Saturday, June 07, 2008

Making Sense Of Oil Prices

Investing Scents When the price of crude oil hit US$100 per barrel, the global equity markets took it in their stride and continued to report decent earnings. What about when oil trades at US$130 or US$150? Surely there has to be a breaking point.

One thing is for sure, there is a time-lag before the full impact of higher oil prices work itself into other goods and services. Hence, we may be seeing US$130 now, but the real effects may only be felt a few months down the road.

Before that, why is it that companies in general can cope with oil at US$30 a few years back, and still record decent earnings with oil at US$100? We need to understand that if we are to come up with well-argued conclusions about oil at US$130 or US$150.

In my view, there are two major things contributing to higher oil and commodity prices:

(a) The rise and rise of BRIC (Brazil, Russia, India and China) thanks to the globalisation movement hitting top gear.

Globalisation is a newfangled way of describing outsourcing basically. Companies have been shifting a lot of manufacturing and services to BRIC, especially China and India. It would not be far-fetched to say that a sizeable portion of the earnings improvements over the past few years had been due to cost savings by outsourcing to China and India.

This in turn has churned good productivity gains. Goods and services were ramped up, thus contributing to the demand for raw materials of all kind. At the same time this globalisation movement has created a very sizable new middle-class in BRIC, which can now afford and demand for more goods and services themselves. Oil and commodity prices kept going higher because productivity gains were much higher than oil and commodity increments. If by paying US$100, these outsourced goods and services can still be churned out at very competitive end-prices, who is to argue that the rise is unsustainable.

(b) The persistently weaker US dollar (USD), prompted by excessive easy money supply from the developed nations, is the other factor. Oil and commodity are usually priced in USD. The weak USD has also contributed significantly to the jumps in prices for all commodities. The USD had to go weaker owing to structural deficits within the US financial system. The USD had to reach a new equilibrium whereby the US economy is realigned with the rest of the world in terms of fundamentals. You cannot just keep printing money and hope the rest of the world does not care about that.

Price of speculation

Hence the pervading question is, will productivity gains be sufficient to outstrip the US$130 or US$150 oil price?

Looking broadly, it may now be more expensive for companies from developed countries to outsource to China and India. But what’s the alternative?

They certainly cannot bring these operations back home, where it is still more expensive. Thus, it will mean high cost for all goods and services for everyone. Unlike before, relocating elsewhere is not a viable alternative. It used to be that the smaller Asian nations were great for outsourcing but much of operations there has been shifted to China and India to further raise cost efficiency. The outsourced components have gotten so big in China and India that they are now too big to move to another cheaper location.

At current levels, how much of the rise in oil is due to speculation? It’s important to determine that because excessive speculation basically will drive prices much higher than its real demand-supply equilibrium.

Open interest in WTI oil futures has been growing exponentially at 18% per annum since 2001 thanks to the entry of non-commercial players. The entry of more non-commercial players and speculators generally mean they would be on the long side of the futures and options.

The recent jump from US$120 to US$130 was swift and clearly showed that it was brought about by massive short-covering.

As more and more speculators and genuine buyers went long, those who sold short would be squeezed, and when they panic and trigger cut loss levels, the short covering would result in more buying activity, thus propelling the futures and options prices.

As we can see from the recycling of petrodollars, most of the supernormal gains from higher oil prices have been recycled to buy important big companies in other industries via richer sovereign wealth funds.

From the records, there had been significant under-investment in the efforts to locate new oil wells, though that figure has risen over the last two years, thanks to much steeper oil prices. This means that supply is likely to be still flat going forward as new oil finds will take time.

Buildup in foreign assets continues, the 15 emerging market oil exporters may have spent US$420bil in 2007, similar to that of 2006, and might balloon to over US$600bil if oil averages US$100 a barrel this year.

If the world is headed for a recession, then there is no way oil can stay above US$120 for long. However, all indicators show that most countries are grappling with inflationary pressures, most of that from the higher prices of commodities now working their way into food prices.

