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Oil above $100 again - what's up?

by Jerome a Paris Fri Feb 25th, 2011 at 06:55:50 AM EST

While the most recent spike in oil prices (with WTI, the US benchmark, jumping above $100 and Brent, the more representative London price, touching $119) is directly linked to the unrest in North Africa, production interruptions in Libya and worries about more disruption in other Arab oil producers as political and social unrest spreads, it has always been deeply worrisome that in the middle of a deep economic crisis, oil prices remained so high. Other than a brief dip back to $40 at the height of the financial crisis in late 2008/early 2009, oil has never gone down below $75, which was an unheard-of price before 2008.

Some have blamed speculation (which had nowhere else to go in the face of QE monetary policies and zero-interest rates), some have kept on flagging peak oil; some, more bullish, simply noted the booming demand in emerging markets. In any case, for most of the past year, $70-80 was seen as the "new normal" and as a price level which would not handicap our slowly recovering economies - it's only been in recent days that fear of a new oil-induced recession has come back to the fore (as suggested by the above graph, attached to an explicitly titled WJS article: Rising Oil Prices Threaten Recovery)

But it seems that a fundamental change is underway in the oil industry: while it's not yet obvious that we're running our of oil, it's now certain that we're running out of cheap oil. Oil companies are busy developing ultra-deep offshore fields in the Gulf of Mexico, off Angola or Brazil; tar sands in Canada, ultra heavy oil in Venezuela and are thinking about Artic oil, shale oil and ever more expensive options. Even Saudi Arabia they are drilling deeper and deeper for oil these days.

And a recent Barclays study (sorry, no link, it can probably be requested from Barclays here) suggests that the cost of producing oil has skyrocketed in the past few years, at least for non-OPEC resources (but remember, OPEC represents only just over one third of global oil production), as shown in this graph. If the cost of a large fraction of the oil produced is now near $80, it seems highly unlikely that prices will ever go back below that level.

And if oil at $120 causes recessions, it looks like we're stuck in a rather nasty bind...

Internal rate of return - Wikipedia, the free encyclopedia

In more specific terms, the IRR of an investment is the interest rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.

Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital.

Your Figure 26 is fascinating. Let me see if I read it right: to produce one barrel of oil outside the OPEC and still get a 12% IRR on it, you currently need to invest about 80 dollars. Correct?

Noob question: At what IRR becomes a financial undertaking no longer interesting? Is that at zero percent, or something in between twelve and zero?

by Nomad (Bjinse) on Fri Feb 25th, 2011 at 07:37:00 AM EST
A project has a zero rate of return for an enterprise when the IRR is equal to the projected cost of funds over the term of the project.  Thus if the IRR for a project is 8%, but the enterprise can only borrow at 8%, then there is no point in proceeding from a return on investment point of view.

In practice, companies also factor in risk factors when evaluating projects - e.g. project cost over-run, project benefits under-delivery, or interest rate rises over the lifetime of the project and often set a minimum IRR rate (often 10%) or payback period as a matter of policy.

Projects are also generally evaluated within the context of an overall capital budget which is considered financially or strategically desirable for a company.  I.e. How leveraged does a company want to be?  Are there other projects with a better estimated IRR?  How strategic is the proposed investment?  How related is it to a company's core business?

I have seen some absolutely crap projects approved because they were sold as a good strategic fit by an influential director whilst many potentially good projects are passed up because the project sponsor hasn't managed to "clear his lines" with key players in the approval process.

In my experience project appraisal processes are often quite rigorous (except in marketing) whilst post completion reviews are often "swept under the carpet" where objectives were not met.

PS - you added "frontpaged by" to my Irish Election post - but it doesn't appear on the front page.  Do you want me to use that diary to live blog results as they come in tomorrow, or do you want to set up a separate open thread?

Index of Frank's Diaries

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 08:03:03 AM EST
[ Parent ]
Jerome's story got there first - so I put your diary back in the diaries for now, but yours will go back to the frontpage this afternoon.
by Nomad (Bjinse) on Fri Feb 25th, 2011 at 08:15:19 AM EST
[ Parent ]
Thanks - I thought it might have been some scoop blip.  Every now and then the number of comments to a story is doubled and then it mysteriously goes back to the correct number.

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 11:21:16 AM EST
[ Parent ]
Frank is right.

The short answer is that you need to compare the IRR to the average Cost of capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
It is an average of the yield of the company's bonds and the implied return on its equity shares which should be higher than that of bonds but is harder to estimate (the yields on bonds is just a market quotation).

Keynesianism is intellectually hard, as evidenced by the inability of many trained economists to get it - Paul Krugman
by Carrie (migeru at eurotrib dot com) on Fri Feb 25th, 2011 at 08:19:28 AM EST
[ Parent ]
In my experience (outside the financial services sector, but within a large publicly quoted global enterprise) the benchmark was a standardised cost of funds derived from the cost of bank borrowings as investor funds were rarely sought for individual projects.  The latter really only applied when evaluating the cost benefit of a significant business acquisition or merger which might require raising funds directly from new investors or existing shareholders..

