Off On A Tangent

It’s been two weeks since that befuddling 9 mb drop in US commercial crude oil stocks, and since then, stocks have fallen another 9 million (about 4.5 m both weeks since).  Oil bounced off $122 up to $138, then back to $131, and now at around $136.  One of the predictions of peak oil is that price becomes highly volatile at the time of peak, and we are seeing that now.  But, more importantly I think, what I predicted might happen seems to be happening.  Crude imports into the Gulf ports from Venezuela and Mexico really are tanking, and there doesn’t seem to be immediate relief in sight.  As a result, we can expect inventories to continue to fall at a sharp rate.  We really only have 30 million more barrels in stocks to lose before hitting MOL (minimum-operating-level).  This is the level where losing more stocks begins to have an impact in the workings of the oil infrastructure - pipelines don’t work without a certain minimum level of constant throughput.  Refineries shut down or greatly reduce their operations if their oil tanks get too low.  Such things led to spot shortages last year in places like North and South Dakota.  It could get worse this year.

One thing that confused me was the jump in refinery utilization while gas prices remained relatively low.  I know the refiners aren’t making money on gas, so why would they work at almost 90%?  I learned in the past week that the US exports diesel, which the rest of the world predominately uses (while the US mostly uses gasoline).  That means the refiners are able to make a profit by making diesel and selling it abroad and as a by-product, gasoline is also produced for domestic consumption.  I am glad for this piece of the puzzle because I didn’t understand what was going on, which could have meant my mental model was off.  However, this fact (exporting diesel) clears things up in a way that supports my previous guesses as to what is going on.  Of course, this is rather bad news economically.

So I expect to see more runups in the price of oil in the next few weeks.  $180 was my target price (pulled out of my ass, but we’ll see).  Saudi Arabia is calling for a meeting on June 22.  That should be very interesting, and could change things tremendously.  If they come out of that meeting blaming speculators for the price of oil, I expect a bloodbath to the upside.  If they come out promising production increases, I expect some sell-off, but mostly flat as buyers wait to see if they deliver on their promises.  Some of us don’t believe they can.

This past week’s oil inventory report was quite strange. It reported an 8.8 million barrel decline in commercial crude oil inventories. That’s a huge drop, especially at this time of year. Inventories of both crude and gasoline are at or near the bottom of the 5-year average range. Just a month-and-a-half ago, gasoline supplies were far above the top of the average range. That’s what happens when the price of gas is so cheap compared to the price of a barrel of oil that refineries don’t work too hard to produce extra gas - there’s no profit in doing so.

But what made the report especially strange is that it included an “explanation” for the 8.8 mb drop in supply: that ships were delayed in offloading supplies in the gulf [of Mexico] ports. All the analysts are citing fog as the reason for the delays. However, there has been no fog in the region in the past week, so it’s a bit of a head-scratcher. On top of that, after the report came out, oil first shot up $3, but ended the day down over $4. I can’t quite figure that, but I suspect a lot of traders are trading on hope - hope that there really was plenty of oil imported and that it was just delayed and hope that therefore next week’s inventory report will show a monster build to make up for it. A build of over 10 million barrels or something like that. Trading on hope - not a good idea.

But more troubling:

Here are the last four weeks of crude oil imports into the Gulf Coast:

6.683 mbpd
6.130
5.173
4.996

(link)

The problem being Mexico and Venezuela primarily, but Nigeria also. This is the net exports problem, explained in the Export Land Model. Mexico’s production is falling off a cliff - 24% in the past year. Exacerbating the problem is that every country that produces oil also consumes oil. And each year most countries consume more than they did the previous year. So, a country like Mexico, where oil production is falling and internal consumption is rising, the remainder left over for oil exports (called “net exports”) becomes less and less at an accelerating rate. Mexico looks to cease being an oil exporter in the 2012-2014 time frame. Canada, often cited as a place where oil production is growing (and it is), is also experiencing declining net exports. Saudi Arabia, often cited as the one place left in the world with excess capacity, is also experiencing declining net exports. Saudi’s oil production ticked up slightly in Jan and Feb this year, but their exports have fallen year-over-year. The problem of declining exports began in 2004, but it may now be poised for a big jump in effect. At some point, it’s likely that exports will “fall off a cliff”, as they say. That point may be right now.

Certainly the problems in Nigeria aren’t helping matters with nearly the entire country’s production shut in by violence for a couple weeks, and even now they are still down a few hundred thousand barrels per day. But Mexico and Venezuela are the real problems right now:

The 2007 Annual Net Export Decline Rates for Mexico & Venezuela (EIA) are as follows, and the recent monthly data don’t look any better.

