…and by crudeness, I mean oil prices.

I wanted to copy the text of an e-mail that I sent out to friends and family back on July 21, 2008:

“Hello Friends and Family,

Normally I do not send out bulk e-mails…however I have believed for a couple of years now that market speculators have done much to drive up the price of our natural resources in the last three years. I have copied the text of a letter from executives in the airline industry below and they provide a link to a website where you can sign a petition. This petition is designed to put pressure on legislators to increase the amount of regulatory oversight of commodities markets. I believe that the most accurate and important point in their open letter is that speculators may be responsible for about $60 worth of the price of oil right now. As a former energy analyst, my professional opinion is that the amount is even higher than that figure. I encourage you to follow the link and to fill out the petition information.”

I have not copied the text of the letter from the airline folks because the point is that our oil markets have been dominated by speculators for three years. Before the Second Gulf War started oil was a little more than $20/bbl. The war did take offline Iraq’s oil production for an extended period of time and, more importantly, the war did increase the instability in the region, so prices should have gone up. However, not by $140/bbl. (!) which is what proceeded to happen over the next several years. Additionally, increased demand from India and China should have driven oil prices up. However, again, not by $140/bbl.

Many of my friends and family responded to the e-mail I excerpted above by asking me what I believed to be an appropriate price and I told them between $50-$60/bbl. Why? If we go back to the 2003 price of $20/bbl., we have to ask ourselves one overarching question: What has fundamentally changed? [and by the way, not much has changed since July 21, 2008]

Primarily two things:

• the perceived risk in the Middle East 
• the increased worldwide demand for oil from the growth of the Indian and Chinese economies

Let’s turn our attention first to how much additional perceived risk is the Middle East now? This is purely a crude (heh, heh), back of the envelope calculation, but I feel that the perceived risks have doubled. That would mean that oil should be around $40/bbl. That is, we take our $20/bbl pre-War price and double it. I know, that sounds sloppy, but this is where the right, intuitive brain comes into play. We must become Goldilocks and sense what “just feels right.”

The next question is how much incremental oil demand has growth in the Indian and Chinese economies caused on energy markets? So how do we bound this issue properly. Let’s define the extremes. Well those economies have grown tremendously, but they have not caused the worldwide economy to double, so oil prices cannot be expected to double based on increased demand. Nor have the economies of India and China not grown at all. So we should expect some move upward. So how much upward? My guess on July 21 was that the incremental demand was worth $10/bbl. Why so high, given that the economies of those two nations have grown around 10%? The reason is that incremental demand is always more expensive than current demand because you are asking the system to grow and expand beyond its extant capabilities. And that is expensive. Anyhow, it was my belief that oil ought to be priced at between $50-$60/bbl. back on July 21, and that opinion has not changed now.

So why did prices go up so rapidly in the first place? The primary reason is that most of the oil speculation being done was by hedge funds. Those entities don’t really care so much about the absolute prices of oil, but gyrations up or down around a starting base number. In other words, their trading strategies don’t depend on oil being at $10/bbl. or at $140/bbl. What they care about is volatility around their entry point into the market. So if they enter the market at $85/bbl. their strategies are typically designed to make money if there is a fluctuation of +/- $5 per barrel of oil. But what happened is that as the price of oil got higher and higher that meant that a 5% swing in absolute dollar terms was higher than if it had swung when oil was around $20/bbl. In other words, 5% of $140/bbl. is $7, whereas a 5% swing at $20/bbl. oil is a paltry $1! So the frothier the markets, the greater the potential price swings. This attracted ever greater speculative dollars.

So why did prices start declining to actually reflect fundamentals instead of speculative fervor? The answer is that the hedgies got spooked by the collapse of financial markets and the inevitable decline in the economy. This is one of the silver linings in the financial meltdown and economic downturn.

In a future post I may address how to end this damaging sort of speculation.

I also wanted to say that in the business of investing if you get 6 out of 10 calls correct you are called “very good” and if you get 7 out of 10 calls correct then you are called a “genius.” The point is that I don’t always get everything right. But the price of a barrel of oil is one of them.

Jason