Understanding Oil

This week we saw a tug of war between the signs of an improving economy and then fear of an oil shortage. As good economic data was published, the stock market and the yield on long term treasury bonds would go up. As fear of an oil shortage was spread the opposite occurred. This newsletter provides the 2 key indicators to watch to see if either exuberance over the economy or fear with an oil shortage will win. The first section is from Vanguard. The last section is OPEC related data.

The world produces -- and consumes -- about 80 million barrels of crude oil a day. At a $100 a barrel, that amounts to $8 billion dollars or just short of $3 trillion dollars a year. World GDP is about $60 trillion using current dollar exchange rates, and about 20% higher if measured on the basis of purchasing power parity. That means oil consumption is about 4% to 5% of world GDP.

Vanguard

March came in like a lamb, at least as far as U.S. economists were concerned. Although turmoil in the Middle East and northern Africa have forced Americans to pay more for gas at the pump, at least temporarily, this week's data seemed to reflect an economy on the mend. For the week ended March 4, the S&P 500 Index rose 0.1% to 1,321 (for a year-to-date total return—including price change plus dividends—of about 5.5%). The yield of the 10-year U.S. Treasury note rose 7 basis points to 3.49% (for a year-to-date increase of 19 basis points).

Understanding Oil

The 2 keys to understanding the direction of oil are oil production from Saudi Arabia and releases of oil from the US Strategic Petroleum Reserve. Saudia Arabia is the largest producer of oil in the world and has reserve capacity that is greater than the production from unstable governments like Libya, Algeria, and Tunisia. The other key is releases from our reserve, enough to replace Liby's production for about 1 year, and this week Treasury Secretary stated that releases would occur if necessary.

The big wild card in forecasting oil prices is predicting what will happen in Saudi Arabia. Saudi Arabia has the largest oil reserves, estimated at about 20% of total world supply. The country produced about 9 million b/d of crude in 2009, although a few years ago it produced well over 11 million b/d. Libya exports less than $2 million barrels a day, about 2% of world output. Saudi Arabia is estimated to be able to produce 3 million to 4 million extra barrels a day (b/d), and they have indicated they will stabilize oil prices.

The 727-million-barrel U.S. Strategic Petroleum Reserve is the largest stockpile of government-owned emergency crude oil in the world. Established in the aftermath of the 1973-74 oil embargo, the SPR provides the President with a powerful response option should a disruption in commercial oil supplies threaten the U.S. economy. When this reserve is tapped, it means that the US Government is going to sell oil on the open market to make money which is why the Treasury Secretary made this statement. It is a clear indicator of a market top for the price of oil. Let's see making $10 profit per barrel brings in $7.27 Billion to the Treasury, very nice.

The U.S. consumes about 19 million barrels of oil a day and produces about 9 million b/d, meaning we import about 10 million b/d. Each $10 rise in the price of a barrel of oil increases our import bill by about $100 million a day or about $36 billion a year. In our $15 trillion economy, this increase costs us about 2 tenths of one percent of GDP. If crude rises $20 barrel, as it has from the beginning of the year, this increase will shave about 4 tenths of one percent from GDP. This is hardly debilitating to an economy that is expected to grow between 3% to 4% this year.

Bottom Line: As long as Saudia Arabia remains stable the current investment strategy makes sense. If unrest hits Saudia Arabia, the strategy will shift immediately to being very defensive.

OPEC Data (WSJ February 28, 2011)

Saudia Arabia: 12 million barrels per day (mbd) capacity, 8.5 mbd production, 3.5 mbd in reserve
Iran: 4 mbd capacity, 4 mbd production, 0 mbd reserve
Iraq: 2.5 mbd capacity, 2.4 mbd production, 0.1 mbd reserve
Kuwait: 2.5 mbd capacity, 2.3 mbd production, 0.2 mbd reserve
U.A.E.: 2.7 mbd capacity, 2.3 mbd production, 0.4 mbd reserve
Nigeria: 2.4 mbd capacity, 2.3 mbd production, 0.1 mbd reserve
Venezuela: 2.4 mbd capacity, 2.2 mbd production, 0.2 mbd reserve
Angola: 2.0 mbd capacity, 1.8 mbd production, 0.2 mbd reserve
Libya: 1.8 mbd capacity, 1.6 mbd production, 0.1 mbd reserve
Algeria: 1.3 mbd capacity, 1.3 mbd production, 0 mbd reserve
Qatar: 0.8 mbd capacity, 0.7 mbd production, 0.1 mbd reserve
Ecuador: 0.4 mbd capacity, 0.4 mbd production, 0 mbd reserve