Oil

There is no question that billions of dollars of buying power in the form of new investors , ETFs and Hedge Funds have some effect on price. However, there is no hedge fund forcing Exxon and Chevron to do more to replace their reserves - which they need to do. The International Energy Agency is set to revise its supply projections - that is , to lower their supply forecasts . according, to a recent report in The Globe and Mail . It had previously stated 100 million barrel a day demand by 2030 would be met by expanded production - by that time . " .. the agency is now worried that aging oil fields and diminished investment that companies could struggle to meet ( expected demand in the future ) "

Exacerbating the high oil prices are production problems in Russia, the world’s second largest oil exporter. Aging oil fields and a lack of infrastructure investment has led to the country’s first annual production decline in 10 years. Output fell 0.9% to 9.76 million barrels a day in the first five months 2008, Bloomberg reported. "Growth last quarter fell on a year-on-year basis, and this has to do with the policies implemented over the prior year to raise taxes on oil industries," Deutsche Bank’s Sieminski said, speaking of Russia’s oil difficulties. "This made it difficult for foreign capital to come in." But "if Russia could reverse some of these policies and get their own oil industry back on, this will help very much" with supply concerns, he added.

"We are burning through supplies at a rate that’s four times to five times faster than we’re discovering new reserves," he said. "Throw in a few [surprises]… perhaps a terrorist event… and add in the accelerating use of oil and gasoline in Third World countries, and we have the recipe for far higher prices."

Worldwide oil production has not substantially increased, even as prices have risen sharply over the past few years. Current prices as of the end of 2007 ($90+) do not produce huge profits for producers as the cost of adding new production has also risen sharply. Demand has not been impacted severely by the rising prices. Hence the rises up until now are largely due to normal market balancing and not do to speculation or worries about political instability. Prices are therefore unlikely to fall much, and will increase as demands increases. The may spike if there are problems with supply.

Having cut oil production in December, the oilmen held another meeting this past weekend in an effort to shore up prices even more. Cheaper oil and gasoline is great for Americans, but OPEC is looking for to get oil back up to the $70 a barrel range.

Most people expected OPEC to follow its December oil production cut with a further output reduction of one million barrels per day at its meeting. But instead of an outright cut, the members decided to enforce their quotas a little more strictly. That should help take about 800,000 barrels per day from the pipelines.

Energy traders’ reaction to the move today was to scoff at it, knocking oil futures down by $2 a barrel this morning. Many oil traders don’t fully trust OPEC to adhere to its quotas, so by not making any direct supply cut, many players could jump back on the bearish bandwagon.

Time will tell if OPEC is truly serious about sticking to its quotas. And with oil currently around $45 a barrel, we should still see it trade in a wide range between $30 and $50 over the near-term future.

Worldwide increases in demand are being driven by developing economies, especially India and China. They are not so closely linked to the US, and a slowdown in the US will not affect their growth very much. Thus, demand will continue to increase even if there is a credit crunch and slowdown in the US. Supply is waning in traditional fields and major swing producers such as Saudi Arabia will not be able to fill demand spikes caused field problems elsewhere. The costs of opening other fields are rising. Nonetheless, in the face of rising demand the value of the product will continue to outpace increasing exploration, extraction and transportation costs.

The bottom line is that long term, oil prices are headed higher, strictly on supply and demand fundamentals. Global demand destruction - if it occurs at all - will be a short-lived phenomenon.

With only 4% of the world's population, the United States is currently burning up 25% of the world's oil supply. Nearly 70% of it must be imported. We're competing with China, Russia and a host of other emerging nations whose demand for oil is rapidly increasing.

In the face of the global financial meltdown, the price of oil has plummeted from a record high of almost $150 a barrel in July to less than $40 recently. And now it seems to be bottoming.

Clearly, this isn’t the precise moment to call a market bottom, but it is reasonable to think about a bottom around this range for a few reasons.

For starters, the forward curve of oil futures prices is showing a very marked upward slope, known in the commodities business as a forward curve in “contango.” This means that – the farther out we go – the higher and higher oil futures prices climb.

