Seeking Alpha: OPEC Will Assure Oil Prices Stay in a Reasonable Range

February 25, 2008
By Jack Yetiv: Bio & more articles

‘Where goeth the price of oil?’ is perhaps the most popular topic these days both at cocktail parties and on the business news channels—especially after last week’s record run above $101. This makes sense given the fact that just about every American is impacted by the price of oil, one way or another.

Although much ink (a fair bit of it virtual “ink”) has been spilt on this topic, the amount of disagreement on this issue remains substantial. Although nobody can predict the price of oil with great certainty, some aspects of the oil market have become clear in the past few months, giving me a fair degree of confidence in what I am about to say here. My goal here is to focus as much on where oil prices WON’T go as on where oil IS likely to be in 6 months, one year and several years down the line.

OPEC’s behavior in the past few months has helped us determine where oil prices will not go. One place the price of oil won’t go on any sustained basis is below $80/barrel (this does not rule out temporary forays below $80, although even that is fairly unlikely). OPEC has traditionally “defended” certain oil prices by either increasing or decreasing production, and in 2006 to early 2007, those prices were in the $40-50 range.

In the latter part of 2007, OPEC learned something interesting that has significantly modified its “pricing set point”–namely, that the West, and especially the US, was not bothered by $80 oil, or even $90 oil. Therefore, in late 2007, OPEC concluded that it could keep oil prices in the $90s without any major adverse consequences to it, whether politically or economically.

To be sure, it would not serve OPEC’s interests to run the Western economies into recession (because oil demand and prices would then collapse) but keeping the price of oil high would certainly benefit the OPEC producers—as long as it wasn’t “too high.” Therefore, whether we care to admit it or not, each one of us who has failed to significantly decrease his (and her) use of oil products as prices have doubled from $45 to $90 per barrel in the past year has sent a clear message to OPEC–“Hey, OPEC, you can go ahead and maintain oil pricing in the $80s and $90s without worrying too much that we’ll cut our oil use.”OPEC has gotten the message, and that is why OPEC snubbed President Bush a few weeks ago when Bush asked that they open up the spigots, to which OPEC replied “No.” It is also why OPEC has actually recently hinted that it may DECREASE production, even while oil prices are in the $90s. It is therefore clear that OPEC’s new “pricing setpoint” is at least in the $80s, and more likely, it is in the $90s or possible higher (see discussion below).

Another place oil will not go in 2008 (barring rather unlikely geopolitical events) is $200, for the same reasons discussed above, but operating in reverse. OPEC knows that oil–at the “correct” price–is the veritable golden goose. Whereas OPEC will not want to see oil below $80-90, it also will not want to see oil at $150, much less at $200, and OPEC will open up the spigots if oil exceeds $110-$120 by too much.

How much is “too much” is hard to know, and it is doubtful that even OPEC oil ministers know the answer to that question today. If oil breaches $100–as it will do repeatedly in 2008–and if it does so gingerly, OPEC will probably do nothing, wanting to see what happens to demand. After all, 2 years ago, everyone was predicting that $100 oil would wreak havoc on the global economy, and yet, it is now obvious that everyone was wrong. Therefore, if the rise is slow, OPEC might well let $110 oil be tested in the world marketplace, and see what happens. If $110 oil is greeted with the same collective yawns as $90 oil was, OPEC’s unofficial (and undisclosed) pricing setpoint might well rise to $110.

Of course, OPEC has to be very careful, especially this year, to not get too greedy for fear of pushing certain economies into a recession that they might have otherwise avoided, but if the US economy recovers in the next few months, this will not be of great concern. If the US economy gets worse, expect sufficient production cuts by OPEC to maintain prices in the $80 to $90 range.

My guess is that OPEC won’t let oil go much over $120 this year, and I consider $150 oil extremely unlikely in 2008, barring the aforementioned unlikely geopolitical events. It would probably take an all-out war with Iran or an invasion of Saudi Arabia or Kuwait, or a radical Islamic overthrow of these countries with resultant production shortfalls (all of which I consider extremely unlikely, but not impossible, events) to spike oil to $150. Anything short of such cataclysmic events is unlikely to push oil to $150 in 2008. Of course, a complete American military exit from Iraq does increase the chance of such events, but a complete exit is not likely to occur in either 2008 or 2009.

Although I think $150 (and even $130) oil is quite unlikely in 2008, I think that longer-term (eg, 3-5 years from now), $200 oil is quite likely–if not downright expected. This is because demand growth in the future will exceed supply growth (see the excellent article on this topic by Jim Kingsdale on Seeking Alpha dated 2-15-08), and because once demand exceeds supply, OPEC will lose any power to increase production to lower prices.

On the demand side, it is unlikely that China, India, Brazil and other developing countries will slow their growth anytime soon, and there are a billion (or more) consumers out there who want to drive cars and improve their general standard of living. On the supply side, many big fields are in decline and newly-found oil is usually much more expensive to produce than the “low-hanging fruit” that was found decades ago. Indeed, I have seen estimates that the Tupi field off the coast of Brazil will cost $70 to $80/barrel to produce and transport to the refineries. Given inflation, it is not inconceivable that similarly-hard-to-access-and-produce fields will cost as much as $100/barrel to produce in 5 years from now. Under that circumstance, and as absolute demand outstrips absolute supply, it seems that $150 to $200 oil a few years from now is not that far-fetched.

The question this all presents, of course, is how to make money from these predictions, and what I have done is to acquire a substantial position in HTE, one of the very-high-yielding Canadian oil and gas trusts. At today’s price ($24.38), HTE offers approximately a 14.8% dividend yield. Given the foregoing prediction that oil will likely remain close to $100 in 2008 and probably higher in future years, it seems extremely unlikely that this Canadian oil and gas producer’s income will do anything other than go up, meaning that total return is likely to exceed 15%.

To me, this seems like an excellent place to invest a substantial portion of one’s investment dollars, especially given the uncertainty of decent returns in other investing spaces. HTE is a bit more complicated than other energy trusts (of which there are several good ones, but HTE is my favorite) because it also owns a refinery and refinery profits tend to be very volatile, but despite that, I believe any stock that offers nearly a 15% return and has very little downside risk is a compelling value in today’s market.

Disclosure: Long HTE

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