"$100 Oil. Not So Farfetched" Market WrapUp by Chris Puplava

Leading up to the landfall of Hurricane Katrina, crude oil prices jumped from $65.71 a barrel on 08/23/05 to as much as $69.47 a barrel on 09/01/05, just 3 days after the severity of the storm began to be realized. Katrina shut in nearly 90% of Gulf oil production. The U.S. Minerals Management Service said that 1.5 million barrels of daily oil output in the Gulf was offline on 09/25/05, 100% of the Gulf’s daily output, as a result of Katrina and Rita, and more than 78% of daily natural gas production also remained offline.

As of this week, the Minerals Management Service said that 52% of daily oil production and 47% of natural gas production in the Gulf of Mexico remained off-line. And despite this week’s mild temperatures in the northeast, forecasts for this winter call for a long, cold and wet winter for the Midwest and Eastern part of the country.

U.S. Refinery Capacity, Inputs, and Production, July 2004 to Present

Source: Minerals Management Service

With nearly 90% of Gulf of Mexico oil production shut in, U.S. politicians voted on September 1st open up the 700-million-barrel Strategic Petroleum Reserves (SPR). This was done to prevent what some were forecasting as $4 or even $5 gasoline and skyrocketing crude prices. The opening of the SPR coupled with oil loans from the International Energy Agency (IEA) brought much needed supply and put downward pressure on crude oil prices. What was the case for natural gas? There are no strategic reserves for natural gas; and guess what--natural gas prices soared from a pre-Katrina price of $9.68 per million BTU on 08/23/05 to $14.22 on 10/04/05, and peaking at $14.34 on 10/25/05, up 48%.

Some scoff at talks of $100 oil but we may be closer to it than we think. This point was made in the Casey Energy Speculator (Vol. 1, Issue 5) in a graph by Bud Conrad showing the movement of natural gas and oil. I found the graph hard to believe and so I recreated it using data for both of the commodity’s prices and saw the same pattern. When one overlays the price movements of oil and natural gas on dual scales, their price movements are clearly seen to move in tandem with crude priced roughly 7.5x that of natural gas. What is even MORE telling is what the price of crude oil might have reached had the U.S. not released the SPR just after Katrina hit. Taking a look at the chart I made below shows natural gas with its price scale on the right and crude oil on the left.

The close price movements between crude and natural gas show what crude oil could have risen to--not $100 a barrel, but $110 a barrel! As the price of natural gas soared from a pre-Katrina price of $9.68 (08/23/05) to $14.34 (10/25/05) for a gain of 48%, the tandem movement of crude would correspond from $65.71 (08/23/05) a barrel to $103.60 a barrel with a 48% increase as was seen with natural gas.

The release of the SPR showed politician wisdom that the economy could not handle a supply shock with oil, but what shows their foolishness is all the talk about oil companies 3rd quarter profits and talks of windfall taxes because of their “outrageous profits.” Politicians need to be reminded of the difference between absolute numbers versus relative numbers (ratios for example). When looking at ExxonMobil’s (XOM) 3rd quarter revenue of $88B and net income of $7.64B, I can see why some politicians are screaming outrage, but they need to remember these are absolute numbers, NOT relative numbers. When looking at the net profit margins for several companies, ExxonMobil’s net income doesn’t look so outlandish compared to other companies profit margins (see table below).

To make an apples-to-apples comparison, one must look at relative numbers. To do this I multiplied ExxonMobil’s sales to each respective company's net profit margin to look at the net income on a relative scale. I think the numbers speak for themselves. Looking at these numbers and hearing talks of oil windfall taxes is ludicrous. They should be talking about chip makers, semiconductor and drug maker windfall taxes, not oil! ExxonMobil had enough of the talks about windfall taxes on the oil industry and put out a piece called “Oil and Apples: Oil Industry earnings are high, but not out of step with other industries.”

Robert Shapiro, former undersecretary of commerce for economic affairs in the Clinton Administration, along with Professor Nam Pham of George Washington University recently conducted a study on what can happen if the leading proposals for a windfall tax were enacted and oil sells for $45 a barrel, $50 a barrel, $55 a barrel and $60 a barrel for the next five years. He commented on his findings in his article, “Making a Scapegoat out of a Windfall” (Wall Street Journal, November 8, 2005).

They had two major findings. First, domestic production would fall by roughly 100 million barrels per year, just like it did when Congress passed the 1980 windfall tax as oil prices rose drastically. The second conclusion is that instead of helping consumers, it would hurt millions of savers and retirees who own stock in oil companies directly or indirectly from their pension plans or retirement accounts from foregone dividends and increases in stock value. Shapiro stated that these plans and accounts hold nearly $267 billion in oil stocks.

Shapiro calculates that a windfall profits tax would take back an average of $8.7B to $50B (depending on $45 oil to $60 oil over the next five years) from pension and retirement savings holdings. Shapiro concluded his article by saying, “Oil companies may be able to shoulder the burden by reducing their domestic investments. American savers and retirees may not be so lucky.”

