Oil Futures

The slip in oil and gas prices over the last few months is mostly due to fundamentals. However, there is the likelihood that some of the drop in domestic gasoline might have been due to some election year thumb-on-the-scales. Regardless, the motoring public seems to have put the price shocks of last fall and spring behind it as a Katrina-dependent aberration. That would be wrong.

Oil has been edging up. Crude has crept back up to the $63 range and has been trending slightly upward since late October after its precipitous drop in late summer.

Barry Ritholtz brings us the analysis of David Kotok, Chief Investment Officer of Cumberland Advisors on oil fundamentals.

Given yesterday's pop to $62 in Crude -- up from $53 when last month's Futures' contracts expired -- its worth taking another look at energy sector.

I am friendly with David Kotok, Chief Investment Officer of Cumberland Advisers. Like me, David remains Bullish on the Energy Sector, and has had some rather astute comments on Oil recently. Back in September, he wrote:

"Many folks are bailing out of oil. Some forecasts now call for a price decline to under $30 per barrel. One extreme forecast suggests the oil price could go as low as $15. We do not agree.

The recent drop in the oil price from the high $70s to a few pennies under $60 per barrel is the result of the lessening of two risk premia. 1. The hurricane season seems to be passing without incident. 2. The Chavez/Ahmadinejad bluster is known and the market is assuming that we have seen the worst. Some players are suggesting that the European initiative with Iran will succeed and lessen the tensions over Iranian development of nuclear enrichment facilities.

Oil risk premia are estimated by computing the cost of adding a barrel to inventory. This helps explain the pricing of oil in the futures market. When the risk premia declines as it is doing now the nearest term oil price declines the fastest. That is what we have seen in the August/ September period. Longer term futures prices are suggesting that the current decline is nearing an end. Oil for delivery 18 months from now is trading near $68 per barrel."

This is true. The NYMEX website is readily accessible and the futures table is available to anyone. As of this writing, oil for May, 2008 delivery is bid at $70.48.

David's view is that "energy prices are going higher and that our overweight ETF investment position should continue in this energy sector."

He also recently criticized what he termed "the ethanol mess" and offered how it didn’t help the energy price -- but it did help create shortages in grains. He notes that some folks in this world are going to starve because of it.

Why does he want to stay overweighted Energy? These factors suggest higher oil prices:

• The dollar has declined about 10% (trade weighted) from where it was a year ago. Oil is about the same price per barrel as it was a year ago. Oil is priced in dollars. Therefore, we in the US have had a price run up to near $80 and back to $60. The rest of the world has had a smaller price run up and is now looking at an oil price 10% lower than it was a year ago.



• The relative price is important because it allows us to estimate the stimulus that occurs from the oil price change in various parts of the globe. In the rest of the world that stimulus has spurred demand. Oil consumption is about 1 ½ million barrels a day (mbd) higher than it was about a year ago. In the US the change has been nearly flat. Our oil consumption is not the growth area. Look to Asia to find it.



• Oil futures prices suggest a return to nearly the $70 level in 18 to 20 months. McKinsey & Co. forecast continuing rise in world oil demand at about 2.2% a year until 2020. We agree. Oil could easily be $100 before then as world consumption rises between 1 ½ and 2 mbd each and every year.



• The unrest in Nigeria continues and may be worsening. Press reports usually do not include this in the top of the list. They should. Nigeria is becoming an increasingly dangerous place for the folks who work in the oil industry. Investors need to keep an eye on this geography.

Nigeria? You didn't know Nigeria was a linchpin producer in the world oil market? Producing 2.5 mbd (million barrels per day) it is the eighth largest producer in the world, producing more than both the United States and Mexico. A good background on the general state of affairs in Nigeria can be had from the PBS News Hour website. The complex and sophisticated nature of the anti-corporate indigenous guerilla groups operating in Nigeria can be had from John Robb in an article entitled, Nigerian Evolution.

• Speaking of geography, the Middle East is deteriorating and the market has ignored it. In Iran, we see Russia supplying missile defense material to protect Iranian nuclear sites. We see the breakdown in Lebanon and the Syria-Hezbollah connection strengthen. The Israel-Hamas battle continues unabated. Clearly we see a murderously intense civil war in Iraq. Soon we will witness the forthcoming pullout of the British. What will that mean? They are in the Basra region; that is where a lot of Iraqi oil exports originate. Basra is Shiite and close to Iran which is also Shiite. Instability in Basra is almost certain to rise when the Brits depart. Right now Iraq still exports about 1.6 mbd. As much as half of it is at risk if the civil war spreads and intensifies in Basra. Also, only about 1600 of the 2300 oil wells in Iraq are working. The civil war prevents regular maintenance and precludes development. So every time a well loses functionality it goes offline. We expect that to continue and intensify.



• All this leads to a strange alignment. In Iran, the Shiite center of power, there is an interest in the higher oil price. Iran has no love for the west and would spend the money on the mischief it spreads in the region and on domestic social spending so as to endear the Ahmadinejad regime to the populace. In Sunni Saudi Arabia, they wish to maintain the present oil price or see it a little higher. They do not want to kill the west but they would welcome the higher oil price if the source of the pressure was from other than OPEC cartel price maintenance. So we have both the Sunni [center of] power and Shiite [center of] power supporting their respective allies who are the combatants on one side of the Persian Gulf while enjoying the benefits of any higher oil price and attendant risk premium. This bodes ill for Basra and any other place where the civil war might spread.

By way of disclosure, Cumberland maintains an overweight position in energy, with the Vanguard energy ETF (VDE) as their first choice. VDE has 118 stocks, with the heaviest weighted components being ExxonMobil (XOM) Chevron (CVX) and ConocoPhillips (COP) Schlumberger (SLB) and Occidental Petroleum (OXY).

I'm going to revisit the ethanol situation soon. But as I've pointed out in previous posts: here (bottom half) and here, ethanol is at best a regional solution to oil dependency. Furthermore, the corn and ethanol industries are hardly pure market-based plays. There are literally tons of federal and state subsidies which enable the industry to exist at all. Read the link above on the "ethanol mess." Key players in this mess are, of course our own state's elected representatives.