Black Gold and Yellow Gold Jude Wanniski September 3, 1999

This week's lesson will be taught by upperclassmen at SSU, in a seminar conducted during the last week at our TalkShop. I simply will run out the string that began with a posting by Dick Fox on August 23, who wondered if any of the other SSU students had any idea what was going on with the price of oil. I'll add comments during the seminar that I did not make at the time.

Dick Fox: Does anyone have a feel for what is going on with oil? I keep hearing it is OPEC holding down supply, but I find that hard to believe since they have never been this successful. Is there a demand component that we are not recognizing, SUV gas mileage or something?

Dan Girand: After 20 years in the oil and gas exploration and production business with a small independent producer, I wish I knew what was going on. There are a couple of things we can see. First, the industry discovered about 300 million missing barrels. We kept hearing there was an oversupply of oil, but flying around the country we would see the tops of tanks at refineries were very low. The tops float up and down with the oil in a storage tank. How could that be? The Energy Information Administration underestimated U.S. demand by 142,000 barrels/day. It also overestimated the U.S. output by 66,900 B/D. These numbers were then used by the International Energy Agency to compute world wide oil supply, demand, and inventory data. This compounded the statistical error and the numbers were reported to the U.S. markets each evening. These numbers were used to set the futures price of oil. That price in turn is used to set the price a refiner is willing to pay a producer at the wellhead. Now everyone has adjusted to the fact that those 300 million barrels are not out there. The second thing that is happening is that every nation in the world except Saudi Arabia is producing all the oil it can. It would take the Saudis 4 to 5 years and $100 billion to open the floodgates. There never was really an oil glut.

Instead we have a world with depleting reserves. Every well begins to deplete as soon as the first barrel is sold. It continues on a decline curve until it can no longer produce and is plugged. Producers are selling themselves out of business unless they can replace the lost reserves. The world oil producers are not and cannot replace the depleting reserves. We are not running out of oil, we ran out of money. It will be several years until this can be turned around, assuming there are no other busts. My own thought is that there are micro price swings in oil and gas prices that are based on the fundamentals of supply and demand. Then there are the macro swings that are influenced, as are all commodities, by economic policies of the Fed. If you plot oil and gold prices, they generally follow the same path with minor individual blips along the way. Hope this gives you some ideas on what is going on.

Pete Madsen: To clarify this in my own mind: You are talking here about known reserves, rather than the unknown (and probably unknowable) total reserves of petroleum on the earth, right?

Dan Girand: You are correct. Production from existing, producing wells, worldwide depletes every day and we cannot drill enough wells to catch up for some time in the future. We have lost too many people and too much infrastructure. Reserves are what our best science tells us is left to produce in all the existing wells plus what our best science tells us is out there to be drilled. But, we really do not know until we put a straw in it.

Todd Davis: I generally agree with Dan's comments. Capital budgets were drastically slashed by virtually every oil company in the world in response to last year's price decline. Inertia plus oil company CEO disbelief that this price level or anything close to it is sustainable will prevent significant cap budget increases for the near future. Also, the risk pendulum in traders' analyses may be shifting. For instance, a normal or severe winter may have a greater impact on upside price pressure than a mild winter will have on downside pressure. Sometimes oil's monetary characteristics prevail in the marketplace. Supply and demand are carrying the day right now. Sometimes both are equally impactful. I think that was the case when oil far exceeded gold in its path south last year. Of course, deflation was the catalyst for oil's fundamental deterioration last year.

Dick Fox: That was a great reply. Thank you, it was exactly what I was looking for. A few questions. If I understand you, the world oil producers are producing as much as they can, but demand is outrunning supply. Is that what you are saying? Are you also saying that a mistake in analysis at the government level released incorrect information that drove the price of oil down last year, or are you saying that the bad information is causing the current high prices? Finally, I agree with you about oil and gold tracking together. That is what has me so confused. Last year oil went through the floor, now suddenly oil is going through the roof. I hate to be a conspiracy nut, but could someone high up be profiting from this government "mistake," a la cattle futures? Is it possible to manipulate the cost? Actually I thought the oil market was so diverse that it would be almost impossible to manipulate. Am I wrong?

Scott Robinson: Great string. I can't wait for Dan's next post.

Ed Breen: I think this is a great string too and I am also waiting for continued comment by both Dan and Todd. In the mean time I offer this: Demand may be inventory buying forward in preparation of Y2K. I see this in many manufacturing businesses including my own. Basic materials and essential ingredients of production are being inventoried now. What I expect is that it will lead to oversupply next year as inventory is worked off.