A futures curve as upwardly skewed as this one provides a great opportunity for profits: One can just buy oil today, sell it forward and hold it until December 2016 and make a guaranteed rate of return of about 62%. In a year, you can make about 11% by just buying now, holding it and delivering in a year. If you add some leverage to the transaction, you can make a nice return.

Some sophisticated players are doing just that: They’re buying oil, and are holding it in a tanker in port – with the obvious intent of capturing these profits.

However, this very favorable contango arbitrage is not going to last for long, as more players have been jumping into it, thus flattening the futures curve with time. It is easy to see that, at some point, as oil gets absorbed into storage, and the curve gets inverted, the speculative players that shorted oil by selling futures long ago without having production or physical oil will be squeezed into covering at much higher spot prices. This spike in spot prices situation will develop in less than a year, as demand recovers.

The slope of the curve also indicates widespread expectations for inflation.

Tropical Storm season generally makes a splash on the commodities scene sending the future prices way up. This is most recognizable in the Oil Markets. With Tropical Storm Fay making its way towards the southern tip of Florida, we’re going to start with the energy markets this week, since a big chunk of oil and natural gas supplies are located near this area in the Gulf of Mexico.

Last we checked, the crude oil September futures contract topped out at $147.90/barrel on July 11. But as you probably know, it’s dropped like a rock, down to its current level around $114 a barrel – $34/barrel from its high.

That equates to a $34,000 move on one futures contract alone. There’s a possibility it could fall further, but not surprisingly, we’ve seen some volatile action today, as Fay swirls towards south Florida.

However, current projections have the storm steering clear of the major oil platforms in the Gulf of Mexico. And when the short-term dust settles, the downward move could end with oil landing at the $108 area. That would put it right at the 200-day moving average line, which would be its last hope for a bounce.

Oil is starting to become oversold in the way the financials were a month ago:

• At $113 a barrel oil is down about 23% from its highs last month.
• The 200 DMA (Day Moving Average) is right around $110 and I’d think that would represent some pretty good support (Oil Chart with 200 DMA).
• Volume in the ProShares Ultra Oil & Gas ETF hit a record today after a steady ascent for a couple months (DIG 6 Month Chart).
• I think the dollar rally which has been putting so much pressure on oil is due for a break.

It’s been a relentless selloff in oil the last 6 or 7 weeks and I think it’s due for a bounce sometime soon.

Each time we see "oil inventory is higher" it implies that there is oil which is unable to be sold at the current price. But what is actually happening is that the oil is being stored in place of curreny and is unavailable to the market at the current price. So the "real" oil inventory is much lower. Inventory is something sitting on the shelf hoping to be sold at the current price.

Mexican Production Declining

Mexico provides about 14% of the oil the US imports. On any given day that makes it either the #2 or #3 leading source for US oil imports after Canada and Saudi Arabia. Given that the US currently imports close to 70% of its oil needs, the Mexican oil is critical. But here's the thing. Using straightforward ELM calculations, Jeffrey Brown is confident that Mexico will ship its last barrel of oil to the United States -- or anywhere else, for that matter -- about 6 years from now, in 2014. In a recent interview with Brown, I asked about this forecast. "Mexico was consuming half of their production at peak in 2004. And if you look at the '05, '06, '07 data, they're basically on track, on average, to approach zero net oil exports no later than 2014," he confirmed. Of course, the US is completely unprepared to replace this ""source of oil, especially considering the growing stresses on global oil supplies causing by ballooning demand from emerging markets. That means the international competition for available supplies is only going to get more desperate in the months and years ahead. What will this mean to oil prices, according to Brown? "From this point out I think we'll see a geometric progression in prices ... you know, $50, $100, $200, $400, whatever. The only question now is how short the periods will be between prices doubling again." Coincidentally, while this report was in preparation, on April 30, 2008, PEMEX, Mexico's national oil company, announced it would be unable to fulfill this year's scheduled oil export obligations to the United States ... falling short by about 11%, or 184,000 barrels a day.