People need to remember that of the profit oil companies make, the government takes 35% of that which flows right to the Treasury via the corporate income tax. Now they want more with the windfall tax! Politicians and Bill O’Reilly need a history lesson.

Lesson 1: When Jimmy Carter signed the windfall profits tax during the last oil crisis the result was oil companies reduced their U.S. Domestic production by 1.5 million barrels a day, nearly 6%.

Lesson 2: A famous study by Harvard economist Joseph Kalt found that U.S. dependence on oil increased between 8-16% after the price controls and profits tax. Just look on the graph below to see current foreign oil dependence rising on a clear upward trend.

Politicians need to look at relative numbers like the business scale of a company. The reason why ExxonMobil’s net income was so high was that they had over $88B in revenue! What happens when politicians start dipping their hand in oil profits? The likely result is less capital expenditures based on lower revenue. Yes, XOM had $7.6B in net income but they spent $15B in capital expenditures last year alone for new exploration and production as well as refining capacity and new energy-saving technologies. When you cut into their profits you cut into their capital expenditures and production goes down, supply goes down, and higher crude prices, NOT cheaper prices results!

Look at the oil and gas chart comparison above and what happens with a supply shock--a rise of 48%! We can’t afford decreasing exploration and production by oil companies with China and India coming onto the scene and record oil demand in this country. Ron Paul, U.S. Representative from Texas, made an important argument in his October 31, 2005 weekly column piece, “A Free Market in Gasoline.” He said, “But we must understand that high oil prices are not the result of an unregulated free market. On the contrary, the oil industry is among the most regulated and most subsidized of U.S. industries. Perhaps we need to ask ourselves whether too much government involvement in the oil markets, rather than too little regulation, has kept the supply of refined gasoline artificially low.”

He goes on further to say that “Federal subsidies and regulations are largely responsible for limiting the supply of refined gasoline in this country. The demand for gasoline has risen dramatically in America due to population growth in recent decades, but virtually no new refining capacity has been added. Basic economics tells us that rising demand and a fixed supply will lead to higher prices. No amount of congressional grandstanding about price gouging will change this economic reality. We must increase domestic exploration, drilling, and refining if we hope to maintain reasonable gas prices. We need more competition, which means we need less government.”

The lesson in all of this, Paul says, is that “Centralized government planning, on the other hand, cannot solve our energy dilemmas. The Nixon-era price controls on gasoline in the 1970s produced nothing but disastrous shortages. By contrast, the Reagan administration’s immediate deregulation of the oil industry resulted in an unprecedented boom in oil production and a dramatic reduction in prices. This is the lesson we must remember.”

A great example of the “hands-off” approach with the energy sector is the regulation of natural gas decades ago. Domestic production of natural gas reached “peak gas” in 1973 at 22.6 trillion cubic feet of production. The supply of natural gas then plummeted through 1983 and then reversed course after price deregulation began. With the price deregulation, exploration increased with supply following suit, increasing steadily through 1994 before leveling off (see chart below).

If politicians want to help the common person with oil prices, tell them to suspend federal gas taxes, which would save consumers nearly 20 cents per gallon as Paul suggests. This can be done immediately irrespective of U.S. Strategic Petroleum Reserves, but would politicians want to cut into their own pockets? I don’t think so. Ron Paul is putting together legislation to allow offshore drilling, eliminate regulations that restrict refining, and suspend harmful tax laws that discourage domestic oil production. As Paul puts it, “If we hope to have a stable, affordable supply of gas, we must allow the free market to operate.”

Index	Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Dow Jones Industrial Avg.	10,546.21	6.49	0.1%	0.1%	2.5%
S&P Dep. Receipts	122.39	0.16	0.1%	0.2%	2.3%
Nasdaq Composite Index	2,175.81	3.74	0.2%	0.3%	4.1%
Nasdaq 100 Trust	40.16	0.02	0.0%	0.2%	4.7%
Dow Jones Transportation Avg.	4,004.37	43.13	1.1%	1.8%	8.9%
Dow Jones Utility Avg.	395.86	2.09	0.5%	0.8%	-4.3%
Inter@ctive Internet Index	171.10	-0.23	-0.1%	0.1%	3.9%

Description	Last Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Basic Materials	1,206,368	2,832	0.2%	0.3%	1.4%
Capital Goods	652,479	-862	-0.1%	-1.1%	-0.5%
Conglomerates	772,665	3,133	0.4%	-0.2%	0.9%
Consumer Cyclical	767,685	-1,706	-0.2%	-0.6%	0.0%
Consumer/Non-Cyclical	1,308,827	2,441	0.2%	0.2%	0.7%
Energy	2,535,121	-10,812	-0.4%	-1.4%	-2.7%
Financial	4,769,189	13,880	0.3%	0.5%	5.3%
Healthcare	2,275,011	2,601	0.1%	-0.1%	1.8%
Services	4,497,646	10,810	0.2%	0.0%	1.7%
Technology	3,042,601	6,636	0.2%	0.3%	4.5%
Transportation	378,530	4,117	1.1%	1.8%	7.0%
Utilities	862,380	6,666	0.8%	0.0%	-2.8%