Why the President's Push for Lower Oil Prices is Nothing But a Pipe Dream

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Every president has a defining moment when the American people, and indeed the world, recognize that he's badly out of touch with some aspect of reality.

I can't help but think that President George W. Bush ["Dubya"] has just had his moment as I watch him muddle around an unsympathetic Middle East this week, pushing for lower oil prices.

The market just isn't going to let this happen.

Turning on the petroleum spigots as he's requesting isn't going to solve the problem. Indeed, we don't even believe that a solution exists.

Here's why.

The oil markets right now face a situation known as "backwardization." This theory holds the future prices of a commodity will tend to rise over the life of the contract. The upshot: Near-term contracts trade at a higher price than the longer-term contracts. With oil, that means that near-month delivery contracts are priced more expensively than distant-month contracts. When this happens, market sellers have every incentive to sell as much as they can as soon as they can to maximize profits, since they know that future prices will be lower.

What this suggests is that no matter how much pushing, prodding or - in this case - begging Bush does, the markets are still likely to push prices higher in search of profits. The Saudis will want to sell all the oil they can at the current high price, and will do nothing to risk sending prices lower.

That means: No production increase.

Let's walk through an example to illustrate how this works.

The February 2008 oil contract closed Tuesday at $91.65 per barrel, while the December 2008 contract settled $2.90 a barrel lower, at $88.75. Accordingly, the markets are telling oil sellers that it's better to sell oil now than it is to sell it later.

At the same time, however, the market also is telegraphing to buyers that they can risk purchasing later at lower prices. But - and here's the important part - the discounted price could push far higher as the delivery month draws closer.

When the markets exist in this state, it is in the seller's interest to sell as much oil as they can as soon as they can, which makes what Bush is asking all the more absurd.

In 2006, Saudi Arabia produced 10.72 million barrels of oil per day. For purposes of illustration, let's assume they sell it for February delivery. At $91.65 a barrel, that sale would result in a staggering $982.5 million in revenue. If they waited and sold it at the December 2008 contract price of $88.75, they'd receive $31.1 million less per day, or $951.4 million for their efforts.

You can do the math as easily as we can. Over the course of a year, that would net out to an "opportunity loss" of $31.1 million a day, or a net revenue shortfall of $11.3 trillion per year if the Saudis elected to sell later.

This means that by asking the Saudis to increase production in an effort to lower oil prices, President Bush is effectively suggesting that they shoot themselves in the proverbial foot to the tune of trillions of dollars in lost revenue - which is why we think there's a not a snowball's chance in Hades that anything other than a short-term reprieve might be possible.

But, just to play devil's advocate for a minute, let's assume that the Saudis decided to play ball.

Could they?

We don't think so.

The massive Golar oil field, along with many of their fields, is in decline, and anecdotal evidence suggests that the Saudis have already reached their peak. Not only are they pumping massive amounts of salt water into their oil fields to sustain production, they're also drilling enough wells in the region to make it look like a giant piece of Swiss cheese from the air. Add in the fact that the Saudis haven't had a major new discovery in half a century, and we have all the ingredients for still-higher-higher prices - and that's assuming they actually have what they say they do in the way of reserves.

However, there's an increasing body of evidence suggesting that the Saudis have falsified their reserve counts since the 1970s, a scenario that author Matthew R. Simmons outlined in his book, "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy."

We've been talking for years about how this reality would ignite upward pricing pressure in the petroleum markets, but the possibility that the Saudis might not have been telling the truth and may actually be unable to meet global demand is something that the masses have only recently started to consider.

And trust us, when they do, the fear that there may not be as much oil as previously thought will send it up to the high-$100 price point I've been predicting faster than you can blink. And the price may go even higher than that.

Then there's the Organization of the Petroleum Exporting Countries (OPEC). The Saudis risk upsetting the apple cart if they move in a direction contrary to other decidedly anti-U.S. OPEC members who want prices as high as possible for as long as possible. Many people think of OPEC as one big happy family. But the truth is that it's often no better than a den of thieves who would just as soon cut one another's throat as cheat on production quotas in search of still more profits.

So the bottom line is that Bush can saber-dance his way through the Middle East all he wants, but his machinations are likely to be viewed within the context of history as too little, too late. Perhaps he could have done something about this the last time he met with Saudi's King Abdullah, and oil was still at $50 a barrel.

But now that oil is north of $90... forget it.

The Saudis, like other OPEC nations, have gotten used to higher oil prices and the global wealth that goes with it. They've also finally figured out that oil can be as much a political weapon as it is an economic one. For them, controlling the petroleum flow is better than having an army to field when it comes to assuming a more-important place on the world stage.

That makes it even less likely that they'll lower oil prices out of the goodness of their hearts.

And that spells higher oil prices for years to come... even if by some stroke of luck we actually do find that snowball in Hades, and get a temporary respite.

News and Related Story Links:

About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

Read full bio