Indonesia Can no longer Export Oil

Indonesia is leaving the Organization of Petroleum Exporting Countries because declining production and investment have made it difficult to meet even its own needs, the energy minister said Wednesday. Purnomo Yusgiantoro told reporters it no longer made sense for Indonesia, the only Southeast Asian member of OPEC, to stay in the cartel. “Even though we are sometimes a net importer and sometimes a net exporter, we are a consuming country,” he said. “Indonesia is pulling out of OPEC.” Indonesia is the region's largest oil producer, but the nation of 235 million people has had to import for years because of aging wells and disappointing exploration efforts. A weak legal system and red tape has scared foreign investors away, even as domestic consumption rises. Mr. Purnomo said the decision to leave OPEC was made by the cabinet of President Susilo Bambang Yudhoyono, which is being forced to slash fuel subsidies due to soaring global prices. In the last few days, consumers have seen prices at the pump jump by around 30 per cent. Mea Culpa “We are not happy with the high oil price,” he said.

Oil has staged an impressive rally since dropping below $35 a barrel in mid-February, soaring 42% in little more than a month to about $50 a barrel.

And while there remains a risk that prices will retreat further due to sluggish demand, there are also three very compelling reasons why oil is still a safe long-term bet:

• OPEC has made substantial progress in reducing the amount of oil on the market.
• The dollar has been made vulnerable by the U.S. Federal Reserve’s aggressive policy of quantitative easing.
• And low oil prices and tight credit have reduced global energy investment, putting future supply at risk.

There’s no question that downside risk remains. On April 13, the Paris-based International Energy Agency (IEA) lowered its demand forecast by 1 million barrels a day, and now expects the world will use about 83.4 million barrels per day in 2009. That would be 2.4 million barrels a day, or 2.8% less than last year.

But so far dwindling demand has failed to contain oil prices.

The futures contract for benchmark crude settled at $49.66 a barrel on March 31, up 11.3% from where it ended 2008. As Money Morning predicted in its annual outlook series, the first quarter was a volatile one, in which oil prices tested the low $30s before surging over $50 in recent market rally.

And analysts are almost completely united in the view that, despite its short-term volatility, declines in production, exploration and development, and the value of the dollar will drive oil prices substantially higher in the years ahead.

Sure, the global economy is suffering from a recession, causing a temporary reduction in global demand and therefore global manufacturing. However, the fundamental drivers of $150 oil:

• The emergence of massive, formerly undeveloped economies like China and India
• Declining exports from large, oil producing countries, either because of increased local consumption or declining production

We may be seeing lower oil prices for now, but once the world economy starts to get back on its legs, oil prices will go back up - and quickly.

Looking at the the technicals alone, the chart has alerted that the next high level price will hit is 140.40. If 140.40 is breached by even a penny the price will go on to 147.29. Prices will most likely continue to climb for the rest of the summer, but at some point prices will crash very hard; the bubble will burst just like the housing market has already done. Investors have poured all their dollars into oil and other commodities, to hedge against inflation and the falling dollar. This is a good idea on makes sense for investors to do, but this idea has turned into hysteria and a massive bubble has been created. If these high prices stick around, it will destroy big oil. The big SUV market has all but collapsed, and people are focusing on smaller cars.GM has already closed 4 plants. This changes demand on a fundamental level. When you combine this with all the global warming hype, it spells trouble for oil in the long term. 'Global warming' is not going away, real or not. Governments are putting lids on carbon emissions; all very bad for oil. With the housing market, all the big money went into high risk mortgages. What happened? The bubble burst and the commodity prices (houses basically) took a hard fall that will take years to recover from. This is the future for oil and it's fall will effect the whole world economy just like the housing crisis. Housing will come back because the demand for houses hasn't really changed. We all still need a place to live, just like before the crisis. When oil falls though, all of us will have smaller gas tanks (if we aren't driving an electric car) and the fundamentals will have changed drastically. China and India will run into the same problem eventually. Oil is dying and we are witnessing the biggest paradigm shift of all time. If I had money to hedge, I'd put it into new energy. Pretty soon a day will come when mega fortunes will be made and lost overnight. Where is your money?

Crude looking bullish $52: Crude completed its downtrend in March2009 after making a double bottom of $33 and has been consolidating around $45-55 for the past 6weeks. Any price move above $55-56 would see a fresh rally in Crude and levels of $75 can be possible in next 6-8months in my view.

