EIS Newsletter #2: July 2007
But Inventory Levels Rise Too.
Two Ways to Cure Oil Dependency…
And Two Ways to Gain from $100 Per Barrel Oil
The steady march of oil from $50 per barrel to
over $70 since January seems to have broadened and strengthened the
confidence of oil bulls. As the price advances, there is also more
frequent and widespread discussion of Peak
Oil, a principle underpinning of price bullishness. The kind of
dramatic talk one can hear these days is illustrated by the following
from Kurt Wulff, the respected chief of McDep
Associates:
“As for one of the fundamental
factors behind oil’s price rise, Mr. Jim Buckee, retiring Chief
Executive of Talisman Energy (TLM), showed a hand-drawn graphic to
a small group at the end of the day illustrating a recent accelerated
decline in production of the world’s largest oil field, Ghawar,
despite a parabolic increase in oil field equipment and service spending
by Saudi Arabia.”
The possible peaking of Ghawar is one of the most
closely watched and anticipated developments in the oil universe.
When Ghawar starts declining it will symbolize, if not directly cause,
The Beginning of the End of the oil economy as we know it and the
eventual end of double digit oil prices in world history.
All of which, along with the disaster we call The Iraq War and the
continuing strife in Nigeria, adds immediacy to America’s quest
for “oil independence.” More later.
The irony of today’s rising oil prices is that they are accompanied
by a build in U.S. inventories. Usually one expects prices to decline
if inventories rise and vice versa. So the apparent conundrum of oil
prices and inventories both rising simultaneously bothers many analysts
and leads some politicians to believe there is illegal collusion happening
among the E&P and/or refining companies.
I’m not half good enough to solve conundrums, but I have a working
theory to explain this one. Here it is: as the oil price rises, fears
increase that global oil supplies are becoming more scarce, causing
wealthy countries to build inventories (see: It’s
Called Hoarding) to protect themselves against possible future
oil shortages and speculators to attempt to profit from the rising
price by holding the commodity.
I am told by George Lucas, senior analyst and former president of
the brilliant energy investment management firm Lucas Capital that
during the oil shocks of the 1970s U.S. oil inventories rose along
with oil prices. Just as they are doing now.
The theoretical underlying cause of rising oil prices is oil production
failing to meet the global desire for oil which causes wealthy people
and wealthy countries to outbid poor people and countries for the
scarce supply. Interestingly, if global demand is challenging supply,
the desire of wealthy countries for higher inventories actually pushes
the price up further by adding to demand, a classic positive feedback
loop.
Anecdotal evidence suggests that poorer economies are now in fact
being priced out of the oil market. For example, poor countries are
increasingly reporting the need to ration electricity, much of which
is produced by oil in such places. An example is this report from
the Nicaraugian paper, Nica Times:
“With an energy deficit hovering
between 20-30% of the nation’s demand, embattled power-distribution
company Unión Fenosa in mid-June began again implementing rolling
blackouts across the country, shutting down whole cities for 6-10
hours at a time.
I am seeing an increasing number of such reports
of energy shortages from countries in the southern hemisphere.
Rising oil prices caused by wealthier countries outbidding poorer
ones would likely be consistent with another unusual phenomenon -
the higher price of Brent crude (set in Europe) vs. the price of West
Texas Intermediate (set in Cushing, OK). Refinery problems in Cushing
were initially blamed for the lower WTI price, but those problems
are reportedly now solved, yet Brent still leads WTI by about $3 a
barrel, far more than the cost of shipping. Perhaps the explanation
is that African, Asian, and even South American countries are shopping
for oil in the European market rather than the U.S. market, which
supplies American needs via pipeline, not ships. If Brent is the venue
for international competition for oil, that would account for both
the higher global prices and the more rapid increase in Rotterdam
than in Cushing.
All this makes perfect sense when viewed from a global perspective,
but the results from an American perspective is a rising price along
with a rising local (not global) inventory level. Conundrum solved
(at least in theory).
