Oil Prices

The price of oil has been oscillating around the US$ 30 mark lately.  Should we care about that number or not?

Perhaps we can understand price movements with a story from my past.  I had a client who owned commercial property in the downtown area.  The fair value for rent was an issue but because the area was then stable, it did not rise to the level of urgency.  His view was that if one store was vacant and no tenant wanted it, there was a glut and the price would fall.  If one tenant wanted a store and none were available there was a shortage and the price would rise.  The price of just one store drove the rental market price of a couple of hundred stores.

And so it is with oil.  The price of a store lease does not change daily and neither does the price of most of the oil that is sold.  Most oil is sold on future delivery contracts, but the price you see daily is the price in the spot market.  The price someone must pay to pick it up now.  The spot market is a tiny fraction of the entire market.

The entire world production of oil is in the 100 million barrels per day range.  The spot market is less than 2 million barrels.  Shortages can exist in the spot market and so can surpluses, just like the downtown store market.

Should we pay great attention to the day to day price when it is disconnected from the real commercial reality?

If a large producer reduces production by 1% of the world delivered amount, the price will shoot up.  If someone else increases production to get more money today, then the price will fall.  Some countries have near zero variable costs so they can do that for a while.  Saudi Arabia for example produce oil for next to nothing while the cost to produce heavy oil in Alberta is very high.  Transportation cost is a factor too.  Transporting heavy oil by rail is expensive per barrel whereas in Saudi, it is possible to put light oil in a tanker without much cost.

Pay attention to reality.  Most large consumers have fixed price contracts far into the future.  Those that do not use, the commodity market to hedge their costs.  No one that uses much oil treats it like the fresh produce department at the grocery store.  They do not go there and shop each morning.

Oil has a real value and it is higher than the $30 or so current price.  It is a fine feed stock for the chemical and plastic industry.  It is an okay fuel.  People will buy it a price that is higher than $30 and not feel they have been robbed.  There is a price where the price is high enough that new technology and exploration are cost effective.  That price is substantially higher than $30.  Probably $70 to $90.

If oil prices stay low too long, there will be a future shortage and the price then will be much higher than $70.  Price is a signal to producers and when it is manipulated for political advantage wrong decisions become part of the market.

The oil industry is likely oversold just now.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  

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