OPEC decided to defer any further cuts in output. In response, oil prices slid. In the short term, this is the natural reaction of the market; however, OPEC has delivered a powerful message. The message is simple. OPEC is motivated to cut production in order to prevent prices falling below the marginal cost of production. Once prices fall below marginal cost, "new production" cannot be brought on to the market, because the marginal cost of production exceeds the marginal revenue; thus production cuts make little sense. It is my view that the action of OPEC is one which will put a floor under oil prices.

Today OPEC controls 40% of global production; over the years I expect OPEC will lose Nigeria and Angola, while it may gain new members from amongst the former Soviet Union. The reason is simple; OPEC will find within it a big conflict of interest if it controls supply from both high marginal cost producers and low marginal cost producers. OPEC will remain very strong and it is likely that over time they will get growing support from non OPEC high and low marginal cost of production producers.

Now let me clarify; the marginal cost of production of OPEC is low, very low; the OPEC oil industry can remain profitable even at $15/barrel. The marginal cost of production from oil sands (Canada) and deep/ultra-deep water (United States, Brazil, Angola, Nigeria) is far higher and it is these which will bring new production on market. At present price levels marginal producers will be forced out of the market. Presently, a production cut is automatically executed without OPEC making any sacrifice on volume because the high marginal cost producers shall withdraw from the market. There are certain OPEC members (Angola & Nigeria) which might suffer from the OPEC decision because they remain high marginal cost producers. For a low marginal cost producer, volume becomes increasingly important in a market where prices fall; this is not the case for a high marginal cost producer.

Now, the marginal cost of production for deep/ultra-deep water (main new production expected from Brazil, United States and Angola) is near enough $60 per barrel; the marginal cost of production for oil sands (Canada) is much higher. Realistically, even with a significant economic slowdown, demand growth will surpass production growth. If production growth is to come to market, oil prices must sustain over $60. Saudi Arabia has opined that the fair price of oil is about $75 per barrel; I do not see them as being far off the mark, because at this level, marginal producers of oil will receive a reasonable but not excessive return on investment assuming a long term marginal cost of production of $60 per barrel.

In my view, the marginal cost of production will fall. Oilfield service and driller resources have been stretched while demand remained elevated. In this environment, the oilfield services and drillers have enjoyed considerable pricing power. For this reason, the marginal cost of production has remained high with capex inflation running at 12% and more for oil producers; at the same time opex inflation has remained elevated at over 6%. Now considerable new capacity has been added by oilfield services and the drillers; some has already entered the market and much more shall come into the market between now and 2012. As new capacity enters the market and as demand eases off in light of falling oil prices, industry inflation levels will retreat. Thus, in my view, the long term marginal cost of production should fall within a range of $48 to $53 per barrel. If new production is required as a consequence of rising demand, long term oil prices can be expected to range from $55 to $61 per barrel. At this level oil producers are provided a reasonable return on investment.

Oil demand today is in the region of 85.893 million barrels per day. Oil production is 85.619 million barrels per day. There is little surplus production capacity outside of OPEC and OPEC surplus production capacity runs are approximately 1.7 million barrels per day. The market is well supplied today. What about tomorrow?

In terms of future visible production, amongst OPEC, Saudi Arabia has the ability to bring new capacity onto the market. The Manifa field in Saudi is capable of adding 900k barrels per day, while re-starting Damman would add a further 75,000 barrels per day. Saudi Arabia is unlikely to increase its production capacity at oil prices under $75 per barrel. Outside of the OPEC, there is visible production able to come to market of 1 million barrels per day from United States (447k barrels), Brazil (291k barrels) and Azerbaijan (268k barrels). Brazil and United States bring new production from deep/ultra-deep water with high marginal costs of production. Azerbaijan has a lower marginal cost of production; nonetheless its source in the Caspian Sea. The Caspian is an expensive operating environment because it is land locked which makes transportation an expensive proposition; in addition because the Caspian Sea is land-locked, the cost of bringing offshore drilling equipment is high; so while cost of production is lower than deep/ultra-deep water, it is not cheap. Offsetting these visible production gains are visible production declines in the North Sea (282k barrels) and Mexico (287k barrels); on a global level, net non OPEC visible production capacity will increase by 105k barrels per day.