Profiting from the Drive for Oil Independence
So....Multiple Choice Question: Alternative fuels
such as cellulosic ethanol and bio-diesel are:
A. Good solutions to the U.S. oil dependency problem
B. Good investments if the price of oil rises further
C. Both
D. Neither
Answer: B. If there were an alternative fuel that could be produced
efficiently (as measured by Energy Returns on Energy Invested, “EROEI”)
and could be scaled up rapidly, that would be ideal, allowing us to
keep doing pretty much what we do now but with much less oil. Unfortunately
the two major candidates for good EROEI, cellulosic ethanol and bio-diesel,
are of uncertain EROEI and unlikely scalability. Corn based ethanol
has terrible EROEI; it is not a solution. Cellulosic ethanol is still
in the process of technical optimization, seems to be a long way from
the goal, and is not yet proven to have a good EROEI. Even if cellulosic
ethanol proves to meet its backers’ efficiency expectations
in high-volume production, it is still not clear that the source material
and the process will allow the product to be highly scalable. Bio-diesel
made from waste products is also speculative right now and even when
proven out, will not be sufficiently scalable to make a major impact
on gasoline usage. If bio-diesel is made from grains instead of waste
products, then regardless of efficiency, it will entail both the problem
of scalability and the worse problem of raising food prices, perhaps
rising very significantly.
On the other hand, either bio-diesel or cellulosic ethanol are likely
to be extremely profitable businesses assuming a continued increase
in the price of oil.
So if America cannot produce its way out of its imported oil dependency
problem, what CAN America do? Since the U.S. oil problem is mostly a
transportation issue, there are really only two options:
1. Americans could begin to buy only highly fuel efficient vehicles
like the Prius and its ilk, which are light and small or
2. Car companies could develop and sell only vehicles that combine good
fuel economy with performance and size.
Today we have many vehicle choices to get double or even nearly triple
the roughly 21 miles per gallon avg. of the American passenger fleet as
a whole. But Americans are not buying them in significant numbers because
they are smaller and generally less powerful cars. So far, gasoline prices
of $3 – $4 per gallon is not sufficient to cause great numbers of
Americans to opt for better mileage over size and power.
One way to change Americans’ behavior would be to enact a carbon
tax or a gasoline tax that would bring the cost per gallon of gas into
the $6 – $8 range, much like what Europeans have. That would be
the fastest and most effective way to move America toward oil independence.
In fact, Rep. John Dingell (D. Mich.) will soon introduce such a bill.
But he is sure his bill will get little support and he is doing it only
to move the debate in Congress “beyond” any consideration
of a carbon tax.
“I sincerely doubt that the American people are willing to pay
what this is really going to cost them,” Dingell, D-Mich., said
in an interview Friday on C-SPAN’s “Newsmakers.”
Assuming Rep. Dingell has counted his votes correctly (he's a good vote
counter), then we will have to depend on the second and much slower
alternative for our becoming more oil independent: the availability
of much more highly efficient cars that do not sacrifice size
and power. That's happening with the development of multiple-power-source
vehicles and will eventually be optimized by the substitution of diesel
fuel in place of gasoline and the addition of an electric plug.
Multiple-power vehicles are symbolized by the hybrid gas-electric Prius,
a somewhat small car that gets about 50 mpg. Toyota plans to sell over
1 million Priuses globally by 2010. Meanwhile, Chrysler — in conjunction
with G.M. and BMW — is developing a 2-modal hybrid car that it
says will be three generations removed from the Prius. Using a “continuously
variable transmission” and “multiple displacement system”
it will switch between gasoline and electrical power in five distinct
varieties of operation, promising a far more sophisticated and efficient
vehicle than the Prius. The result is projected to be a 25% efficiency
improvement (40% in city driving) with equal power and size.
At some point everyone will realize that diesel fuel is better than
gasoline. Diesel engines are now as powerful as gasoline, make less
noise, run cleaner, and are 30% MORE FUEL EFFICIENT than gasoline.(
Ethanol, by contrast is about 30% LESS efficient than gasoline.) Amazingly,
if all the gas-powered cars in America could magically have an engine-transplant
from gas to diesel, we would immediately save nearly 2.5 million barrels
of oil per day or about 17% of imports. Diesels are about to explode
in popularity now that clean diesel fuel is mandated and available in
the U.S. Numerous diesel models will be offered soon by VW, Mercedes,
Jeep, and others. I was recently told that the new Mercedes diesel E320
will get 40 mpg highway.
Now imagine if the diesel and the hybrid were married and had a child
called the electric plug. The result would be a diesel powered plug-in
hybrid with continuously variable transmission and multiple displacement
system. I’m certainly not an automotive engineer, but a little
common sense says that such a vehicle cannot be too far off from production
and that it should be MUCH MORE efficient than the Chrysler/GM/BMW vehicle
now under development.
