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Oil price and marginal supply

0 Comments| June 6, 2008

I was reading an article last night written by Gavekal oil analyst Ahmed Abdullah.  He made the following comments about oil supply and demand dynamics and peak oil:

I am working on a large paper to be published soon [on supply side response]. What really matters is understanding the behaviour of the demand side and accurately predicting future growth in what types of oil and sectors and invest accordingly; leads and lags will be taken care by price for the intermediary adjustment. What I clearly did not foresee is how far the market will take price away from the marginal cost of production of the marginal barrel. $65 is about the right marginal price on a fundamental basis at today’s massively inflated input costs. The market is pricing a 100% premium over that. The last time we saw that was in fact just before the first Gulf War. Here I take my share of responsibility for not seeing it coming… 

Ah, yes.  The magical marginal cost of supply theory. Abdullah went on to conclude his argument with the following: "I guess it all boils down to whether one believes in peak oil or not." 

Well no, it doesn't. 

The thrust of Abdullah's argument is that you have to believe in peak oil to believe that high oil prices are sustainable. If you don't believe in peak oil then you must believe that oil prices will revert to the marginal cost of supply in short order. 

There are two points here I want to address. First of all, peak oil. Second, the marginal cost of supply. They are intertwined with one another. 

Let me put it this way.  You did not have to believe in peak copper to believe that copper prices were not going to come back down to the marginal cost of supply in 2004 and onward.  You did not have to believe in peak potash to see that potash prices were going to stay well above the cost of supply for many years.  You don’t even have to believe in peak coal to see the metallurgical coal prices are going to stay high for more then a few months. 

What you did have to believe was that: 

  • There was a new source of demand that would outstrip the existing supply response mechanisms and that demand would continue for years.
  • There would be an inevitable increase in government intervention once they got $$ in their eyes.
  • There would be skyrocketing costs for building new mines and maintaining existing one's due to the boom.
  • There would be a shortage of workers to continue to expand supply at a faster rate and this would be exacerbated by birth rate trends and an aging workforce in these industries.  

One does not have to believe in peak oil to believe that oil prices are going to stay high and go higher.  You only have to believe that the demand for oil is going to outstrip the ability of supply to respond in a timely manner on a continued basis.   

This is what has happened for the last four years.  And this has been happening to other commodities, like metals, and now grains and fertilizers.  Yet we still hear this marginal cost of supply argument touted as though it means something.  To put it bluntly, economic theory is wrong.  Price does not have to revert to the marginal cost of supply in any time frame other then the very long run.  And in the long run we are all dead, so who cares. 

I pick on Gavekal because they are an easy target.  They charge more then $15K a year (last I looked) for their analysis, and if you had listened to them you would have never bought copper stocks, never bought oil stocks, and probably would have loaded up on “platform companies” like Dell (NASDAQ: DELL, Stock Forum).  You would have missed out on one of the biggest booms in history.   

But Gavekal isn’t the only one.  Analysts have stayed married to the antiquated idea that price must revert to marginal cost of supply.  Even after years of evidence that it is a baloney argument. Yet, it is the primary reason why copper companies continue to trade at three times earnings, and oil companies are priced on $60 oil, and why Potash Corp. (TSX: T.POT, Stock Forum) has been considered "too expensive" by many, even as the price went from $50 to $220. 

The response of supply is a function of time.  And if practical limitations of how quickly supply can respond are exceeded by the rate that demand is increasing, then prices will keep going up.  It’s that simple.  If this was taken into account, folks wouldn’t be making dumb forecasts like the $70 oil one that Gavekal made for this year.  

Somebody should write a paper on that.

To read more work by liverless, visit his blog at Reminiscences of a Stock Blogger.

This article was written by a member of the Stockhouse community.

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