One of the mysteries in the modern day world is the price of crude oil. Nobody really knows why the price of oil varies on a daily basis and why prices continue to go up. So it is not surprising that even the U.S. government’s Energy Information Administration states the following on its website: “The world oil market is complicated”. In this post lets take a quick look at this “complicated” market.

The two types of companies that dominate the world oil market are the International Oil Companies known as IOCs and the National Oil Companies called as NOCs. The IOCs are private companies while the NOCs are owned by governments. The NOCs control the majority of the world’s proven reserves and produced at least 55% of the world’s output in 2010. An example of IOC is Exxon Mobil and an example of NOC is Pemex of Mexico.

The following chart shows the share of the world’s oil production by type of company in 2011:

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Source: Who are the major players supplying the world oil market?, U.S. EIA

The U.S. has no NOCs. The entire oil market from exploration to production to distribution is in the hands of private companies who determine the price that the public pays at the pump. Some of these US-based IOCs include ExxonMobil (XOM), Chevron (CVX) and ConocoPhillips(COP). As these companies are private, they are only answerable to their shareholders and not the U.S. government.  The U.S. government cannot set the price of gasoline or interfere in the workings of these companies. Hence consumers are the mercy of these giant corporations when they fill gasoline for their cars and other vehicles. As these companies are responsible only to their shareholders who demand ever-higher returns and not to consumers or the government, price gouging at the pump occurs 24 hours a day on every day of the year right under the nose of the state.

The top three international oil companies by production in 2012 were Exxon Mobil, BP (BP), and Royal Dutch Shell (RDS-A, RDS-B). The top three NOCs based on production were Saudi Aramco, National Iranian Oil Company (NIOC) and PdVSA  of Venezuela .

The majority of the NOCs such as Saudi Aramco (Saudi Arabia), Pemex (Mexico), and PdVSA (Venezuela) are directly owned and operated as an extension of the government. All NOCs of the OPEC fall into this category. The goal of these NOCs is mainly to provide subsidized oil to the domestic consumers and generate revenue for the national governments by selling oil in the international market at market prices. Theoretically the states are supposed to use the oil wealth to help advance the country’s economy. Hence price of gasoline tend be very cheap relative to world prices in countries with these type of NOCs. As the government sets the price of oil in these countries, the price of gasoline does not vary based on the international market prices.

The second type of NOC are the ones which do not operate as an agency of the government but operate as a corporate entity. They try to satisfy both the profit-motives of a private corporation and further the goals of the country. The state may hold a major stake in these companies in order to have some control over how they are run. Statoil (STO) of Norway and Petrobras (PBR) of Brazil are example of such as NOCs.

OPEC:

Organization of the Petroleum Exporting Countries (OPEC) is a group of some of the the world’s most oil-rich countries.  They control about 70% of the world’s proven oil reserves. In its simplest form the OPEC can be considered as a cartel. Though the formation of cartels is illegal in most countries in all industries, the OPEC has been allowed to form and operate as a cartel. The OPEC controls the production, prices of oil and other matters related to oil. So just like any cartel, its job is to make sure that prices stay at a specific level to generate enough profits are determined by the member countries. So for example, if the price of oil falls because the world’s demand is down, the OPEC cuts production to bring up the price to the level it desires.

The 12 member of the OPEC are Iran, Iraq, Kuwait, Saudi Arabia, Qatar, United Arab Emirates, Algeria, Angola, Ecuador Libya, Nigeria and Venezuela. Ecuador and Venezuela are the only OPEC countries in the Western Hemisphere.

So one reason that can be attributed as to why the world’s oil market is complicated is that the OPEC cartel is allowed to exist to manipulate prices. One can only wonder why Western powers are unwilling to apply the the principles of free-market to the oil industry and force the dismantling of the OPEC.

Disclosure: No Positions

The global financial crisis exposed the big flaw in debt-led growth in most developed countries. The U.S. became the poster child for the world see the harmful effects of how unsustainable debt levels held by individuals, companies and governments alike. Even after the credit crisis debt levels remain still high in many countries. For example, at the end of last year U.S. gross debt stood at 370% of the GDP.This figure includes all the four types of debt shown in the chart below.