Will it come in time to save America? Well, it takes 9 – 15 years
for America to replace half the vehicles on the road. My guess is that
it will take at least five years - maybe even ten - for the plug-in
diesel electric hybrid to become available. If that vehicle achieves
a 100% improvement in fuel economy, it could yield a 35% oil savings
— or maybe 60% if it also impacts trucks. But we are talking 20
or so years from now and the number of cars on the road will increase
by about 1% a year also. So the net savings in 20 years or so might
be an improvement of only 30% – 40%. Meanwhile, oil production
will probably be in a (steep) decline, perhaps in as few as 10 years
from now.
Hmmm. We can’t produce our way out with new fuels. We won’t
legislate our way out with more efficiency. And it doesn't seem like
we will engineer our way out with greater efficiency in time to solve
the problem. It seems, then, that the upward pressure on oil prices
is unlikely to abate for a good long time (unless peace breaks out in
Nigeria and Iraq). I guess we’re back to the consideration of
how to benefit from triple-digit oil.
Soo…how CAN we profit from rising oil prices? My thoughts are
inherent in the distribution of my portfolio as shown on the home page
of www.energyinvestmentstrategies.com
. My largest allocation is to oil and gas service and drilling companies.
They help “oil companies” find and deliver more oil. Spending
on oil exploration and production will only increase even if the quantity
of oil produced goes down. To participate in this business, an investor
can buy an excellently selected basket of service and drilling companies
through an ETF with the symbol OIH. As you may have noticed from my
home page, the historical appreciation of OIH over the past few years
has been nearly as good as the results of my “EIS Portfolio”
as a whole.
A second approach is for an investor to buy companies that own gigantic
quantities of oil. The principle such companies on earth are those developing
the oil sands deposits in Canada.
My three favorite names are Canadian Oil Sands, the primary partner
of Syncrude, the largest oil sands company, symbol COSWF; Suncor (SU);
and Opti Canada (OPCDF) and/or Nexen (NXY), which owns half of Opti.
Ordinary oil companies like Exxon Mobil must spend billions in what
is becoming a futile effort to replace the oil they sell every year,
but the oil sands companies own fifty years or more worth of oil. Of
course they also face daunting environmental and possible regulatory
issues. But it seems highly likely that their assets will ultimately
be developed at a huge profit if oil prices keep rising.
A more esoteric way to own lots of oil is to buy the more speculative
shares of a small company that owns rights to some of the most promising
oil plays in Libya, a country with enormous potential to expand oil
production. It is a Canadian company called Verenex, symbol VNX on the
TSO. The stock has already come a long way, but I suspect it has even
further to go eventually, subject to the continued support of the good
Colonel Quaddafi. Hence the speculative rating.
A third approach is to own companies involved in the oil-substitution
or conservation trends we just discussed. This would include companies
involved in producing hybrid diesel cars or their components such as
Johnson Controls (JCI), Cummins Engine (CMI), or Corning Glass Works
(GLW). This letter is already too long to permit a discussion of how
these companies participate in the coming hybrid diesel revolution,
but you can go to their web sites and find out with relatively little
effort.
And finally, there is a small company with very large plans for producing
bio-diesel from animal waste products. It uses a proprietary process
that it believes allows for substantially higher gross margins than
other proven bio-diesel technologies. It also benefits from federal
and state tax credits worth up to $1.50 per gallon. For a small company
it boasts an extraordinary management team of individuals with long
records of past success. The company’s objectives are also impressive:
the production of perhaps 500 million gallons of bio-diesel per year
within five years. The profit margin on each gallon of bio-diesel that
they sell, which they believe will be positive without subsidies at
$50 oil, will obviously vary with the price of oil. That little fact
is both a risk and the great beauty of this potential investment. The
company is Nova Biosource Fuels (NBF on the AMEX). It goes for about
$3 a share these days with about 110 million shares outstanding.
People have asked me to offer more specific investment names. I hesitate
to mention specific names because companies' situations and my perception
of companies' values change and I write only periodically. Therefore,
readers must perform and maintain their own research on specific stocks.
I may point readers in a direction that seems to me to be fruitful,
as above, but readers must do their own work to stay current with such
stocks. For those not wishing to devote much time to investing, but
wanting to be invested in the energy “space,” I strongly
recommend they use a basket of stocks including mutual funds and ETFs,
one of which is mentioned above, symbol OIH.
Finally, I would refer energy students to the just-released IEA report
that estimates global oil supply and demand for five years, a link to
which can be found on my website. Best wishes for an excellent summer,
Jim Kingsdale
Editor, Energy Investment Strategies
www.energyinvestmentstrategies.com