Mike Rothman Says: Short Oil

Elliot, an excellent commenter, directed me to Mike Rothman's Interview in Barron's. Rothman believes that oil is so expensive because prices are no longer driven in the short term by supply and demand, but rather by the perceptions of players in the oil futures markets, which didn’t even exist until the early 1980s. These traders can drive up the price of oil even if supply and demand might dictate otherwise. “I have never seen a gap between the reality and the perception of reality as big as it is right now,” The commonly held belief that tremendous demand growth in China and India is driving up prices simply doesn’t withstand analysis of the data.

Barron's: What's the view from the OPEC meeting? The Saudis agree to increase output and crude goes to new highs.

Rothman: That's not the story. The story is not the increase, the story is why the Saudis are pushing for an increase in production. A big part of the answer is that it seems that the Saudis want to try to take the froth out of the oil price because they are concerned about what higher prices have done to supply and demand. Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. (My comment: The widespread idea is that the Gowar field is almost depleted and they have not enough oil to sell. That is nonsense because demand is being fully meet.) It wasn't that they were depriving people of barrels, but OPEC had less demand for their oil -- and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that's an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn't been at nearly the pace people thought it would be.

What are your forecasts for demand growth?

My forecast for the fourth quarter, excluding Angola and Iraq, is for about 26.6 million barrels a day. Their production right now is about 26.8 million barrels a day. From these levels it doesn't look like they have to raise output. Mind you, it's not the consensus view. The consensus view, which is from the International Energy Agency, is that demand is going to be about a million and a half higher than what I am talking about, and most people use the IEA forecast. OPEC is producing at a level that even their internal supply-demand model suggests is probably the right number for what they would need to supply -- in other words, what the market is going to demand. Qualitatively, you should know nobody is being deprived of barrels. Now, with the Saudis pushing for a higher quota, it is not about making barrels available to meet demand. It's about sending a signal or trying to lever down oil prices. The reason they want to do that is because the higher average price levels we've seen for the last couple of years have affected demand growth, and they have affected supplies from non-OPEC countries and for alternative energy supplies. The Saudis are the ones bearing the brunt of that because as demand for their oil has dropped, they have been the ones that have had to cut back.

There was talk they would delay increasing output because of concerns about the impact on prices.

That issue, of how do you engineer a soft landing, is really a tricky issue because the amount of speculative paper in oil has increased dramatically. The level of open interest in crude on the New York Mercantile Exchange has tripled in the last three years. The over-the-counter market, according to data from the Bank of International Settlements, suggests outstanding positions in oil about 20 times as big as the Nymex. Now we didn't have a big OTC market back in '85, '86 or '88 or '94, nor in the '98-'99 price crashes, so the big concern right now is when the unwind happens, it could be terribly disruptive. If you look at an oil-price chart back to 1983, when crude started trading on the Nymex, all you will ever see in the price patterns are V-tops and V-bottoms. What happens when hedge funds who have been net long in crude since October '03 decide to go short or sell? You can understand the concern. It's not just about easing prices; there is the potential for a blood bath.

So how do you explain crude prices rising to new highs after the Saudis announced they would increase production?

It would be an understatement to say I was taken aback by that. In a few days, the market went from expecting no hike in production, to expecting a largely symbolic increase, to getting a final agreement to inject 500,000 barrels a day above existing levels -- which is the equivalent of a 1.4-million-barrel-a-day boost in quotas. The big question at the meeting is, "What is bolstering the price?" I'm not sure, except the market seems to still believe the world is running out of oil.

The US Government has a different opinion. They say (see yesterday's entry) that "The market fundamentals, characterized by rising demand for OPEC oil and fairly low surplus capacity, should keep markets firm even with the planned increase in OPEC production, leaving the market vulnerable to supply disruptions". As I heard today in Kever Benjamin, Allah hum maghfirlee war-ham nee, May God have mercy on me.