In a previous blog entry, about a month and a half ago, I commented on how oil will not reach 100 USD per barrel. I posed the argument that to reach a doubling of the oil price would require the price to reach 160USD, which would have devasted the economies of the world. Now oil is dropping and some have commented that the price of oil will jump back up next year. I am skeptical that oil will jump up again, and I will share with you why I think oil or gas will have hard time edging back up again.

Three nights ago I was flying from Frankfurt to Zurich and while walking onto the plane I grabbed a copy of the German Financial Times. (BTW I find the Financial Times a superb newspaper). Half sleepy, I browsed through the news articles, and a small article grabbed my eye. The article was about the Shakhalin project. The article caught my eye because Russia may revoke the drilling licenses, etc based on environmental damage carried out by the oil-multis. I thought, huh, Russia pulling a license on environmental damage. I kept reading the article, and thought, what if there is something more going on?

So off I went digging on the Internet, and I found an interesting pattern. Have you noticed that recently many oil and gas governments are revoking the contracts made with the oil nationals? You only have to do a Google news search with the terms "Bolivia, Ecuador, Venezuela, or Russia oil, and contract" and you will find oodles and oodles of articles. Many of the articles have the following theme:

  • Many oil and gas countries are doing one sided contract negiotiations. For example in Bolivia instead of 18-25% of the profits, demanded is 50-82% of the profits. Do the numbers; if a country demands 51% ownership with a 50% royalty requirement the company is left with 25% of the profits. What many forget is that when a company is 51% owned by the government then automatically 51% of the profits go to the government.

The oil companies are on the short end of the stick and thus have nothing to say regarding their contracts. But I think the oil companies are fighting back in ways that are extremely sly, or at least I think are extremely sly.

To understand what I am getting at, what if the price of oil dropped? What would be the ramifications. Let’s do the numbers and you will see an interesting picture. Here are my assumptions; it takes about 15 USD to produce oil (not entirely correct because in Saudi Arabia its about a dollar and a bit, but Saudi Arabia is not in the picture), and there is a 10% decline in production (chose number arbitrarily based on comments) on some oil fields there are up 50% reductions.

Following is a table that calculates the take of the government based based on their new contracts, dropping price, and dropping oil production.

Oil Price
Government Royality Government Take USD
(after production/decline)
Diff from 70 USD
77 25% 15.50
70 50% 24.75 160%
60 50% 20.25 130% 81%
50 50% 15.75 101% 63%
45 50% 13.50 87% 54%

The interesting part of these calculations is that while increased royalties bring in higher amounts of revenue with higher prices of oil, when the oil price drops so do the revenues. If you look at when oil is priced at 50USD the governments only get 63% of the revenues that they would have at 70USD. This is interesting because it means that if some of these leaders made big promises based on the high prices of oil or gas they will have a hard time keeping those promises.

Consider the following quote from the linked article.

High economic growth, fueled by very lax fiscal and monetary policy, has generated a surge in Venezuela’s inflation to solidly double-digit levels. Weakening oil prices threaten to upset the economic boat and deflate his political support, which has been buoyed by lavish spending. The government is set to release the 2007 budget in mid October but already most analysts predict spending for next year will likely rise or remain at current highly elevated levels.

Now you should be getting an idea of what is going on, at least what I think might be going on. The oil multi’s spent billions and billions of dollars on fields that were taken away from them. I am sure this is getting the goat of the oil companies and they are not happy.

Here is what I think the oil companies and investors are doing.

  • Playing a waiting game, where they drop the oil and gas price to levels that makes it very difficult for the governments to be fiscally responsible. Fiscal irresponsibility will result with lower prices, resulting in coup’s and losses at elections. Without being able to prove it I am guessing the oil people are waiting for the next "regime."
  • Playing the alternative fuel card. Alternative fuel will not be used to replace oil and gas, but provide a vent when things get to hot with the price of oil and gas. A sort of counter measure to keep everybody "honest" when creating or breaking contracts.

Cramer said alternate fuels were dead with the notable dead being ethanol. However, I am thinking otherwise. In the link referenced in the previously there is the following paragraph.

Tobias says $62 a barrel for crude oil is the point at which conventional diesel and biodiesel match up. When Imperium brings a new refinery on line in Grays Harbor County, the breakpoint will fall into the $50s, he says. The bigger impact of lower crude prices, he says, is likely to be on development of other, more expensive sources of crude.

It means that bio-diesel is profitable in the 50 USD dollar range, which interestingly enough is the price range that makes it difficult for many of the socialist leaders to keep their promises.

So here is my theory:

  • Oil is going to stay in a trading range of the 50’s with a low of 45, and high of 65.
  • If the oil or gas price gets too hot the alternative fuels are going to force the price down.
  • Alternative fuels will slowly creep into the mainstream

How would I invest based on this theory?
I would follow the alternative fuel makers and everything associated with alternative fuel. For example, earlier privately I mentioned to an investor friend the company Sued-Zucker and how they will become a player in the alternative fuel industry. The reason has to do with the falling of sugar subsidies in Europe. The dropped subsidies will result in an overflow of sugar beets. The sugar beets can be made into ethanol, and because Sued-Zucker has the infrastructure and capital ethanol is a no-brainer.

The pattern I would follow is one where you find a company that has a stock in the doldrums. This company should be fairly large and want to expand, and very importantly be able to put the alternative fuel card into their business model. New companies while interesting do not have the infrastructure to support producing, managing, carrying anything related to alternative fuels.