Many nations are also grappling with the enormous subsidy that is involved in keeping fuel prices from spiralling in their domestic economies.

Despite the growth in speculators in commodity prices, most of the fundamentals lead to the conclusion that much of the gains have been due to genuine demand and real supply factors. Even if you strip out the speculative element currently, it is unlikely to see oil below US$110 from the current US$130 level.

Hoping for a pullback

The removal of subsidies will reduce demand for oil. Even at current levels, there have been some shift in consumption behaviour owing to higher oil prices. Trying to defuse inflationary pressure will generally mean higher interest rates to rein in the economy. While we probably won’t see a global recession, that move alone will pull back some of the growth momentum, as evidenced in most of Asia.

What is clear is that production of oil has plateaued, and all things being equal, oil prices should rise US$12 a year during a shortfall of a million barrels per day. The International Energy Agency has forecasted that demand will exceed supply by 13.5 million barrels per day within next seven years, leading to a supply shock. However that is quite some time into the future.

If we were to take the yardstick of US$90 as current fair value of oil, this translates into a market price of oil of US$252 by 2015. With that as a backdrop, it is unreasonable to see oil price shooting to US$150 this year as that would be highly speculative compared to the “eventual theoretical price” of US$252 by 2015. Even if you work in a higher theoretical price of US$300 by 2015, the US$150 level still seems a bit out of whack.

Right now, the media is obsessed with reporting on higher oil prices. The slightest rumour of social unrest in Nigeria or Iraq will send futures and options up a few dollars. All things being equal, there has been excessive speculators going long on futures and options. For that to continue, speculators will have to rise in numbers exponentially to take oil price futures much higher.

I tend to be of the opinion that global developments — inflationary pressures, a more stable USD, a pullback in economic growth for most countries in 2008 and 2009 — all should work towards a dramatic pullback soon for oil prices.

A drop back to US$100 - US$110 should be likely by August/September. The follow-on effect from that is probably the re-ignition of a major bull run for equities for the second half of 2008. I know many investors would be hoping that I am right. So do I, so do I.

The Malaysian solution

(Editor’s note: This article was written before the Government announced measures to restructure the country’s subsidy package last Wednesday. For comparative purposes, the writer has decided not to revise the article.)

What does all that mean for Malaysia? The country is expected to go from a net exporter to a net importer of oil in 10-15 years’ time. It is high time that the Government plan accordingly in light of the evolving landscape.

Cutting the subsidy in stages would be advisable, e.g. reducing the subsidy in four stages over eight years. Let’s assume that the current subsidy bill (oil & gas) is RM40bil a year.

That could go to RM60bil - RM80bil if left unchecked over the next few years. Companies will need to learn to compete at global market prices. Some industries may be displaced because of that.

More importantly, we need to address the burden on the public.

The burden could be easily counter-balanced by, say, a five-year holiday on road tax for cars 2,000cc and below (e,g, charge RM1 a year to road tax renewal). This should be accompanied by a complete removal of import duties and related taxes on all cars.

This way, it will ease the burden of higher oil and at the same time sway the buying away from high cc cars. Those who can afford big cars should not be too bothered by the removal of oil subsidy. The other measure is to increase the tax-free threshold for personal income tax to, say, RM20,000.

It is silly to think that the removal of oil and gas subsidy will mean we have an additional RM40bil to invest somewhere else. The removal of oil and gas subsidy will flow into other goods and services via higher prices.

When you save RM40bil or more a year, much of it will have to be reinvested to have better safety nets for the poor. It’s imperative to have a minimum wage scale of at least RM1,200 per month going forward. It is not as easy as it sounds to just stop the subsidy.

There are related side effects from wages spiralling and the Government may have to end up reallocating more subsidy into other necessities just so that the whole fabric of the basic economy remains intact.

But it’s high time that we do a thorough cost-benefit analysis. And we definitely need a smarter reallocation of resources to optimise employment and the general well-being of the country’s economic future and competitiveness.

p/s photos: Fiona Sit Hoi Kei

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