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Tuesday, December 30, 2008

Light Crude Oil Breakeven prices: Personal Observations and thoughts

From my own personal observations, most of the fundamental arguments as to why "crude oil can never fall below $x" is based on the reasoning that in the long term, the price of crude oil should not fall below the long term production costs.

However, the long term production costs seems to be a complex and ever-changing figure for several reasons. My own observation has shown that the number varies depending on who publishes it, when they were published, in addition to varying by country, types of oil extraction methods, by company, etc. Intrinsically, it is probably a "living figure", meaning it changes over time, and is expected to continue to change over time.

Unfortunately, without a perfect filing system, it appears I have missed past figures. So, this article is an attempt to link to these figures, based on a limited search recently.

1. IMF Oct 2008 Report (World Economic and Financial Surveys - Regional Economic Outlook - Middle East and Central Asia, 60 pages - http://www.imf.org/external/pubs/ft/reo/2008/MCD/eng/mreo1008.pdf):

MCD stands for Middle East and Central Asia with an average of $58.

GCC stands for Gulf Cooperation Council, and has a lower average of $47.

Both figures are based on IMF staff estimates and projections, based on 2008 Fiscal Accounts for the countries concerned. As crude oil price fell below $40 at the time of writing, my expectation is that some of the more prudent countries are probably preparing to rewrite their Fiscal Budgets if crude oil price don't rise soon ...

2. Seeking Alpha 25 Dec 2007 article - http://seekingalpha.com/article/58322-oil-price-predictions-and-break-even-prices

Note the GCC average in July 2006 is $38, which is lower than IMF Oct 2008 figure of $47.

If one wants to be prudent, then, one should lean towards the $38 figure since it is common for analysts to jack up the figure when crude oil prices are high, and they were definitely high when IMF produced the report prior to Oct 2008. Whilst there may be valid reasons as to why the cost of extracting crude oil has risen since July 2006 (or approximately 2 years ago) - e.g. inflation - there are also valid reasons as to why the same cost will come down due to deflation. You should have your own figure.

Note also that Canadian Oil Stands cost is also not very high - only $33. It is true that these costs have since then increased to around $50, but it would not be surprising if going forward, they will attempt to lower the production costs down due to deflation. Again, you should have your own figure.

3. 21 Oct 2008 Wall Street Journal article - http://blogs.wsj.com/environmentalcapital/2008/10/21/

Venezuela 2008 Budget based on $35.
Nigeria 2009 Budget based on $39 (down from $62).
Iran next 2 budgets based on $55 to $60 (down from very high figure prior)
Angola plans for $65.
Russia $70 (previously need $95 to break even)
Iraq plans for $80 (but IMF previously said it needs $111 to break even)
Iraq Plan B for $60.

It is obvious these are not static numbers, but fluid and will keep changing depending on how the world changes. Some may have been forced by circumstances (e.g. must tighten belts during tough times), others may be due to choice (e.g. artifically over-inflate during good times, etc). What I take out from this is that the so called "break-even" price is NOT a static figure, but a dynamically changing figure, and it is very important to understand the timing and underlying motive of such announcements.

4. Merill Lynch projects crude oil price to drop to $25. This is widely reported in Bloomberg and else where (e.g. http://www.thewashingtonnote.com/archives/2008/12/the_oil_floor/).

Bottom Line

If you are a true fundamental investor who believes that you can never time the market successfully, then, I still stand by my previous thoughts that any price below $40 is a decent entry price for the long term (> 12-36 months).

But must be extremely careful and beware of the effects of contango on futures rollovers and possible similar impact on passive index funds.

Personally, I lean towards shorter term market timing.

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