Where Should We Invade to Bring Down Oil Prices?

By Martin Hutchinson
Contributing Editor

According to Venezuelan president Hugo Chavez, whose economic acuity is legendary in quality, if the United States invades Iran we can expect crude oil to soar to $200 a barrel. Clearly this would be undesirable.

However, it raises an obvious question: There must be a country we can invade that will result in oil prices at a much-more palatable $50 a barrel.

Chavez's number appears to be plucked out of the air. If the United States attacked Iran, it would almost certainly be a messy campaign, with no quick outcome and the likelihood that Iran's oil production would be disrupted - with an obvious upward impact on crude prices. However being Shiite, Iran has no oil-producing allies - other than Venezuela.

The Case For $200 Oil

The cost in lost production - even from a total Iran/Venezuela shutdown - would be no more than 10% of gross world production. In the short term, the United States could use its Strategic Petroleum Reserve to plug the gap, but even if 10% of world production were lost for a considerable time, it would be most unlikely to send prices to $200.

As prices rose towards $200, the basic economic principle of supply and demand would cause oil consumption to decline in the face of rising crude prices. There is no evidence whatsoever that the marginal propensity to consume oil is as low as 0.1, which would be needed for a 10% reduction in output to produce a 100% increase in prices from already-elevated levels. Much more likely, a squeeze in output would spawn a price increase of no more than 20% - to a peak of $120 a barrel - with any higher prices being only a short-term blip due to speculative pressures.

At that elevated price, oil consumption would decline sufficiently as consumers and commercial interests alike adjusted to the much-higher costs of energy, transportation and raw-materials costs. The U.S. and global economies would undoubtedly slow markedly - and would most probably even drop into a recession. But that recession, in itself, would reduce oil consumption and would therefore arrest any additional upward movement in oil prices.

A Look to the Past

Analyzing Chavez's threat demonstrates an important fact, however: At $90 per barrel, crude oil is already up more than 50% so far this year. While the current price may be below the inflation-adjusted equivalent of the $40 "peak" reached in 1980, it's important to note that oil prices remained at that pinnacle for a very short time, retreating to the $28 to $32 range where prices stayed until further supplies came on stream in late 1985. Prices then collapsed to $10 a barrel.

Thus, the current $90 plus oil price is likely to be fairly short-lived, even if the frenzied mania of speculation pushes the price up and over the $100 level before the market turns. The global economy is already starting to slow and new International Monetary Fund (IMF) data demonstrates that world growth in the last few years has not been over 5% - which would have been a record - but has actually only been running at around 3.8% -- somewhat less than the boom times of the middle 1980s.

Don't get me wrong: That's still very good growth, but it isn't the frenetic expansion that suggests that oil and other commodities must continue to trade at or near their stratospheric levels.

If oil prices have, indeed, reached their peak, and may soon be headed downward, we should be investing in oil companies that do not have huge reserves, but are active in refining, distribution and petrochemicals. Their customers will have got used to the high prices caused by the recent spike in oil, and so as prices begin to decline they should begin to see their margins widen, as the squeeze that rising oil prices has put on them lessens.

How to Profit From the Reversal

In Europe, Spain's Repsol YPF SA (REP) is positioned nicely in this sector, and furthermore boasts a high share of its domestic market.  It also owns YPF [Argentina], which has brought it headaches and political risk, preventing it from getting the stock price boost it might have obtained. However the new Argentine government of Cristina Fernandez seems likely to be a modest improvement on that of her husband, Nestor Kirchner, president since 2003. In any case, at a Price/Earnings ratio of 10.5, Repsol is trading at a multiple that's 40% below the global oil industry average - making REP cheap.

Another possibility might be a chemicals company, since oil is the principal feedstock for the industry. Here Brazil's Braskem SA (BAK) looks attractive; its supplies of oil feedstock were given a boost last week when Petroleo Brasileiro SA, better-known as Petrobras (PBR), discovered a gigantic new oil field with the potential of 5 billion to 8 billion barrels in reserves [At $100 per barrel, that's $500-800 billion worth of crude oil reserves - enough to make an investor drool with anticipation. That's probably why Petrobras' share price, up 60% in three months, may be a bit ahead of itself right now].

Finally, lower oil prices are good for resource-poor economies like Japan, so the streetTracks Japan small company fund (JSC) is worth looking at for that reason alone [as well as several others we could cite].

Let's suppose for a moment that the Pentagon got serious, and decided the United States really needed to get oil - not to $200 - but back down to $50. Could it do it?

In a word - yes.

The United States could just invade Venezuela itself, which, under Chavez's economically counterproductive and politically bombastic rule, must several times have made some of the trigger fingers among the Pentagon's most-hawkish set tremble with anger - or anticipation.

In the Orinoco tar sands, Venezuela has more oil than the entire Middle East. Its population has an easily comprehensible language (Spanish), religion (mostly Catholic), and a Western desire to achieve the high standard of living it ought to have, given the country's oil resources. U.S. companies could ramp up production at Orinoco to levels that would drive oil prices down, and bring wealth to the Venezuelan people. The new production, and the knowledge the massive Orinoco reserves were no longer controlled by a madman, would cause a sharp drop in world oil prices.

It's just an idle daydream - some "woolgathering" - to be sure. But Chavez would be wise to be careful what he wishes for…

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