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Lapse of Judgement

by Frank A Lechner
whynotgold@msn.com

December 1st, 2005

For too long now, I have been subjected to this constant whining about oil prices, gas prices, and of course the coming heating oil prices. The media took the recent numbers from Exxon and completely twisted this to a criminal investigation. The con-gress too jumped in the act, calling the large players up to answer questions about the rise in prices.

Even the quotes from a certain radio/TV personality were completely off base. Although he took it to a higher level, through his accusations without merit, concerning the oil companies. Wouldn’t you really like to see his net profit margin for his organization prior to making up your own mind, whether or not what he states is accurate?

I did pull up multiple companies, using their quarterly reports, and compare the net profits to the oil companies. It was plain for all to see that the net margin achieved by Exxon was much less than many industries, and definitely not out of proportion.

What really has people in a tizzy, I guess, would be the volume of the profits, ending in billions, instead of millions. But again, if you research this a little, and it really doesn’t take very long, you will find that Exxon is one of the largest companies in the world. Consequently, the equivalent net margin of 9% for a multi-billion dollar company adds up to billions, while the same 9% for a $500,000 business is only $45,000. The magnitude of the reported profits is directly attributable to the size of the company. ‘Nough said on that.

Let’s be realistic and look at what is causing the rising oil and gas prices. The lower prices or bear market in oils is not that far removed in our past. With the exceptional costs associated with exploring, drilling, and moving the oil to market, during the bear market, many projects were put on hold for lack of resources. The rise in prices, as is typical has increased the activity in this area to a more frenzied pace, yet we must realize that it still must be brought to market. For instance, we may have the actual crude oil supplies, yet I cannot drive my car using crude, it must be refined.

If you go through Barron’s over the past number of years, you will notice in their charts on rotary rigs running, or supplies on hand, and other available data, that the supplies on hand have been decreasing while the equipment churning out the oil has increased. In addition, the refining capacity has been running at break neck speed and I would argue over capacity for quite some time. The published numbers have run the ranges of 80-95% in the refining capacity area.

This bull market was created by demand; increasing as world oil is becoming more in demand by other countries, as their markets continue to expand. The world economy really isn’t that awful, as others would have you believe, consequently, demand has been increasing at an almost breakneck pace.

Simultaneously, there has been little expansion in the real bottleneck in the industry, which is refining capacity. There has been no serious move in conservation of resources. While most recently, you see some persons switching to more economical vehicles, or coop driving to work, it is not as you would expect with the increase in gas prices to these levels. The reality is that the consumer has absorbed these increases without major hiccups in the system. The consumer will become more under pressure as their newly revised heating and electric bills come pouring in.

With government regulations, and the NIMBY syndrome (not in my backyard), refining capacity does not look like it is going to increase significantly anytime soon. So we have general demand increasing, and no real increase in supply. Don’t expect much lower oil or gas prices until this situation is resolved. Either demand must decrease, or supply must increase, easy as that. Econ 101.

Backing up a bit, you may say that your effective use of oil products has not increased dramatically over the most recent past, so how can this be? Look at it as Chinese water torture, over time, incremental increases in demand begin to add up.

For instance, you eat out more often than you used to, creating demand for more restaurants. You have to develop the site, build the restaurant, equip the restaurant, load it with workers, and products to sell, turn on some lights, turn on the ovens, cash registers, coolers, freezers, etc, etc. Each person that adds to restaurant demand, is effectively adding to oil consumption. Now multiply this to just about any industry that you can think of.

In addition, the average house constructed in the US is much larger than it was in the past. This results in more lights, more plywoods, more sidings, windows, doors, and so on. It takes oil to bring these products to market. Instead of the old standby of a one bath home of about 1000 sq ft, we now have 2 and 3 bath homes as standard, with multiple garages. A two car garage is standard now, and many homes have 3 stalls on up. All of this contributes.

We haven’t even discussed the kids having TV’s in their rooms, playstations, Xboxes, cell phones, and all of the other non-essential items adding to increasing demand. I won’t bore you any further, as long as we can agree that electrical demand is also part of this issue through the use of more oil, coal, and natural gas to produce this electricity.

So where are we? I believe we can agree that our consumption is of our choice, and that the resultant oil and gas price increases are mostly due to our making these lifestyle choices.

In order for oil and gas prices to come down in the future, there are some things that must be accomplished. One is for demand to stabilize or drop with conservation, changes in lifestyles, or conversions to alternatives. Buying a hybrid vehicle is a conversion to an alternative. In addition, the supply must come up to meet demand.

This means that we must allow refineries to be built in the very near future, remembering too that any decisions made now, will actually take years to see the benefits of these decisions. The longer the politicians choose to play house with this issue, the farther into the future the solutions are pushed.

We are going to have to allow further exploration, for instance in Alaska, off the coasts of California, Florida, and so on. Now, if we choose to make the decision to not allow this exploration and development, as we may consider this prudent for national security reasons, that is a choice that must be made in the open, and then we will continue to purchase our excess oil requirements from off shore. It is not a stretch to say that we know this oil and natural gas is there, and that we choose to leave it there, until such time as it is economically necessary to bring these products to our local markets, due to ever changing world supply considerations. I could even agree with this, providing it is in the open that this is what the intentions are. A strategic petroleum reserve without the hassle of purchasing, transporting, and pumping it back into the ground for long term storage. We could leave it there, knowing full well that it is accessible at some future date.

We also must consider seriously a change of lifestyle. It may mean that more fuel efficient vehicles must be used, car pooling to work, or using mass transit facilities. Simultaneously, recommendations can be made that will improve efficiencies of the homes constructed. The technology is already available and being used in other parts of the world where oil and gas isn’t so affordable, where governmental taxes on usage are much greater than here in the US. There are any number of things that we can do on an incremental basis that can have positive effects on the demand for oil.

There are choices that must be made, and these must happen, even if on an incremental basis. We do not have exclusive right to oil produced in Russia, or Saudi Arabia, we have to pay whatever value for that oil in competition with other countries.

And please don’t write me telling me how we have no choice in oil consumption while we have a choice to purchase an Xbox or not. This is patently false. We have made choices on what we drive, what we wear, where we live and so on. All of these affect oil prices.

There is more to this story than some simplistic minded tv personality would have you believe.

Frank A Lechner

whynotgold@msn.com

Frank A Lechner is a private investor, You make your choices and you live with them. He does in fact believe that we are indeed in a time of turmoil, a time of increasing prices, much as wrote about before, and that this period will resemble the 70's. Those that fail to learn from history are destined to repeat, or so I hear. Good investing to you.