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Wednesday, September 26, 2007

More Oily Thoughts

My oil post drove record traffic on my blog! Thanks to everyone who visited.

I wanted to follow up with some brief additional thoughts that have been inspired by discussions on my FAVORITE investor board, the FAX board at

On that board, there has been a lot of talk about whether oil is experiencing an unsustainable price boom similar to housing, internet stocks, and other past bubbles.

I have argued that the run up in price for oil has been driven by real demand, a demand which is necessitating the addition of supply in the near and immediate terms. Because it is not easy to create additional oil supply quickly, the market is driving prices higher and rewarding those who risk their capital on new, expensive oil projects. The fear is that eventually these high prices will lead to too much euphoria and too much investment in new supply. However, I don't think we're there yet, as the forecast for new mega-projects shows only marginal supply additions coming online over the next several years.

From my point of view, the real issue is demand. Until the central bankers of the world get serious and raise interest rates to reduce demand, high prices should continue to exist, especially given the potential for price spikes because of the limited amount of excess spare capacity. Therefore, I would expect high price to remain in place until we see evidence of inflation in the U.S. CPI numbers and a willingness on the part of the Fed to address this inflation.

Of course, this forecast assumes that the Fed will act aggressively in the event the U.S. economy begins to slow. My belief is that the economy is already slowing significantly and that the Fed will continue to lower rates. Remember, the Fed is a political organization (despite their claims at independence). They are under tremendous pressure to keep the economy out of recession in the short term. During a recession, the pressures to lower rates are enormous, even if inflation is beginning to increase.

Looking a year or two out, sustained high prices might lead to a plethora of new supply projects just as the Fed is being forced by higher inflation to end its 20+ year policy of consistently lower average rates. That would indicate a good time for investors to begin cashing in on their oil investments. Until then, I think oil and natural gas continue to be the best investment to protect against the irresponsible policies of the Fed.

Finally, here is a good piece on the Apache website about how this upcycle in oil is being demand driven:

"During the past 20 years, each region of the world, except Africa, has experienced declines in oil demand. However, there have been only two minor decreases in worldwide oil demand in the same time period: 19,000 barrels per day (Bpd) in 1991 and 141,000 Bpd in 1993.

"Nominal oil prices rose dramatically in the 1970s and early 1980s, contributing to high inflation rates. The chart below shows a spike in oil prices associated with U.S. economic recessions. Those spikes were generally caused by supply disruptions. On an inflation-adjusted basis, current oil prices are still not at the level reached in the early 1980s. The recent rise in prices has been caused by a strong growth in demand rather a supply disruption. Despite a dramatic rise in oil prices, no recession has yet occurred and inflation has remained in check.

"During the past four years, the U.S. dollar has fallen over 30 percent against major currencies. Because oil is priced in U.S. dollars, the rise in oil prices has had a lesser impact on foreign buyers of oil."


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