Schork: Oil Prices Inflated but Could Keep Rising; Peak Oil is Political Phenomenon

Posted by Steven Zweig on November 16, 2009 at 10:53 am

Stephen Schork. (image: media.cnbc.com)

Veteran commodities trader and analyst Stephen Schork was recently interviewed about the oil markets, as reported Thursday by the investing website SeekingAlpha.com. In it, Schork expressed several opinions that seem unconventional, even heretical, at first; however, in reality, they are more explorations of conventional wisdom than departures from it.

Take one of his simplest, most made-for-controversy remarks: when asked about peak oil, Schork replied, “I don’t believe in it at all.” Not believe in peak oil? Does Schork believe that oil is infinite? And that we will always be able to find what we need, easily and cheaply?

No. Schork believes “there’s a political peak. I believe there may not be the will to extract.” And that’s exactly what peak oil is—it’s not when oil runs out, it’s when enough of the most readily extracted oil has been taken out of the ground that the cost to produce oil climbs sharply. Schork is pointing out that in this way, peak oil is more like having an adjustable rate mortgage when the initial rate lock period expires and rates go up, than it is like getting an eviction notice or having your home burn down. It’s something that can be managed, though it may require re-budgeting or other economic adjustments.

Fortunately, as Schork points out, there’s a built-in self-correcting feature to any sort of an oil price peak. When the price per barrel soars, energy companies find it worth their while to explore more: “if you drive prices up to $100 oil, sure enough, you do find that oil in the Tupi field and so on. Surprise, surprise. All of a sudden, you start finding oil again.” So instead of being a static peak, like a mountain top, it’s more of dynamic feedback system, like a thermostat (to thoroughly mix metaphors): when prices go up, you look for and find more oil, increasing the supply. When prices go down, you don’t look so hard or drill so deep, and supply starts contracting.

That’s why Schork opines that OPEC would prefer prices in the $50’s per barrel. At $55 per barrel, OPEC makes a nice living and controls around 40% of oil production. But raise prices to $100, $120 per barrel, and people are going to start looking (and presumably finding) oil in more places, and OPEC loses market share, power, and influence.

Before leaving the topic of peak oil, Schork also points out that only one 15 billionth of Earth’s volume has been explored. While that figure needs a great many caveats—to the best of our knowledge, oil can only be found in the crust, not the mantle or core (which together make up most of Earth’s mass), for example—Schork’s point is that we’ve hardly explored enough of the Earth to declare that we know where all the oil is, or how much exists.

In terms of oil price and whether it’s too high, Schork eschews the more typical responses of saying either that it is too high or defending the current price. Instead, he points out that there is no absolute or intrinsic value to oil, any more than there is an absolute or intrinsic value to a Monet—the value is simply what people are willing to pay for it. So in a real sense, if people are willing to pay $75 - $80 per barrel, that’s what it should be priced at.

That said, Schork does note that based on average cost of producing oil, if you assume a three times mark-up from production cost, you’d probably be talking about $55 - $60 per barrel. (In retail, the typical mark-up from manufacturer’s price is four times.) He also notes that demand, if you define demand as consumption, is still soft and is not the reason for today’s high prices. Instead, Schork sees pricing as driven by “[t]he idea of a billion Chinese trading their Schwinns for Cadillac Escalades—I think that is what is driving the market.”

He notes that actual Chinese—and, for that matter, Indian—consumption has not been that high; those two countries have been building up their inventories, stockpiling oil and distillates, such as heating oil and diesel. The lack of what he calls “real demand”—i.e. consumption—means that the impact of China is limited to the psychological impact of “the idea of China.”

In short, though he puts it a different way, Schork is not disputing that oil prices are higher than consumption would indicate, or that people are speculating—betting—on future consumption and prices, in the process influencing those prices.

A point where Schork fully supports conventional wisdom: the impact of the value of the dollar on the price of oil. Since “OPEC prices in dollars … if you want cheap oil prices, you want a strong dollar—but I don’t know how the government can do this, given the deficits we’re running…if you get a strong dollar, you’ll see oil at $50 - $60/barrel.” An implication of this is that the best energy policy the government could follow, at least from the point of view of making oil more affordable, has nothing to do with carbon or drilling. Instead, it would be to reduce the deficit so as to strengthen the dollar. Conversely, government programs that run up the deficit tax every American by raising the price of oil.

Schork on regulation: he takes a middle ground, between those calling for strong regulation of commodities trading, in order to reduce speculation, and those who want a completely unregulated commodities market. Schork supports regulations that increase transparency, which will let market participants better gauge risk and reward. In theory, this would lead to pricing that is better aligned with those factors.

Schork is concerned about some of the proposed substantive regulations, such as forcing commodities trades to clear through a regulated exchange. He believes that this sort of more heavy-handed interference with market functions could end up distorting prices and potentially putting market participants—especially non-financial participants, such as oil distributors and heating oil retailers—on the wrong side of price or supply movements.

However, the example he uses to illustrate this last point leaves does not seem to actually clarify his concern. He says, “[a] lot of heating oil distributors in the Atlantic/New England area (the largest heating oil market in the U.S.) base their product off of regional racks that don’t trade every single day. So how do you have a regulated futures contract when you can’t have price discovery every single day?”

Where the lack of clarity comes in is two-fold:

• First, it appears that many racks do clear daily, if not several times a day.

• Second, he doesn’t explain exactly how the lack of daily price discovery (trading, since that is how price is “discovered” in the market) prevents effective regulation.

That last point aside, while seeming to deny peak oil or the concerns of many that oil is overpriced at present, Schork primarily points out that in a properly functioning market, just as supply influences price, price influences supply; and that price is nothing more than what people are willing to pay, based on both objective criteria (e.g. consumption) and subjective expectations or valuations (e.g. the belief that oil demand will spike in the future). In this, he’s reinforcing that oil markets are in many ways simpler and less mysterious than commonly made out, and that they also function more “messily” than pundits might describe. That messiness comes about because the functional components of markets are people. Even if markets ought to be rational in theory, how can they be when the human beings who comprise them are not?