So in terms of visible production capacity we have 85.619 million barrels per day capacity today; add to this OPEC surplus capacity of 1.7 million barrels per day and visible Saudi Arabia additional potential capacity of 975k barrels per day and we come to 88.336 million barrels per day. Add on the non OPEC visible capacity net addition of 105k barrels per day and we have total expected and visible future production capacity of 88.441 million barrels per day. Production capacity not presently visible can expected to continue to come to market as and when prices and demand justify investment. Amongst the high cost of production producers, there is plenty of "not presently visible" opportunity in the deep/ultra-deep water & harsh environment theatre; I see great promise in Angola, the Gulf of Guinea (in fact most of the African West Coast), Brazil and United States; Canadian oil sands will one day provide a valuable source of oil. There are other sources of incremental high marginal cost production such as Russia, Venezuela, Nigeria and Equatorial Guinea; however due to instability inherent in these States, it cannot be reasonably relied upon. Iraq, Russia, Kazakhstan, Turkmenistan and Azerbaijan remain opportunities for lower marginal cost producers; but once again stability within the jurisdiction is an issue. India and China also have high marginal cost of production potential, albeit with not as much promise as the preceding countries.

From a supply perspective, compare the expected and visible future production capacity of 88.441 million barrels per day with demand of 85.893 barrels per day and you will understand why there was no fundamental reason for oil to trade at $147 per barrel. Now keep in mind that at least 7 million barrels per day of this production comes from high marginal cost producers; to keep this production on market, oil prices must remain over $60 per day. Additionally, if we assume long term demand for oil grows at 1% per year, demand will exceed production (including visible future production) in three short years. Just as there was no reason for oil to trade at $147 per barrel, there is absolutely no fundamental reason why oil should trade at levels below $60 on a long term basis.

From a demand perspective, we have the same story; cheap oil is history. During 2000, oil demand was at 76.715 million barrels per day; this level of demand could be significantly satisfied by the low marginal cost producers. Thus, in the past as expectation of future demand growth were optimistic, we saw a significant rally in oil prices, because it was required to bring new production online. As future demand growth expectations reduced, prices collapsed because present demand could be satisfied by low marginal cost producers. The low marginal cost producers cannot satisfy today's demand of 85.893 million barrels per day during 2008; the best they can do is 81 million barrels per day; the last 4.893 million barrels must be paid for to compensate the higher marginal cost producers and it is at this higher level that the price of oil will settle.

In looking at demand for oil during 2008; United States demand has shrunk from a peak of 20.687 million barrels per day during 2006 to 19.562 million barrels per day during 2008. This level of demand is beneath demand during 2000, 2001, 2002 and 2003. In my view significant further contraction in demand is highly unlikely, even when confronted with a deep and prolonged recession. China on the other hand has seen demand increase from 4.797 million barrels per day during 2000 to 8.004 million barrels per day in 2008. This economy continues to grow and energy demand will remain elevated even in a slow down. As for the rest of the world; I look at it in distinct segments. The OECD Ex United States includes several mature slow growth economies in demographic decay, these economies are at greatest risk of contraction. Non OECD Asia (Ex China) includes moderate growth economies; some contraction in energy demand can be expected amongst these economies. Former Soviet Union & Eastern Europe are high growth economies; slowing growth in energy demand can be expected, however demand for energy will not contract for several years. All other (including Emerging Markets India, Brazil) includes economies with high growth but with significant slow-down risks; energy demand growth will slow but with little risk of an outright contraction. The below table illustrates my view on an absolutely worst case scenario for energy demand.

