Why crude oil prices should not collapse

Oil, refinery

The recent fall in oil prices have warmed the hearts of many a market watcher. While the immediate sense of relief is undeniable, I foresee a bigger and far-reaching problem in the future as a result of declining crude prices.

Before I proceed, a clarification – I do not have any trading exposure to oil, therefore, have no vested interest in this view.

I subscribe to the “Hubbert’s peak” hypothesis, which indicates that global oil reserves are declining and oil will be gradually more difficult to recover from reservoirs. This view is endorsed by the Society of Petroleum Engineers, environmentalists and geo engineers like Kenneth Deffeyes, Peter Tertzakian, Matthew Simmons and Lester Brown.

Oil cos keep cost squeeze on

The business of oil is very complex. Veteran oil traders will readily admit that. Oil is about money, politics, power, terror and about leverage to bargain in international trade. Therefore, countries with reserves of oil tend to inflate their reserves. It gives them a sense of invincibility during negotiations. If an OPEC country was to admit a decline in reserves, imagine what terms it could garner in the international weapons/ technology /forex trade?

'Oil price fall an "alarm bell"

Inflated reserves are an open secret in the oil world. The OPEC is apparently hinging on fond hopes that new discoveries will compensate for the frantic pace of opening the reservoir valves and early depletion of wells. This is a boon and the bane at the same time.

Replenishment angle

Oil exploration is extremely expensive as compared to what it was a decade ago. Schlumberger, a global leader in exploration technology and equipment, sells special drill bits for as much as $1,20,000 per piece. These drill bits last longer than conventional ones, but wear out anyways. What if sustained drilling yields no oil? You drill more, and costs keep climbing higher. Exploration, therefore, is an expensive endeavour. Clearly, profits from selling oil from present sources will fuel exploration costs.

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Oil analysts will agree with me when I say that offshore drilling rigs are not easily available and even if they are, costs are much higher compared to those a decade ago. Salaries of oil engineers zoomed over the moon even before our Chandrayaan could blast off. I can go on and on.

If prices are driven lower, the incentive to explore will vanish. This will result in a bigger and a more brutal oil shock into the future. With marginal costs of drilling oil averaging $72 per barrel, selling oil below this price will see a clampdown on output from –- the first step is already taken after the recent OPEC meet.

While these shocks may not occur in the coming months or quarters, remember this – commodity trends are made over the years and when they take off, they are difficult to stop. If what I fear comes true, the rally from $28/barrel to $147/barrel will feel like a pin prick in the future. The next shock will be very painful indeed.

The alternate energy myth

I wish for the sake of my children that viable alternate energy is in place and fast. But wishful thinking alone is insufficient. Energy has to be cost-effective and commercially viable to make a business sense. Tell the global citizens to switch to electric cars, solar refrigerators and geysers, eco-friendly blenders and the governments to switch to nuclear power for power generation.

You are likely to be in for a rough time – many people are worried about job security and existential anxieties, capital expenditure (even if possible) is the last priority. People will extract the last drop of juice from their existing automobiles and appliances till they break down.

Oil consumption will continue till economic boom returns and alternate power research commences again. Even then, relatively poorer Asian countries may switch to alternate power at last. Oil will be in circulation for a few decades more.

Advocates of alternate energy sources who promise quick miracles don’t just need to smell the coffee, they need to smell strong-smelling salts and wake up from their infatuated stupor.

Middle East - a cornered cat?

The oil-rich sheikhdoms have been upgrading their infrastructure, quality of life and preparing for a future without oil as a major source of revenue. Selling oil is all they got to pay for this splurging. Lower oil prices will result in turmoil in these countries, possibly delay or default in overseas debts, currency declines and internal strife. Iran, for example, needs to sell oil at $90-95 to break even in their budget.

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Many countries, after fresh overseas borrowings, need oil prices in excess of $65-70/barrel to stay solvent. There is trouble brewing there. I fear the worst is yet to come if oil collapses further. Do I need to tell you what could be the impact if these countries try to sell their US holdings of bonds, stocks, real estate and bank deposits?

While I also need lower oil prices just as everyone else does, I want it at an economically viable, long-term level.

Fire-fighting the current problem to solve near-term issues will merely postpone the problems for our children to face in the long term.

Under license from www.3dsyndication.com

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