Record High Oil Prices and Interventionist Policies

``Since Japan's boom ended in 1990, its regulators have been using every presumed macroeconomic "tool" to get the Land of the Sinking Sun rising again. The World Bank, the International Monetary Fund, local central banks and government officials were "wisely managing" Southeast Asia's boom until it collapsed spectacularly in 1997. Prevent the bust? They expressed profound dismay that it even happened. Argentina's economy crashed despite the machinations of its own presumed "potent directors." I say "despite," but the truth is that directors, whether they are Argentina's, Japan's or America's, cannot make things better and have always made things worse.”-Robert Prechter, Elliott Wave Theory

Well, news headlines had been surprisingly silent about recent spike of crude oil prices to new record nominal levels exacerbated by brewing geopolitical tensions. I say exacerbated because, oil prices have been advancing incrementally even prior to the controversial ‘tests’ which provoked a worldwide uproar as shown by the blue arrow in Figure 1.

Figure 1: stockcharts.com: benchmark WTIC Crude oil at a trading range?

While it maybe premature to discern as to where oil prices would be headed for over the interim, Friday’s activities as portrayed by the price movements in the chart appears to suggest that oil could have hit a peak following a “double top” (red arrows). However, since the second quarter, the oil benchmark appears to be in a trading range from about a low of $68 to a high of over $75. Again, it is too early to say where oil prices are headed for but if it does successfully breakout over and above from the said channel, we could possibly see oil prices test the $80 to $85 mark. Otherwise, it could fall to the lower segment of the trading range.

Conventional mainstream analysts argue that slowing economic growth would likely depress oil prices. I am, however, uncertain and unconvinced of that outcome. If history would be a guide, and by vetting at the factors buttressing the present cycle, it may even suggest the contrary, according to the maverick guru Jim Rogers in his book “Hot Commodities”, ``In the history of oil prices, supply demand imbalances trump even poor economies and technological revolutions.” He goes to mention that in the 1970s as major economies like the US, Europe and others went sour, the price of oil rose 15 times! Such that not even technological breakthroughs supported the increase in supplies then to dampen prices.

Figure 2: Chart of the day: Inflation adjusted Oil prices

A replay of history or even a semblance of would translate to over $150 bbl, based on the 1999 low of $11 bbl at 15 times. Despite the fresh nominal record high last week, current oil prices are still below the inflation adjusted highs of the late 70s as shown in Figure 2.

If one would discern from the present market activities, despite the consensus outlook of some $10 to $15 per barrel of “speculative” or “terror” premium, the recent liquidations on heightened risk aversion last May appears to validate the supposition of inelasticity of oil prices relative to economic growth. If oil prices continue to ascend despite economic doldrums this could be a possible affirmation of the Peak Oil theory, or the diminishing supply of cheap oil.

One should not forget that Oil economics has been one of the areas where government intervention has been a primary mover. In other words, the massive imbalances as a result of the contortions brought about by the collective governments attempt to control the industry, for the so-called ‘social benefits’, have been reflected in today’s market prices.

While news accounts and mainstream analysts incessantly talk about growing demand from China and other emerging countries and the geopolitical tinderboxes as key drivers of sky high oil prices, hardly anyone talks about the structural side, namely, the past and present “nationalizations” of the industry and government price subsidies (limits efficiency and restrains output and investments), the inadequate “transparency” of proven oil reserves by Oil producing states (overstated OPEC reserves that allowed for higher production rates during depressed oil prices), “windfall” taxes and the tomes of environmental regulations and other legal strictures imposed (NAMBY-Not in my backyard drilling, gasoline formulations that led to refinery shortages); all of which has contributed considerably to the shortages of investments or the underinvestment to the industry thereby restraining supplies.

Moreover, on the demand side, the inflationary policies, such as prolonged periods of easy money policies (boom in worldwide real estate industry), surging credit growth and expansionary money base (boom in global financial markets), currency pegs (e.g. China remimbi-US dollar-current account imbalances) adopted by major economies aside from the stockpiling of strategic reserves have contributed to its explosive growth.

If government’s directives have been efficient, why has there been a massive shortage of investments by both public institutions and the private companies? Why has the demand-supply imbalances remained unresolved, if not aggravated? Or simply, why have oil prices persists to remain at lofty levels? And again, who pays for such miscalculations or ineptitude? Obviously, the people/consumers/constituents who ironically had been the intended party to benefit from supposed control. Whereas in the free markets erroneous decisions lead to individual losses or bankruptcies, flawed government policies have been borne by the citizenry or constituents via increased taxations or loss of purchasing power which essentially leads to the deterioration of the standards of living.

In short, the colossal high oil prices have simply been a manifestation of failed aggregate interventionist policies, very much like the endemic structural inequalities present in the Philippine economy and not due to the inadequacies of laissez faire markets. It is not the inability of free markets to function, but rather the lack of it. We tend to see what we believe in rather than believe in what we see.

As an offshoot to these, major Oil companies have been restrained from expanding of their reserves and/or adding production outputs due to the regulatory constraints and most importantly due to the inability of the companies to ascertain on the viabilities of prospective projects as a result of the uncertainties from the actual data on existing demand and supply (remember fudged data on proven reserves).

Petro companies have instead embarked on buying up of reserves of existing companies rather than undertaking drilling or oil/gas exploration themselves; the account of Chevron-Unocal merger in August 2005, the recent $21 billion Anadarko acquisitions of Western Gas and Kerr-McGee, Devon’s Energy’s $2.2 billion purchase of Chief Holdings attest to these unfolding developments.

Figure 3: Energy Letter: Global Rig Count (April)

Yes, while there has been a surge in drilling activities worldwide mostly due to juniors explorers see Figure 3, another problem according to Elliott Gue of the Energy Letter is of declining well productivity-well flows are of lesser quantity and target wells are of smaller reserve/reservoirs.

So, government interventionist policies, diminishing reservoirs/declining well productivity and geopolitical anxieties have been significant fundamental contributors to rising oil/energy prices and continue to do so.

Investment implication: the obvious trend is to search for junior explorers who could build up sizeable reserves and become likely acquisition targets by Oil Majors.