Scenario for Spike in Price of Oil (Not a Bakken Story)

Note: I posted the blog below on October 25, 2010. Today, one day later, October 26, 2010, I stumbled across this article: further pressure on OPEC to keep oil prices high. This is one further data point that supports my view below.

Original Blog

Back in late September, 2010, I wrote a long piece why I was bullish on oil as an investment. My basic premise is this: the price of oil will bounce around pretty much tied to the strength of the dollar until the global economy turns around and oil consumption starts moving up.

It has been shown, and I'm not going to go through all the links again, but it has been shown, that regardless of the price of oil, global daily production of oil has not changed much over the years. Even with the spike to $150/barrel, daily oil production remained fairly stable. There was a flurry of increased drilling activity but the actual amount of oil production did not change much. With all the activity in the Bakken, has the daily global production of oil changed much? No. Not even.

Others argue, and I agree, that the reason oil production has not changed much over the years is because "it" can't. Some argue this is because it has to do with declining fields, and some even suggest "peak oil" theory. That may be true, but that's not the reason that production has not increased. The biggest reason, in my humble opinion, and I don't have data to back it up, is the fact that infrastructure can only find, produce, ship, and refine so much oil on a daily basis. [Enbridge announced it will be forced to ration oil shipments next month due to over-supply and under-capacity due to pipeline repairs, as just one very minor example.]

Whatever the reason, why daily production does not increase over time does not change the fact that daily production does not change much.

Once the global economy turns, and most economists and "talking heads" think the economy will eventually improve, the demand for oil will go up. There may be a slight increase in production, but close observers of the situation will notice that demand will start to rise faster than any change in global production. At a certain point, a tipping point will be reached, and whether you want to call it speculative or not, the price of oil will start to rise dramatically based on concerns that production can't be ratcheted up. And once the spike begins, the price of oil will move up quickly.

I wrote all that back in September, but tonight there was yet another article that supports my contention. Brietbart reports that "Chinese Investment Soars in Brazil, With Eye on Resources," dated October 25, 2010.

[As you read this, remember, the Chinese have bought resources in Canadian oil sands and have taken a huge position in Chesapeake's Eagle Ford oil assets in south Texas. That Texas oil is fungible; anyone can contract to buy it, but I would assume that whoever finds, produces, and ships it will have first chance at contracting for it. Remember also, that China has significant presence in Africa, specifically Sudanese oil: it is estimated that China imports 50% to 60% of Sudan's oil.]

Now back to the Breitbart Brazilian story:

• Chinese investment is expected to reach $30 billion this year
• This investment is aimed at securing access to Brazilian oil
• Prior to the end of 2009, Chinese investment was less than one-half billion dollars
• In the first half of 2010, Chinese investment exceeded $20 billion
• Two-thirds of that investment will be invested in the oil secor
• China has privileged access to Brazilian oil after extending a $10 billion credit to Petrobras
• China's Sinopec bought the Brazilian subsidiary of Spain's Repsol for $7 billion dollars
• In 2009, China became Brazil's top trading partner, overtaking the United States

The perfect storm: when the global economy turns, and there is a psychological (speculative) upward pressure on the price of oil, it will be exacerbated when there is a realization that global daily production will not change much, regardless of the price of oil. But it will be the headlines that China has secured oil assets around the world, oil that may not be available to the market if China needs that oil.

The price of oil is not set by the cost of producing the first barrel (about $5/barrel in Saudi Arabia); the price of oil is set by the cost of producing the last barrel (about $60/barrel for Canadian oil sands). That puts the price of oil in a trading range between $60 and $80 based on the strength of the dollar.

If the global recovery comes around slowly, at best there will be an orderly upward trend in the price of  oil. Once folks realize that daily production cannot be increased significantly, the price of oil will start to rise more quickly. Once more Breitbart-like stories come out, showing who controls the oil, the price of oil will spike.

That's just my humble opinion.

[I would love to see an exhaustive report detailing Chinese oil activity in 2010 compared to 2009. For all the talk about how big ExxonMobil is, in 2008 this company produced about 3 percent of total global oil production, which is less than several of the largest state-owned petroleum companies. According to Wikipedia, when ranked by oil and gas reserves ExxonMobil is 14th in the world with less than 1 percent of the total.]

[By the way, the opposite is not true. As the price of oil rises, global production does not change much. However, if the price of oil drops below $60 for any length of time, production will be held back.]

Updates

November 8, 2010: OPEC sees increasing demand for oil starting in 2012, but due to "bad image" of fossil fuels, governments may restrict its use. OPEC warns developers from rushing into big oil-related industrial industrial initiatives.

November 5, 2010: More and more difficult to find oil to meet global needs.

October 26, 2010: Average price of gasoline today is $1.01 more than when President Obama took office.  Despite severest recession since the depression which one would think would keep prices down. Moratorium on Gulf of Mexico drilling; de facto moratorium continues; global economy starting to turn; Keystone XL project dead / delayed / maybe (choose one); dollar at lows (driving price of oil up).