2006

2007

2008

2009 Est

2010 Est

2010 On

Assume

United States

20.687

20.680

19.562

19.317

19.076

19.076

Reduce by 1.25% for 2 years then stable

China

7.201

7.578

8.004

8.340

8.690

8.690

Grows by 4.2% for two years then stable

OECD Ex US

28.888

28.459

28.233

27.598

26.977

26.977

Reduce by 2.25% for 2 years then stable

Non OECD Asia Ex China

8.656

8.784

8.915

8.870

8.826

8.826

Reduce by 0.5% for two years then stable

FSU and Eastern Europe

4.981

5.065

5.213

5.270

5.328

5.328

Grows by 1.1% for two years then stable

Other

14.539

15.242

15.967

16.526

17.104

17.104

Grows by 3.5% for two years then stable

84.953

85.809

85.893

85.921

86.001

86.001

Until something fundamental changes (new oil alternative or new significant low marginal cost fields), from here on energy will be in an irrepressible bull formation; the upswings will be higher with the downswings being less severe. Oil can trade at below $60 per barrel if demand contracts to 81 million barrels per day because at this level of demand the supply from high marginal cost producers is not required. Even with demand at 81 million per day, prices would need to be substantially higher than the marginal cost of production of the low cost producers as long as there is an expectation of demand growth from these levels. As illustrated in the chart above, demand destruction of this magnitude is not something I can contemplate even in a deep and prolonged recession; the only other reason demand destruction of this magnitude can occur is through new technologies providing a new source of energy capable of replacing oil; neither are remotely visible today. Long term oil prices can also fall with a sustainable decrease in the marginal cost of production; this again will require new technology – none in sight today. Oil prices can also fall if a new low marginal cost of production source is found; this needs to be a significant find – nothing below 4 million barrels per day will reduce dependency on high marginal cost sources; once again nothing of this magnitude is remotely visible.

My conclusion - go buy, oil is finally trading at and below fair value; it might fall on sentiment, valuations might get better, but no one can time the market to perfection.

In the past OPEC's production decisions have often failed to influence prices. Many have opined that OPEC's policy was aimed towards price manipulation; my belief is that OPEC's decisions have had more to do with keeping production at levels where supply matched demand to protect against price declines through over-supply. This time is different. OPEC has a hard job, on the one hand, cutting production too deep will lead to price increases which will ultimately cause demand destruction. On the other hand, not cutting production allows prices fall to levels which will cause under-investment and major price escalation and demand destruction in the future. It is likely that oil will trade back up following the OPEC 12/17 expected cut. Much depends on how they present it. If they present the cut as being in response to an over-supplied market because of falling demand, then oil has further to fall. Such an approach does two things (1) enhances concerns on present demand and (2) alleviates concerns on future supply (because there is a cut to production not capacity). If on the other hand OPEC is clear and says it like it is; i.e. they state (1) an intention to cut production capacity (i.e. no new production enhancing investment), (2) demand and supply are well balanced before the cuts, save perhaps the need for a minor inventory drawdown being required and (3) the cuts in production are intended to uplift prices towards an equilibrium price level; then oil should rally strongly. Hopefully, speculative excess will not drive it to sensless levels once again.