The U.S. economy was about $14.0 Trillion in 2011. To put the U.S. Federal government debt in perspective, the total outstanding U.S. public debt is $16,701,250,641,109.6 as of March 7, 2013. Out of  this figure, $11.8 Trillion is held by the public and the rest are intra-governmental holdings according data by the U.S. Treasury Department. The U.S. is the largest debtor country in the country and China holds the largest amount of U.S. debt. Nobody knows if this debt will ever be paid to Chinese. The only thing that everyone seem to focus is on for the time being is the interest paid out to the Chinese and other countries every year. Since this interest is only a few billion dollars the U.S. is easily able to pay it without any worries about the principal amount of the loans.

As a result of the sovereign debt crisis in European countries such as Spain, Italy, Portugal and Greece, temporary solutions have been implemented in the past few years to avoid the collapse of the Euro. However debt held by private individuals and corporations have not been reduced much. For example, Spanish households and financial institutions continue to hold high levels of debt from their exposures to the once-vibrant real estate industry.

Niels Jensen of Absolute Return Partners LLP of UK shared some of his thoughts on the debt levels in developed countries in their latest report. From the article:

Overall debt levels remain excruciatingly high (chart 1) and I note with some trepidation that Greece is not even close to being the most indebted nation in the world today. In chart 1 debt from all the four main sectors of the economy have been added together. As experience has taught us, it is total debt that matters. Focusing on government debt alone will lead to bad investment decisions.

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Without a healthy level of economic growth there is no way that all this debt can ever be repaid, hence the growing focus on nominal GDP growth, so, in that respect, economic growth still matters.

Source: Expect the Unexpected by Niels C. Jensen, The Absolute Return Letter, March 2013
Absolute Return Partners LLP, UK

The Dow Jones Industrial Average closed at a record 14,329.49 yesterday. The S&P 500 closed at 1,544.26. With the Dow breaking past the previous record high some investors are wondering if this bull run is sustainable and how high the markets will go. The media is filled with stories of all types of forecasters and pundits predicting the continued upward trajectory of the stock market.

Here is James K. Glassman , executive director of the George W. Bush Institute with this Dow 36,000 article in Bloomberg:

The Dow Jones Industrial Average set a record this week, but it’s still far from the mark that economist Kevin Hassett and I forecast in our 1999 book, “Dow 36,000.”

We wrote in the introduction that “it is impossible to predict how long it will take” to get to 36,000. Then, in the same paragraph, we rashly made a guess anyway: “between three and five years.”

Today, the far edge of that time frame is clearly in reach. From its low of 6,547 on March 9, 2009, the Dow has risen 117 percent. Another 117 percent in four years would put it at 31,022, just 16 percentage points shy of the magic number.

Mr.Glassman prediction in 1999 did not come true but now states that the Dow may reach over 31,000 in just four years based on some wild assumptions. However a much closer figure from current levels is Dow 20,000.

When will the Dow reach the next psychologically-important milestone of 20,000? 

Certainly I do not know the answer. There are too many variables to consider especially when some are voicing concerns over the  irrational exuberance of investors and questioning if the current stock prices are warranted given the weak macroeconomic conditions.

Last August,  Seth J. Masters, Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management wrote a fascinating article providing a possible answer to my question above. From the article:

The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.

Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t expect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.

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Source: The Fundamental Case for the 20,000 Dow, August 13, 2012, The AllianceBernstein Blog on Investing

The chart shows the number of years for the Dow to reach 20,000 based on five different scenarios.  It would be interesting to see how the Dow performs in the next few years.

The chart below shows the 10-year return of Dow and S&P 500:

Source: Google Finance

Clearly both the Dow and the S&P have had an astonishing recovery from the lows of the global financial crisis.

Related ETFs:

• SPDR S&P 500 ETF (SPY)
• SPDR Dow Jones Industrial Average ETF (DIA)

Disclosure: No Positions