700.00 share of Google into $700.00 of gold, because he saw gold as a much better investment.