Todd Davis: Interesting thought on inventory buildup in anticipation of Y2K. NYMEX crude is showing significant backwardization (Oct. 99 contract is $21.43, Aug. 00 is $18.94) which indicates near-term supply concern. It doesn't take much to move near-term contracts but contracts further out are usually fairly stable. When the prompt contract dipped near $10 bbl last winter, the contracts a year or so out were around $16. I recently completed a study covering 1991-98 which indicated excess returns could be attained by selling forward the next twelve contracts or "strip" anytime the current average strip price exceeded the 75th percentile or greater price of the previous five years. Also worked for buying when the strip was below the 25th percentile. This indicates a strong tendency for the price to revert to the mean in a timely manner. Have any traders out there seen anything like this? I think I recall a posting here about a long gold, short oil position based on the current vs. long term oil/gold relationship. This seems to be somewhat complementary to my study. To summarize, the current strip around the 85th percentile plus oil's relationship to gold and other commodities would seem to indicate a selling opportunity. By the way, I'm not a trader. I'm a portfolio analyst for a major...I stumbled on Memo on the Margin while doing some research on historic oil price trends. I've learned more about the oil market (not to mention economics and politics in general) from Jude and the participants in Talkshop than I've learned from nine years in this business. The perspective I've gained here has paid dividends on the job. I've begun lobbying for us to become a client. Anyway, I do appreciate the discussions here.

Wanniski: So far what we learned is that the price of oil began a steep decline two years ago, from the $22 range to as low as $7 or $8 a barrel. The decline was due to two things happening at once: The price of gold was falling because of the Fed's monetary deflation, which was pushing all commodity prices south. The second was an error by an international agency that keeps the world markets advised on the level of unused capacity of crude-oil production -- that the oil producers had a surplus in the ground that they could get out of the ground with the turn of a switch. The agency was wrong by 300,000 barrels. Meanwhile, oil producers everywhere had stopped investing in the drill rigs and accompanying infrastructure necessary to turn "known reserves" into ready crude into refined product. In the last several months, oil began climbing in price as the market realized there was more demand than supply, and no supply on the horizon, plus inventory building for Y2K. We actually advised our clients along the way of all these factors -- including the Independent Petroleum Association of America, which tipped me off to the statistic error on oversupply.

The posting referring to "backwardization" is important for SSU students to understand, where Todd Davis refers to the fact that the futures market is now willing to pay a higher price for oil delivered before the end of the year (and Y2K) than next August. By the way, all commodities save one can at one time or another be subject to "backwardization." Gold is the exception. Its future price is always higher the further out you go. The other important point made was about an idea of going gold long and oil short. Once these temporary events surrounding errors by the Fed, by agencies predicting oil supplies, and Y2K realities are worked out, the price of gold will be higher and the price of oil will be lower. Guessing when to make that bet is the kind of thing Polyconomics does for its paying clients. Hopefully, your company will sign up soon, Todd.

Dan Girand: Except for the Saudis, supply is decreasing and demand will continue at least at the current rate, or some say will increase. Supply really has two components in this industry. Supply can be the products of crude oil refining in storage and crude oil in tanks waiting to be refined. That storage is fairly constant. Because of environmental considerations, there have not been any new refineries built in the past 20 years. Little storage has been added for the same reason. The other component of supply is the producer of crude oil. This supply is depleting as the oil wells go through their natural life cycle. Unless producers drill new wells that produce more crude oil than is being sold to refineries, the decline in supply continues. For the reasons Todd and I have discussed, the depletion of wells will outstrip the new supplies.

Todd Davis: Confidence will rise if the price stays up, emboldening non-OPEC producers to increase exploration and ultimately production. OPEC, specifically Saudi Arabia, which is more concerned with maintaining market share than high prices will probably respond or try to preempt this by raising production marginally to maintain market share by dampening upward price pressure and slowing non-OPEC exploration and development. This, I believe, is the primary cause of oil price reversion to the mean I referred to in an earlier post. Kind of like creditors and debtors thrive with a stable unit of account, I think crude suppliers (and consumers) peacefully coexist with an oil price around $18/bbl WTI. What really throws this out of whack besides wars are Fed errors.

Dick Fox: Larry Kudlow seems to believe that the normal Oil/gold ratio should have oil near $15/bbl. Do you feel this is too low? You seem to believe $18 would be closer to the norm. Do I read you correctly?

Judith Grady: Quick comment: gold should be where the 'normal' gold/oil ratio is closer to $18 per bbl. (gold $ price is too low) It is just that deflation problem . . . and many 'normal' relationships are out of whack. This is not over.

