Upbeat and Downstairs: Home of Daryl C. Donatelli

U.S. stock markets have been off to a very rough start in 2008, with all of the major indices — the Dow, Nasdaq, S&P 500, and Russell 2000 — significantly below their record closing values in October, 2007.

As a distraction from logging in to my brokerage account and staring at red down arrows, I wanted to pass along a little piece written this afternoon by David Gaffen at The Wall Street Journal detailing just how far the markets could fall:

By now the Standard & Poor’s 500-stock index has achieved something that hadn’t happened since 2002 — it is sitting at levels below the previous year’s lowest closing level, which some technicians view as a bearish signal.

The S&P 500’s lowest close in 2007 was 1374.12; the index finished below that level yesterday, and today, barring a miraculous turnaround, it will leave stocks below the intraday low in 2007, which was 1363.98. Todd Salamone of Schaeffer’s Investment Research says the action in the S&P is “an indication of a change in the trend,” noting that it hasn’t happened since 2002.

The Dow isn’t quite there — 2007’s closing low was 12050.41, and the index was currently traded at 12318. But analysts at Asbury Research see other technical problems on the Dow, noting that the recent closes below 12518 suggest “a larger, more sustainable top is in place in the Dow at the October 2007 high.”

They’re putting a downside target on the Dow of about 11,025, which suggests this is “the beginning of a bear market, not just a correction within the 2002 cyclical uptrend.”

The Wall Street Journal reprinted a piece this morning from BreakingViews.com about why oil at $100 just can’t last. I found the article, “Why $100 Oil Can’t Float” compelling and thought-provoking. Here are the top ten reasons why justifications for the price, like supply and the dollar, crumble under economics:

1. Supply above ground is abundant. The amount of oil in storage tanks around the world is near all-time highs — 4.2 billion barrels at the end of June in the industrialized countries of the Organization for Economic Cooperation and Development alone, according to the U.S. Energy Information Administration. Falling inventories in the U.S. have received a lot of attention, and the EIA does predict slightly lower stocks by year-end. But this has more to do with inventory management than a lack of supply.
2. Supply below ground is abundant. The world’s proven reserves are now at 1.4 trillion barrels, up 12% in the past 10 years, according to BP. That’s not even counting the estimated 1.7 trillion barrels of oil locked in Venezuela’s Orinoco tar sands. Combined, that comes to a century of production at the current rate.
3. Production is set to increase. Sustained high oil prices have encouraged drilling. There are 45% more oil rigs in service today than there were three years ago. New rigs are more productive than old ones and new technology is helping to squeeze more oil out of old fields.
4. The cost of production is much less than $100 a barrel. Even with oil-services costs soaring, Royal Dutch Shell’s lifting cost per barrel of oil equivalent in 2006 was about $9, according to energy research firm John S. Herold. Extracting oil costs Saudi Aramco, the Saudi Arabian producer, an estimated $4 to $5 a barrel. The full cost of new production — including both capital and operating-cost components — in the most challenging oil fields, for example in Canada’s oil sands, is perhaps $30 a barrel. Oil prices can fall heavily without making any of this production uneconomic.
5. Iranian exports aren’t likely to be cut. The U.S. is in practice unlikely to take military action against an adversary three times the size of Iraq. And with oil exports accounting for 50% of Iran’s gross domestic product and 90% of its hard-currency earnings, a self-imposed cut in exports would be self-destructive. In any event, the world has the equivalent of nearly three years of Iranian production in storage, according to research from Oppenheimer. This risk shouldn’t be a big factor in oil prices.
6. High prices are pulling back demand. Oil consumption in the U.S. fell by 1.3% in 2006 and world-wide demand grew a measly 0.6%, according to BP. World-wide, demand this year is expected to be flat compared with last year. Exxon Mobil cut its long-term forecast for oil-consumption growth this week.
7. High prices are forcing governments to cut subsidies. Iran is rationing gasoline, and last week China ordered a 10% increase in oil-product prices. That should curb demand growth, too.
8. Energy from oil is looking expensive compared with energy from gas. Oil by the barrel has usually traded at six to 10 times the price of natural gas (measured per million British thermal units). It is currently at 13 times.
9. The weak dollar is a poor excuse for high oil prices. Since Aug. 22, the dollar is down by only 8% against a basket of currencies while the oil price has risen by 40%.
10. Speculation is artificially boosting prices. A speculator needs to put down only $4 per barrel as margin to bet on the oil price in futures markets. The net volume of open crude-oil contracts held by financial players is up 50% since August, when the credit crunch made it harder to make leveraged bets in some other markets. This looks like short-term, hot money.