Mexico: -16%/year
Venezuela: -7.6%/year

(link)

To make matters worse, gasoline hasn’t gone high enough in price yet. Wholesale gas is at $3.40, which translates to about $4.05 in retail gas once it works its way through the system. But, at $3.40, refiners aren’t making much money with oil trading above $120. Therefore, their utilization rates have been very low this year, and in about 45 days, we’ve gone from very high gasoline stocks, to pretty low stocks. Traditionally, refinery utilization at this time of year would be 91-92% in order to keep up with summer demand. The highest it’s been so far is 87.9%. It needs to go higher, or there will be shortages of gas. If it goes higher, it will only be because the price of gas went high enough to warrant the increased costs of overtime, maintenance, etc that such high utilization rates entail. So therefore, if oil stays high, I think we’d see gas go over $4.50 by the end of summer. Possibly $5.

But, crude stocks are also low. This was not the case last year when gas stocks went dangerously low - then, crude stocks were pretty high. If we’re having a net-exports-falling-off-a-cliff problem right now, that’s going to throw all estimates out the window. It will take many weeks to find other exporters to replace Mexico and Venezuelan oil as they are relatively nearby countries. If we have to get more oil from Saudi Arabia than we do now, it will take a while for the extra tankers to get here. And we’ll have to outbid China and India for that oil. In the meantime, we’d probably have to make withdrawals of oil from the SPR (strategic petroleum reserve) to avoid shut-downs of refineries, pipelines, and gas shortages. All this would send the price of oil and gas into a pretty severe spike - maybe up to $180 in a matter of a week or two. Gasoline to $6-7.

And, even after the immediate crisis was over, oil would probably remain above $140 due to the need to outbid others for the oil we’d no longer be getting from Mexico and Venezuela - and there’s no end to the decline in net exports. Soon, these countries stop exporting, and then, they start wanting to import oil. I say “wanting”, because I don’t think Mexico will ever be able to afford to import a drop of oil. Mexican civil war of some sort is probably happening relatively soon (ie, within 10 years).

If it happens like this, we’ll end up with gas at $5+ at the end of summer and only headed upwards from there. The crisis of peak oil could be starting - may have started with this latest odd inventory report. We’ll know within 3 weeks either way, I think. If the things I describe above haven’t started happening by then, then it’s a false alarm.

Happy Hurricane Season!

We had so much fun with Nana and Papa … Over a week has passed since they left and we still look for them when we get home, specially Jaime who comes into the computer room and calls out their names.

Life has returned to the usual routine and Summer is quickly approaching. Perhaps soon we will see them again. Here is Dada reading a book to Jaime, like to peas in a pod.

Last year I talked about peak oil and I’m hoping some of the events of the past year
reminded you of some of the things I talked about.  Oil rose from about $50 at the
beginning of the year to $100 at the end of the year (oil was just a few cents shy of $100
in November, and crossed the $100 threshhold on the first trading day of 2008).
Previously, in 2005, the world was a bit shocked when Katrina caused oil to hit $78 a
barrel.  This year, no particular severe event happened to push oil up.  It was simply
supply and demand getting tighter and tighter, as well as the dollar falling in value.

That situation continues as this past week, oil hit $103 and the dollar continues to fall
sharply.  And even though the dollar is losing value, the stock market and the real estate
markets are also dropping in value - a sort of double-whammy on our wealth.
Additionally, we are seeing the beginning of a similar potential drop in the bond markets,
as lending becomes tighter and tighter and is perceived as riskier and riskier (otherwise
sometimes known as the “credit crunch”).  Despite the fed lowering short-term interest
rates, mortgage rates are starting to rise, and I expect them to continue to rise.

Mortgages around the country are going into foreclosure at record rates, and there are
signs that various other economic data are heading southward in a hurry.  Already, the
financial and retail sectors of the market have lost about 40-50% of their value, and will
in all likelihood continue to lose more.  Another 50% is not unlikely, I don’t think.

There are two basic reasons I think we will see a severe economic downturn, with the
dow going below 10,000 (currently at 12,266 and with a high around 14,100) and the
S&P 500 going below 1200 (currently at 1330 with a high around 1550).  Real estate,
nationwide, has lost around 10% of it’s value, with some areas being hit harder
(california, michigan, florida especially).  To get back to historical norms (as measured
by prices to income ratios), it will have to drop somewhere between 30%-50% in total
from it’s high.  A 20% total drop would leave a little more than 10 million homeowners
“upside-down” on their mortgages - ie, owing more  than their house is worth.  A 30%
drop would leave around 20 million homeowners upside down.