The president of OPEC has already indicated that cuts will be deep; deeper than the market expects. The aim is to remove supply to an extent that will surprise the market. Why then inform markets of a surprise ahead of the event? I believe the intent is to gain an insight into market expectations; and then cut marginally ahead of those expectations! Or else, it is to prepare the market so the impact of the shock is spread over a week instead of a day. My view - OPEC will have learned from the last downturn when they failed to cut production and the result was oil priced cheaper than mineral water. This time OPEC will cut deep. They shall force a sharp draw down of inventory. OPEC will not supply cheap oil to build and maintain inventory levels; instead production cuts will force a sharp draw down of inventory. Once inventory is down, prices will rise and at that stage enhancing production to allow inventory to return to normal levels will make sense.In the immediate term, energy prices may decline as inventories are drawn down and non OPEC oil is used in an attempt to break OPEC. Short term, it is likely that oil prices shall escalate once more. Can a production cut backfire and cause a collapse in oil prices? Yes, if the production cut is presented to the market as being on account of a catastrophic reduction in demand, prices will collapse. If it is presented for what it is - an attempt to secure rational oil prices, then oil prices should firm up and rise towards equilibrium. Today the market is well supplied, but far from over supplied; it can only be viewed as over supplied on a very short term basis on account of inventory being reduced because of a gradual reduction in demand. So a reduction in production, properly adhered to by OPEC members will force a faster inventory draw-down and ultimately this will lead to an under supplied market which will drive prices upwards. Oil trading needs strong regulatory over-sight, otherwise price levels will rise on rampant speculation once again; this can derail prospects for recovery from amongst the longest recessions in US history - it could be the straw which breaks the camels back. To price oil, there is demand which comes from users, and supply which comes from producers; there need be nothing more. Demand is created by users with a desire together with the willingness and ability to pay. Similarly, supply is created by producers willing and able to deliver at a price. A supplier will never increase supply if the price for that unit of supply falls below the cost of production of that additional unit; to do so would be an economically irrational decision. The equilibrium price is what the user is willing to and able pay the producer for that last additional unit of production; it is the point where marginal revenue equals marginal cost; this is where the price of oil must be and it is my belief that a reasonable estimate of the marginal cost of production is $60. Oil needs to be priced rationally; in my view a price substantially below $60 means the needs of future generations will not be met. A price substantially above $60 is damaging to the present generation. Why then are bubbles created? When oil prices were at $147, I wondered how speculation could occur without an inventory build by hoarders; everything produced was getting consumed at the price without an inventory build, so speculation seemed unlikely. Here is how I think it works. This bubble was created because the relationship between users and producers became obscured. In the very short term, because demand destruction takes time, a users "willingness & ability" to pay can exceed the producers marginal cost of production. This spread between user willingness and ability to pay and the marginal cost of production creates an arbitrage opportunity. It is fairly easy to exploit the arbitrage opportunity through the futures market in a manner which does allow today's production to continue at capacity with no inventory build up. The only problem is that real users end up paying tomorrows potential prices today. As long as demand continues to grow as expected by financial investors, everyone is happy. But once prices go above that user "willingness & ability" to pay, future demand falls as demand destruction occurs. The last financial investor owning the futures instrument holds "the can" as the cookie crumbles. And prices rapidly fall back towards marginal cost of production; then prices fall below the marginal cost of production as losses are limited by the can holder. Then the producer response occurs and we have come a full circle. All this occurs because the user and producer relationship has been obscured by intermediaries and arbitrageurs. The futures market has an incredibly important role to play. It allows better pricing and provides producers and users information which will permit both better planning. However, when the market is distorted by a chain of financial investors with no underlying demand for the physical commodity, things start to go wrong. In truth the futures market should reduce volatility; in fact since it has obscured the relationship between users and producers it has enhanced volatility and economic risks. This market should not be abandoned, but I believe it requires strict regulatory over-sight; it should be a market operational only for parties with real demand for the physical commodity.

I believe that oil is just down too much. I will buy some USO at $48.70 or lower and stick it in my IRA.

The charts and the story tell me that oil is just down too much and I will nibble at a small (1/16 of my portfolio) position.

There is no question that billions of dollars of buying power in the form of new investors , ETFs and Hedge Funds have some effect on price. However, there is no hedge fund forcing Exxon and Chevron to do more to replace their reserves - which they need to do. The International Energy Agency is set to revise its supply projections - that is , to lower their supply forecasts . according, to a recent report in The Globe and Mail . It had previously stated 100 million barrel a day demand by 2030 would be met by expanded production - by that time . " .. the agency is now worried that aging oil fields and diminished investment that companies could struggle to meet ( expected demand in the future )

Many Big Oil companies still have solid fundamentals. One of the main rules for investing during volatile times is to look for companies with strong fundamentals. This is especially true for an investor like me who isn't overly active and who likes the less-sexy "buy and hold" strategy. The idea is to look for companies with strong underlying value, and then buy more shares when the stock is pulling back a bit. That way when the market (and the company) recovers, you make more money since you were able to buy more shares.

And it's tempting to get into Big Oil right now. After all, what is more fundamentally sound than a company like Exxon Mobil (XOM) that has a proven business model and a penchant for making huge profits? Big Oil stocks have remained relatively stable (though they are down from last fall) throughout, and recent events seem to indicate that they will go up. (Well, maybe not BP -- BP, it's the one Big Oil company that I consider kind of shaky.) But for the environmentally friendly investor it's hard to justify investing in Big Oil. This is why STATOIL ASA (STO) offers such an interesting option. It is an oil company, but it is also trying to work toward carbon neutrality. And it appears to offer good valuation.

The IEA report will be published in November 2008 and may rattle the market if those findings are accepted. they are studying the major oil fields and projects . this has been done by CIBC World Markets and Goldman Sachs and they have predicted prices as high as $200 by 2010.