Oil: Something Has Got to Give

by Andrew Butter

If oil prices don’t crash down to $67 within the next two months, that means for sure the evil one-eyed-drooling-spirit of Peak Oil, which everyone has been studiously trying to ignore for so long, has finally arrived.

The dotted red-line on the chart is the “fundamental” or if you use International Valuation Standards, the other than market value. That roughly follows the algorithm:

FOOT = 3.3% TOAD/OIK

That basically says the whole world can afford to spend 3.3% of the whole world’s (nominal) GDP buying oil, so the price is that number divided by supply (or consumption – same thing). That’s also called Parasite Economics insofar as the seller of oil needs to judge it right so that he sucks just so much money out of the golden cow (Daisy) so that she stays healthy, it’s a delicate balance, suck too much and Daisy can get mastitis.

The Parasite Economics line can be calibrated using the algorithm:

E² = MC

That’s The General Theory of the Pebble in The Pond which is another way of saying “what comes around goes around”; it allows you to figure out where the fundamental was after a bubble/bust cycle, so that way you have two independent ways of working out other than market value, or in other words Daisy’s mastitis threshold.

That’s all very well, except there is another way to value oil in the ground, if you are a seller.

That is to let some of the less productive Daisy’s keel over and die in the knowledge that the Daisy’s that survive will be the strong ones, and they will produce baby Daisy’s who will be more productive in terms of delivering the golden milk, when they grow up.

That’s called “Survival of the Fittest”. The idea there (if you have oil) is that you need to price it according to what other people (your future competitors) are going to have to pay to find, develop, and ship to market, oil that so far hasn’t been found or developed.

That’s called the replacement cost, and if you judge that will be more than the cost to you of foregoing income today, and then making 2% a year parking that in U.S. 10-Year Treasury bonds, and instead just waiting, for the price to double, in ten years, and selling it then.

And here’s the rub, the longer Ben manages to duck and dive to keep the yield on the 10-Year at or around 2% to “stimulate” bankers and to help USA to pay the interest on their mountain of debt, the more attractive the idea of just sitting looking at your oil, rather than selling it, becomes.

That sounds as if the Big Idea behind letting all the morons who can’t pay their debts off the hook; might have some unintended consequences.

So which Daisy is going to get the bullet in the head first?

Not many people know this, and those who do would often prefer not to know it, but the way that America finances her current account deficit (that’s basically the balance on goods and services), is by selling securities.

Those come in three main flavours, from the BEA numbers on International Transactions, Line 58 is US Treasuries sold to foreign governments (net), Line 65 is Treasuries sold to anyone else who is foreign (those are the guy who have to queue up under a big sign that says “aliens” at Miami Airport), and then there is Line 66 which is “Securities Other Than US Treasury Securities”, commonly referred to as Toxic assets. Those sold great up to 2008, but the sparkle has kind of dropped out of that market. Add all those together and you get to the amount of money from foreigners that can be used to buy foreign stuff…a lot of which is oil.

This is the rub, when the amount of money coming in from selling the birthright of America to foreigners, so that everyone in America can drive SUV’s and the politicians can boast about how they are committed to keeping gas prices less than $4 a gallon, which makes it cheaper than gasoline in Saudi Arabia, and is an explicit subsidy…when the amount of money America can borrow to pay for that luxury…is not enough to pay for it (that’s when the orange line in the following chart goes below zero)…there is trouble in store.

Oh My!! When oil prices go up above the “fundamental”, look-see, America IS IN TROUBLE, as in they can’t even borrow enough to support the lifestyle that they have become accustomed to.

Looks like Daisy will have to start producing more milk, or she might not be getting her feed tonight!!!

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About the Author

Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.

Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens. Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.

Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics. Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.