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 08:37:14 AM EST
[ Parent ]
Easy answer, as quoted to me by my first employer, when I asked for money to buy a new oscilloscope: "I have $4000 in my wallet. I can put that $4000 into the bank or I can give it to you. Show me why I should give it to you."
by asdf on Fri Feb 25th, 2011 at 09:37:53 AM EST
[ Parent ]
Most companies are financed partially by bank borrowings.  So the slightly more accurate formulation is:  I'm going to have to borrow more to fund your project.  Can you guarantee me your project will enable me to pay the bank back the capital and interest and also leave me with a tidy profit to justify the risks any project entails?

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Fri Feb 25th, 2011 at 04:34:07 PM EST
[ Parent ]
A Jerome a Paris post with Oil and $100 in the title?

Just like old times! ;)

by afew (afew(a in a circle)eurotrib_dot_com) on Fri Feb 25th, 2011 at 08:15:43 AM EST
Quick, start a contest!

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman
by dvx (dvx.clt št gmail dotcom) on Fri Feb 25th, 2011 at 08:41:01 AM EST
[ Parent ]
enjoyed by some of us (i.e. certain people in certain countries) in the past few decades was predicated, in very large part, on cheap energy.

In particular, oil was outrageously cheap; cheap to extract, and competition in the form of excess supply kept prices so low that it undercut sustainable forms of energy, and undercut efforts to diminish waste.

And that added (unsustainably) huge amounts of wealth into the world economy.

As the price of oil goes up, more expensive oil finds its way onto the market. Those who are producing this oil are only making an "honest" profit. Those who ares still producing cheap oil from legacy fields are making out like proverbial bandits. You thought those sheiks were already rich?

Meanwhile, we (those of us who became used to the relative wealth derived in large part from nearly free energy) have a nasty adjustment to make.

Who Could Have Predicted?

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Fri Feb 25th, 2011 at 10:00:32 AM EST
The problem is that those that have accumulated wealth will hold on to it as the global pie shrinks, causing the pie to shrink even more. The accumulated wealth needs to be defaulted or inflated away for the benefit of the 99% of the rest of us. ( * )

But, if it can be defaulted or inflated away, it was just paper wealth in the first place - claims on inexistent future energy resources at inflated prices.

( * ) I just checked the Global Rich List and I found that I'm actually in the top 1% of the world. So I'm the bad guy I am ranting about.

All youI have to do is make a choice.

$8 could buy youme 15 organic apples OR 25 fruit trees for farmers in Honduras to grow and sell fruit at their local market.

$30 could buy youme an ER DVD Boxset OR a First Aid kit for a village in Haiti.

$73 could buy youme a new mobile phone OR a new mobile health clinic to care for AIDS orphans in Uganda.

$2400 could buy youme a second generation High Definition TV OR schooling for an entire generation of school children in an Angolan village.

Keynesianism is intellectually hard, as evidenced by the inability of many trained economists to get it - Paul Krugman
by Carrie (migeru at eurotrib dot com) on Sat Feb 26th, 2011 at 02:11:03 AM EST
[ Parent ]
I get the general idea -that we are much richer than we think if we look at things at the world level. But I don't believe their distribution.

I entered the UK median salary. And it said that I was the 58 millionth richest person in the world. That would be very, very odd. The UK has 62 million inhabitants. Even counting only half as having a salary (an obvious underestimate), that's already 16 million richer people in the UK alone. Probably around 80 million in the US. We still have quite a few countries to go and we are way already way over 58 million.

Then, of course, it does not seem to take the difference in purchasing power into account at all.

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Sat Feb 26th, 2011 at 03:11:28 AM EST
[ Parent ]
Anyway, it's false, because it says "wealth" instead of "income"...

My parents own a house, the're richer than me.

But their salary is lower (pensions...) so they're poorer?

That's just an example to show it's dumb, even if the truth is that I'm probably richer than I would feel compared to third world nations. After two year's working on african projects, I had gathered that news alone, thanks.

by Xavier in Paris on Sat Feb 26th, 2011 at 08:15:46 AM EST
[ Parent ]
But unless these goods are in competition for scarce resources, there is no reason that we cannot have all of it.

They do not strike me as being in direct competition for raw materials, so basically they're in competition for qualified labour. Which is currently sufficiently abundant as to be a problem.

So the actual choice is whether to provide all of these things (with the possible exception of the TV, which might be in competition for energy resources), or providing only a subset of them. The latter is of course only desirable if your objective is to keep third-world countries miserable, suppress labour bargaining power through unemployment, or both.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Feb 26th, 2011 at 09:28:48 AM EST
[ Parent ]
How much oil is actually traded and makes up this WTI or brent index and how much is traded bilaterally. I.e. how relevant are these two benchmarks really? Chris cook, please explain!

Having said that, I believe the price can only go up if you look how many cars india china etc are buying, many of which are now cars entering the market and not like in the us replacing old ones... Just a thought...

by crankykarsten (cranky (where?) gmx dot organisation) on Mon Feb 28th, 2011 at 04:20:39 PM EST
Lots of over the counter energy trades are priced to Brent or WTI. That's what Chris used to holler about a couple of years back - oilcos and banksters could take smallish (well, relatively speaking anyway) losses "on exchange" and then cash in from the much higher volume of over the counter contracts linked to the exchange.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Feb 28th, 2011 at 05:41:56 PM EST
[ Parent ]

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