EIS Newsletter #3: August 2007
July: Backwardization and Manic Depression…
Drilling Down on Higher Oil Prices…
Why Even Republicans Should Want a Carbon Tax
Oil and natural gas price trends were extended in July — oil higher and gas lower — and it seems that valid fundamentals are driving both trends. The gas situation is well known — a surge in U.S. supply combined with non-event weather has resulted in huge gas storage numbers. What else can be said? Oil is more interesting.
Backwardization has come to oil. The market says the price of oil
will be lower in virtually each future month, making the near term
contract nearly $4 more expensive as of 7/31 than the December, 2008
price (though the price has flatened substantially since month end).
$70 oil for 2008 would still be high enough to drive strong ‘08
earnings for the Energy Investment Strategies portfolio. But I think
prices in December of 2008 are likely to be much higher. Backwardization
suggests that oil traders think the price of oil will fall after the
hurricane season this year, like it did last year. We’ll see,
obviously. My take: anything can happen in the short term but the
supply/demand fundamentals for oil seem too tight to avoid $100 plus
oil by 12/08 assuming the forecasted 5% +/- global growth rate is
accurate.
July’s background chatter on oil featured reports from two respected bodies, both declaring uncustomarily that oil looks to go into short supply at some point in the future. The International Energy Agency (IEA) in Paris said oil will become scarce by 2012 if present trends continue. In the past the IEA has not been alarmists about oil supply adequacy.
Even more surprisingly, a committee of 1,000 experts put together by The National Petroleum Council (“NPC”), an oil industry trade group, and including the heretofore cornucopian commentator Daniel Yergin, has responded to Energy Sec. Samuel Bodman’s inquiry of two years ago with the recommendation that (almost) any and all actions possible to help future oil supply meet demand should be taken. Normally the NPC simply lobbies for enhanced drilling rights, but this report changed directions and recommended policies such as fuel economy standards aimed at damping oil demand. The report did not go so far as to suggest a carbon tax and its concerns were muted by the report’s 30-year time frame unlike the IEA’s five-year horizon. But my, my, it does seem like somethin’s up, doesn’t it?
The EIS Portfolio
The oil-centric EIS portfolio had a manic-depressive
month in July, as did the general market. By the 22nd the EIS stocks
were up nearly 10% for the month. After that they exaggerated the
general market downswing, ending July on the upside by 3.25%. But
I must say, to those who may wonder how this portfolio could have
done so much better than the OIH and IYE, that it helps a lot when
your largest position goes on a remarkable tear. TBS International
(TBSI), a company I mentioned in the first EIS Newsletter gained over
30% in July. It is a globalization play in the shipping area. Since
globalization is one of two trends causing oil to move higher (the
other being the decline of mature oil fields) TBSI is appropriate
for the EIS portfolio. TBSI, which I first bought under $9 and went
to $38 by 7/31, constitutes over 12% of the portfolio because it has
appreciated so much. I think of the company as the Federal Express
of the ocean shipping business and do not believe it is currently
over-priced..
Anatomy of the Auction Market for Oil
Some oil scarcity exists now, as discussed
in last month’s Newsletter, since
current prices are several times what they were just a few years ago,
but a great deal more scarcity lies before us. While we wait for the
future to unfold let’s visualize what real oil scarcity will
look like.
Current scarcity is causing poor people and poor countries to be priced
out of the market as a portion of their usual oil purchases go to
richer country that bid more for it. There are now on the Energy Investment
Strategies website’s Information and Links
page a growing list of news articles about developing countries
which are experiencing energy shortages, some of which are at least
partly caused by insufficient oil supplies.
A perfect analogy for the oil market is the residential real estate
market. Today’s energy shortages in some developing countries
is like gentrification in real estate, the process of upwardly mobile
people (think China in oil world) buying run down houses and forcing
the poor to move out. In the oil world today Americans, Europeans
and other wealthy countries get the oil they want but a town in Kenya
runs out of gas. Or a hospital in Nairobi must close for all but a
few hours a day for lack of diesel fuel to power their alternate electricity
generator.
The future of oil will look more like a different real estate phenomenon:
the life and death struggle for the best apartments in Manhattan or
the best ocean front properties in The Hamptons or Santa Barbara.
