Oil Slickonomics-Part 12-An Update

David R. Kotok
Chairman and Chief Investment Officer
Oil Slickonomics-Part 12-An Update
November 4, 2010

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We will start this note with two links. The first is to the October 2010 edition of the National Geographic. It is devoted to the Gulf oil spill, with a comprehensive report that includes excellent maps and photos. Those who lean green will find support in this assemblage of data. Anti-BP forces will like it as well, since it quotes some of their errors. There is also support for those who believe the US must expand deepwater drilling. Greens will not like this part.

I personally think the report is objectively done. It tells the drilling story, and the risks and results are outlined clearly. The NGM photo-essay style certainly enhances the story line.

The second link is to our website. My friend and LSU Emeritus Professor Loren Scott assembled a presentation for the recent NBEIC meeting. The National Business Economic Issues Council meets privately under the Chatham House Rule. We gather four times a year, mostly in the US and occasionally elsewhere in various parts of the world. Loren granted permission for us to share his slides with our readers. We suggest readers take the ten minutes or so to examine them. They are loaded with information about the oil spill, the aftermath, and specifically about the continuing de facto moratorium on drilling. President Obama lifted the formal moratorium right before the election. As you can see from Loren’s slides, the administration is using the bureaucracy to continue it.

Loren Scott’s slides are here, under the title “NBEIC Conference Bethlehem, PA by Dr. Loren C. Scott.” We thank Loren for permission to share his work with our readers.

The oil price has now broken above the $60-$80 trading range. It looks like it is headed higher. Many reports suggest world markets are tightening on the supply side at the same time that the US dollar is weakening. Remember that oil is globally priced in dollars. However, it must be noted that the price is now rising nearly everywhere in local currency terms. This was not the case a few months ago when the dollar initially weakened . Then, the oil price languished in other economies and currencies. That seems to have changed.

For the US, the drilling moratorium is a disaster in the making. We already import 67% of our oil needs. Let us do a little math. In the US, we currently consume about 20.7 million barrels of oil a day. Two-thirds of it is imported; that equals 13.8 million barrels a day. Oil comes in different grades and there are various refined products. Let’s simplify and just use the recent price of $87 per barrel to make our point. In round numbers, our daily trade deficit from oil importation is $1.2 billion. That’s over $400 billion a year and climbing.

This occurs as the Federal Reserve is engaged in quantitative easing in an attempt to raise the rate of inflation. Nevertheless, a rising price for gasoline and heating oil and jet fuel and diesel is not the kind of inflation the Fed seeks. The Fed views the commodity price and the related price shocks from things like oil as “exogenous.” They are beyond the control or influence of monetary policy. The Fed sees action on the price level from an oil shock as one of substitution. Raise the price and something has to give.

It will. Moreover, the something that gives may be more weakness in economic terms. A higher oil price will slow the tepid US recovery.

That oil price shock may becoming. The average price of US gasoline is $2.80. It is again headed higher. It will not be long before the $3-plus number starts to make the headlines. Diesel is already above $3. Consumers will feel this like a tax increase, since the weekly fill-up is a universal phenomenon in the US.

Meanwhile the toll from the de facto moratorium continues. America’s oil import dependency worsens because of it. Barclays Capital reports (November 4) that “There are no signs yet of any rejuvenation of US Gulf activity. Oil drilling in federal offshore waters remains at just 14 rigs, some 40 rigs lower than this year’s pre-Macondo peak, and six rigs lower than at the start of September.” Also note the job losses in the oil industry caused by the moratorium; Loren’s slides set this out clearly.

One final note on the oil spill. The BP official cost estimate is up to about $40 billion. We believe that will double before all is said and done. The period of litigation intensifies and the fines from the spill still lie ahead. At the federal level, we expect the US government to make the case for a $4300 per barrel levy on 4.9 million barrels spilled. That is about $20 billion. In addition, there are the various state fines and levies for environmental damage. See Loren Scott’s slides for details. He is estimating that Louisiana alone will seek $10 billion in damages.

The fight between BP, Transocean, and Halliburton is not resolved. Each is trying to blame the other and avoid paying a share of the damages. The FT noted the irony that Halliburton is a “cutting-edge technology” company, yet it is the allegation of negligence regarding HAL cement that may trigger the damage claim. Oil well cement, notes the FT, “… is how Earl Halliburton, its founder, got started 80 years ago.”

Cumberland’s US ETF portfolio has an overweight position in energy.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com