Dick Fox: Judith, if you have time, how is this affecting the oil producers of South America? I would think that they would love this situation and be producing all they can, and looking for more.

Todd Davis: Judith answered your question. If gold were at a more optimal price ($320 to $350), $18/bbl would be about right barring supply shocks. If dollar liquidity were managed such that the $ price of gold holds at current levels for an extended time, $15/bbl might be the appropriate average price of oil. Over time I'd expect to see drilling & production costs drop to a level so that effectively margins would be similar to the $18 world. Of course, there's a great deal of unnecessary pain with this deflationary adjustment as most commodity producers can attest. Looking at both sides of the equation, oil prices and costs, is one the great insights I've gained from reading TWTWW [The Way The World Works] and attending SSU. Most folks I deal with in this business have varied views on the direction of oil prices (and worry constantly about them). A few see gradual increases, some see relatively flat prices, and many see declines to a lower level. However, most think costs will simply climb at a gradual rate from current levels - not a great deal of dynamic analysis. I think it's more appropriate to focus on average margins over time in planning rather than some discrete price vs. cost relationship. For example, deep gas wells which cost $15 million to drill in 1981 now cost about $5 million. The trade press credits technology improvements with this drop. Technology is a part of it but I'd also say deflation is a component. Simply put, oil and gas wells will only be drilled if an acceptable risk adjusted return can be expected over time. The successful companies in this business are the ones that recognize and can handle the chaos of monetary policy without getting killed in the process.

Dan Girand: Unless the nation's entire economy turns downward, I think the bottom oil price for a healthy industry is $18. A historical note, when the U.S. economy has boomed, the oil business has not and vice versa. As a commodity, the oil business is a price taker, not a price maker. Producers absorb all costs and cannot pass anything on to anyone. Todd is right; there has been more deflation than technology improvements. I would suggest the deflation is within the industry. Prices of drilling rigs and pulling units had to come down or companies would close the doors. But there are other costs that the industry has no control over. According to a recent study, the industry has spent over 10.6 billion on the environment. We produce crude oil, but must pay the ever increasing retail cost of gasoline and diesel fuel. Some $0.40 per gallon is tax. We are in a seven day a week, 24 hour a day business and have to pay people to work in snow and 100 degree heat. We are no longer a high paying industry, but must compete with other industries in the area for employees. We are rated second only to farm and ranching as a risk for the insurance we must carry. We have to require ever higher coverages from our sub-contractors. So we pay increasing costs for things we must have, while receiving less for our product. I have the citation for the GAO report on the International Energy Agency. GAO/RCED-99-142 Oil Market Report.

Todd Davis: I think you hit the nail on the head regarding the health of the oil business running counter-cyclical to the health of the U.S. economy. I think it's directly related to oil's sensitivity to monetary policy with the oil business getting excess gains in inflations because prices react so quickly with costs lagging and vice versa with deflations. The U.S. economy as a whole is obviously negatively impacted by prolonged inflation. The question I have is how the nation's economy will do if the deflationary actions of the Fed continue. I think we'd all prefer stable money which would shift the measure of success back to who can find, develop, produce, and market oil most effectively rather than who can dodge Fed bullets. You're also on target about the escalating burden of non-operating costs that are out of the control of the producer. This is a burden for many industries but oil seems to be at the top of many hit lists.

Wanniski: In a way, Greenspan has done the world a favor by making a bigtime deflationary error. As long as the Fed's management of the currency consisted of minor errors on the inflation or deflation side, the impact on the real world of production (supply) and consumption (demand) was obscured against other background noise. In making a colossal error, Greenspan now has the oil industry and the agricultural industry and commodity producers everywhere thinking about how expensive it is to have a floating dollar. As Judith Grady put it, it's not over yet.

What is the correct price of oil? If the price of gold remains at $250+ per ounce, the price of oil will probably settle at $15 or so. If gold comes back to $350, oil will stay at $22 or so. The marketplace makes these determinations as best it can, trying to guess what the Greenspan Standard will yield six months or a year from now. At $250 gold, nobody is opening marginal gold mines where refined product will sell for less than $250. At $22 a barrel, producers are beginning to wonder if it is safe to invest in infrastructure, which would enable them to turn known reserves in the ground into profits at the wellhead.

I was happy to see Ed Breen join the seminar with his comments about Y2K. If it produces a softening of the world economy for the first quarter or two or three, there will be less demand for monetary liquidity from the Fed. Unless the Fed mops up the existing liquidity surplus, the gold price will rise. If the Fed adds liquidity on top of the surplus, the price of gold will rise a lot. We will all have a front seat at the laboratory experiment.

Thanks to all of you for your contribution to the summer-session seminar.