Saturday, October 29, 2005

On Oil and Oil-Shale

So we've seen the price oil go from $1.80/gal to $2.80/gal under normal market circumstances. We hear about the oil companies reporting record profits on declining reserves. Of course the oil companies sight higher exploration and extraction costs in finding new reserves as the reason for justifying their higher profits, but shouldn't these expenses cut into their profits or at least leave them the same profit level?

Don't get me wrong, I'm not saying oil companies should be subject to windfall profit taxes as in the 70's, I'm simply saying the rationale is a smoke screen. The price of gasoline has gone up not so much because of the lack of oil, but the lack of refinery capacity. This is nothing new or illuminating. In fact a decent analogy for the reason gas prices rise is to imagine a 20 foot in diameter pipe of oil flowing into a garden hose that turns the oil into gasoline.

So given that the problem is not actually in the current supply of "light sweet crude", but in gasoline refinery capacity, why is the price of crude going up at least as much as the price of gasoline? The answer I believe is for the same reason that insurance companies typically report record profits in the months and years after natural disasters. They use an incident/disaster for justifying an increase in premiums knowing that the average consumer knows so little about risk management and hedging that they'll actually feel sorry for the insurance company or at least rationalize their increased premiums. In reality, any decent responsible insurance company already had hedged out the risk of the incident such that they payouts were manageable and forseeable and therefore built into the risk models, business models, and long term profit forecast.

So how does this equate to the price of crude? The oil companies using China (increased demand) as an excuse for raising prices are in effect only excercising their monopoly power in conjunction with media created psychological effects that make the public believe there is an actual oil shortage.

Now, how does this all tie into Oil-Shale - as the title suggests? Well, the situation above - the monopoly power being the real impetus behind the rising price of crude will be upset if the current price of a barrel of oil exceeds $65/barrel. I won't bore you with the analysis because the price point will inevitably change in the coming months and years, but the reason is that above a certain price levels (I estimate $65 currently), the extraction of oil from oil shale will become a profitable venture and exploration and extraction of oil-shale will occur and the traditional oil companies monopoly power will wane - much like the cheating on quotas by OPEC when the price of oil is high.

So, for those people who suggest that the price of oil is going to $100/barrel, I suggest you stop and look at the impact this would happen on the pricing power of the cartel at these levels. If Oil shale extraction cost/barrel = $20 and traditional oil extraction costs are $5-$10/barrel, its only a matter of time at $100 before the oil shale will be extracted because the enterprise is profitable with respect to other ventures in the marketplace. At this point the vastly larger supply of oil tied up in oil-shale will make the limited reserves of old-line oil companies a non-issue.

Now for some ripple effects if I've convinced you even slightly. What does a monopolist do to ensure their continued monopoly power and status? Well, they drive others out of the business. Currently this is done by holding the price level below $65/barrel. However, if you believe demand will spike and the price will head to $75, then the only recourse of the oil company would be to eventually buy up the oil-shale thereby locking the reserves up from extraction.

So, given this long term problem solution, is it not likely that as soon as these oil-shale companies stock price drops (since they can't profitably extract oil at the price the cartel is holding the price at) they will be bought up by the cartels on the cheap? In fact, its possible that some oil-shale companies will be bought only in bankruptcy. WOW! This sounds a lot like history - just look at the modus operendi of Standard Oil in the beginning of the 20th Century. Oh, and don't believe that this cannot happen again because the new "Standard Oils" aren't subject to US Anti-trust laws.

Bottom line, watch as the price of oil stabilizes at a high but not obnoxious level, watch as the stock price of all new oil-shale ventures tumble, then watch as the "Big Oils" buy up one after another on the cheap.