Upside-down homeowners tend to default on their loans, and this is what is happening.
Banks are losing money and it is a big reason why we’ll see a number of bank failures
this year.  Also, people struggling more and more with their mortgages stop buying
discretionary items.  Consumer spending being 70% of our economy, this can have a
severe impact.  The American public stopped saving money in 2005 and the savings
rate went negative.  We, as a whole, have piled up a large amount of personal debt, and
as lending becomes tighter, credit cards cancelled by banks, home equity lines of credit
cancelled by banks, a lot of people will no longer have the means to keep their current
lifestyles going.  For this reason, a fairly dramatic slowdown of the economy is in the
works.

But, it gets worse, because, as you may or may not have read or heard, there are some
“experts” suggesting gasoline will cost $4/gallon this summer.  I would like to take a
moment now just to say “I told you so!”  I’ve earned that much.

You may have also heard about the recent dramatic rises in food prices.  Wheat is going
throught the roof and our stocks of wheat grain have not been lower since the 1940’s.
We’ve been eating more wheat than we produce for 7 of the last 8 years.  Less than 4
years ago, wheat was $3-4 a bushel.  In the last couple weeks, it has gone over $20.
Other grains are rising similarly, if not quite as dramatically.  Two major reasons for this
increase is corn ethanol - the demand for food has increased because we are burning
more and more of it in our cars, and bad weather has hurt production, especially of
wheat in places like Australia.  The central breadbasket area of the US is having less
than ideal conditions right now, which is partly why wheat is booming in price most
recently.

The higher prices from these food items is still in the process of getting to the end
consumer, which means that while food prices have risen noticeably already, they are
set to continue to rise significantly throughout 2008.  Gas prices, currently around $3,
are still yet to rise to $4, but they almost certainly will unless oil drops in price
dramatically back to below $80 or so.  These additional expenses, when combined with
the difficulties of real estate and people losing access to credit, ARM mortgages
resetting to higher rates will make for a severe contraction of consumer spending, which
will tank the economy.  The markets are set to fall sharply when this becomes obvious.

So, what to do?  In the short term, I hope everyone is making moves to protect their
money and investments.  I think cash is a pretty good place to be for now.  I am mostly
short the market - there are ETF’s that allow one to invest in indexes on the short side,
meaning you make money when the averages fall and lose money when they rise.
ETF’s like SDS, SKF, SRS, for example (they are “ultrashorts” meaning they rise and fall
at twice the rate the actual markets do).  I am long on energy and agriculture, stocks like
APA and POT, which will rise if oil and food continue to rise.  They are pretty high right
now though, and I think they are likely to get hammered a bit with all the other stocks in
the next month or two.  Gold and silver are good investments at this moment too, though
I feel more confident in energy and food myself.

I would like to stress that short-term, there is every reason to fear a dramatic fall in the
markets, and protecting your money would be prudent.  If you really don’t like to be in
cash, then consider being neutral on the markets at least - ie have at least as much
money on the short side as on the long.  Bond markets may not be safe either as
corporate default rates are on the rise and long-term bond rates are rising (meaning the
price of the bonds is falling).  If the bond insurers Ambac and MBIA do not get bailed out
by the government, then there could be a real bloodbath.

I would also recommend storing some gas at home.  A little bit of stockpiling could go a
long way in the event of short-term (but severe) shortages.  It is perhaps not likely that
you’ll be unable to buy gas anytime you want it this year, but if there is a hurricane like
Katrina or some other event, it could happen, and a couple dozen gallons of gas at
home might be enough to get you through it.  In any case, it’s easy to do and can’t hurt.

For the longer term, I don’t have any really good suggestions, mostly because it would
require convincing you of a lot more than I’m attempting to in this letter.  Maybe you’ll
come around to my thinking about the crisis of peak oil a few years from now, but I don’t
think any of you do just yet.  We’ll get there :-)  I would like to point out one reality
though - if oil keeps going up, then eventually gas is going to cost $10/gal, air travel will
be out of reach for someone like myself, and I won’t be able to visit places like North
Carolina or Florida, not to mention Egypt and Chile.  I expect 5-10 years from now, we’re
all going to be forced to live a lot more locally (but me in particular, being of the most
limited in means), and we could get cut off from one another.

So, happy 2008 everyone! ;-)