This auction is limited to the rich and powerful. $110 million for
one waterfront acre in Palm Beach? Hey, no problem for the people
bidding on this deal — it’s chump change to them.
Similarly, the competition for oil will some day be waged among first
world countries and those with the ambition and means to become first
world countries. Between the U.S., the E.U., China, India, Singapore,
etc.. Each will be crying out higher and higher bid prices to tempt
Russia or Saudi Arabia to part with more of their oil, their patrimony.
In that contest, $75 oil will be seen as a quaint number. Will it
be $250? $750 a barrel? For some people and some countries, even those
numbers represent chump change.
Such oil prices may not unfold for a while, but now we can visualize
the auction participants who will make those prices happen. It will
be the national equavalents of hedge fund managers and Silicon Valley
billionaires. Remember, the per-capital GDP of the U.S., E.U., China,
etc. are already many orders of magnitude greater than those poor
countries which are already starting to be priced out of the market
today. So when only the rich compete, the price will have to be stratospheric
compared with today.
When Will Oil Become Scarce?
Just how far off are such prices? We can determine
that by estimating the amount of oil currently being bought by the
non-rich people in second- and third-world countries, then estimating
the future global supply and demand for oil at current prices. When
the time is reached that the global under-supply equals the amount
of oil desired by today's poorer buyers, then only the wealthier buyers
will remain as bidders in the oil market. At that point hardly any
price for oil will be too high because all of the bidders have lots
of money.
Let’s take an example. Suppose 10 million barrels of oil a day
(out of 85 million consumed globally) currently goes to the 90% least
affluent users of oil in second- and third-world countries. Then assume
that in 2015, the total oil desired at today’s prices is 97
mb/d (12 mb/d more than today) but that the world can only produce
a maximum of 87 mb/d ( about 2 mb/d more than today) regardless of
how high the price is. In that case, in 2015, there will a 10 million
bpd “shortfall”, which is the total amount currently used
by all the poorest players today. Therefore in 2015, all the poor
will have been priced out and the oil auction participants will consist
only of first world countries and the wealthiest individuals in the
poorer countries. Can you imagine what price oil would need to reach
in order for a wealthy bidder to be unable to afford it? That is how
the price of oil will reach currently unimaginable levels.
Which Should Cause the Investor Class to Support a Carbon Tax
Of course, a different question is, “when
that happens, will it be good or bad for a portfolio of energy stocks?”
That is going to depend a lot on how much energy efficiency has been
increased by that time. If we can buy 100 mpg cars, there will not
be excessive strain on our society because most Americans will be
able to “do” pretty much what we currently do at a similar
cost. So if gas costs $15 a gallon but a gallon takes us five times
as far as today there will be a lot of pressure on people to buy new
cars, but that will not be a catastrophe for the economy. In this
case I would guess many energy stocks will be soaring.
On the other hand, if vastly increased energy efficiency is not available,
Americans will begin to be extremely constrained in what they can
do; the cost of energy will crowd out Americans’ ability to
buy other things; and our economy may be in great danger of collapse.
In that situation, I suspect the stock market will not be a happy
environment. Energy stocks may do better than most, but that may not
be enough advantage to make them into profitable investments.
So the interesting conclusion from this analysis is that we energy
investors should be cheering whenever we read about progress being
made toward energy efficiency. That seems counter-intuitive because
the more efficiency there is, the less “demand” there
is for oil. But we energy owners don’t really have to worry
about slowing demand in a world that has about two billion Chinese,
Indian, Russian, Middle-Eastern, and Asian people who are currently
impoverished but who are near-term candidates for membership in the
middle class. That is the lesson of the EIA and NPC reports released
last month.
Carbon tax, anyone? Maybe it’s time we all called our elected
representatives to explain why a carbon tax is in everyone’s
best interest — even the oil companies.
And finally, this month, a news item about
Iraq from the Associated Press: "We wait for the sunset to enjoy
some coolness,” said Qassim Hussein, a 31-year-old day laborer
in Karbala. “The people are fed-up. There is no water, no electricity,
there is nothing, but death. I’ve even had more trouble with
my wife these last three days."
I hope you have a pleasant August regardless of what this manic-depressive
stock market does.
Jim Kingsdale
Editor, Energy Investment Strategies
www.energyinvestmentstrategies.com