EIS Newsletter #5: October 2007
What Is the Price of Oil…Now?…
Mid-Term Exam for Global Oil Supply…
What’s Going On Lately?
Have you ever looked at the “Information” area of this web site? It’s turning out to be quite useful to me and it’s growing rapidly. Brief summaries of published articles organized both by topic and then in chronological order indicate vectors and trends for each topic. If more detail is desired just click on the posting to read the article. Say, for example, the oil sands of Canada are of interest. Simply click on the “Information” tab and then scroll down to the “Oil Sands” heading.
Here are several future trends that the postings discuss:
• Solar — A very exciting suite of new techniques and technologies has been assembled by a private company that has financing from an elite group of investors. The company’s new concentrating solar power (“CSP”) system generates electricity at “competitive” prices and 24/7. At the recent Clinton conference in New York two forward thinking utilities announced that they have signed contracts to build CSP plants using this company’s system, which is an updated version of a CSP plant installed over three decades ago that is still generating electricity in the Mojave Desert, but which until now has not been competitive with coal or gas in price or reliability.
This new CSP development is potentially significant for several reasons. It would be great for the environment, obviously. It could be quite negative for coal (and therefore railroads) and to a lesser degree for natural gas. And when the system proves out (eventually either this or another CSP technology will prove out) it will be great for electric utilities, enabling them to avoid major environmental and cost problems caused by the carbon taxes that are sure to come. It will provide electric utilities with a stable-cost long term sources of power that will be needed for the electric economy that will replace the petroleum economy, particularly including plug in hybrid vehicles that are clearly the future of automobiles. These two disparate but connected developments, CSP and plug-in hybrid cars, could both begin to hit the market in a 3 — 5 year time frame. Electric utilities in the era of renewable electric transportation may become a very interesting investment.
• Mexico is headed for serious problems, as I’ve written previously, because its oil production is falling as its internal use of oil increases, thus reducing oil exports which fund the bulk of its Federal budget. Recent news accounts of terrorist attacks on Mexican gas pipelines suggest funding from Venezuela and a sophisticated indigenous military opposition which adds a troublesome dimension to Mexico’s suite of problems.
Because Mexico is the U.S.’s third largest foreign oil supplier, reduced Mexican supplies will have a leveraged importance for the U.S. This problem will bite much more in three years than in three months. In the short term, Mexico is being helped by higher oil prices, but in the future, as its exports drop faster than the oil price rises, Mexico will find itself in deep trouble if it does not develop alternative sources for tax revenues to replace the taxes on exported oil.
• Russia is focused on internal economic growth and external power growth, as a recent report discusses. Oil and gas — but particularly oil at this point — are the key to both Russian objectives. Russia is the world’s largest producer of oil. The Saudis are thought (by some) to have the capacity to expand production, but Russia has the most production. The contrast is interesting because the Saudis have little to gain from higher oil prices while the Russians have much to gain. Higher oil prices increase the Saudi royal family’s sense of vulnerability and provide them a literal embarrassment of riches in the eyes of their Western protectors. For Russia, though, higher oil prices provide much needed funding for domestic economic development and simultaneously they weaken Russia’s Western competitors for global political power.
Russia must use its oil weapon with subtlety right now because they are trying to convince Europeans to let them buy more of the existing European oil and gas infrastructure. They are finding the Europeans to be less than naive on this subject, however. So, needing to be seen in Europe as cooperative on energy security, Russia’s hoarding efforts must therefore be subtle. Thus, they reduce foreign participation in oil and gas extraction which tends to draw out the time frame for extraction. They fail to fully fund Siberian exploration and production efforts, again putting off extraction into the future. These are subtle ways of hoarding. Like the Mexican news, events in Russia will have more impact in future years than in future months, but even in the short term I believe Russian actions (or inaction in developing their reserves) is a significant factor behind higher oil prices.
I hope readers will find the Information area of this site useful. If you have suggestions for how it can be improved, please write me and let me know. The entire site is now four months old. I am discovering new capabilities for it to help me as an investor and as I do, I am seeing ways that the site can be improved. So a new look for Energy Investment Strategies is under development — E.I.S. 2.0. I hope to present it to you before year end.
Can We Know the Price of Oil?
It may come as a surprise to some, but there is no exact price of oil. There is a price for Brent Crude, one for West Texas Intermediate (“WTI”), another for Light Louisiana Sweet. Each of these is a separate market and there are many other oil markets around the world which trade their oil at different prices at any one time. Beyond that, the price in each market fluctuates by the minute.
Investors should keep the “relativity” of the oil price in mind. It’s not about whether “oil” is $83 or $78 (it can be both at the same time in different markets). It is the trend that matters because we are really interested in what our companies will be paying or receiving for oil in six months, a year or — even more importantly — in three years.
In fact, the oil price that is the most relevant to investors may be the one that top managements ascribe to future oil transactions when they determine capital budgets. All oil-related companies have such a number. It is key to whether, for example, an E&P company like Devon decides to contract with a drilling company like Transocean for a rig that might cost them $600,000 per day over a multi-year period starting three years from now. It is that oil price — the one in the minds of the executives that applies to oil three years down the road — which is key to that important decision. And this oil price is never published.
Because of this phenomenon investors should set their sails by the “big picture” and not whether a hurricane or something else could cause WTI to rise or fall next week or next month. That “big picture” is a large part of what I try to address on Energy Investment Strategies. Whether it is where we stand in the march toward Peak Oil or what political forces (such as hoarding) are exerting long term influences on the amount of oil produced, or how effectively the world is developing and adopting more oil efficiency technologies and techniques like hybrid electric cars. I try to collect the relevant published information by topic. I try to pull together the various strands of information. And, looking at all that, I try to suggest where the trends are pulling our dear planet and how best to invest with those trends.
The Future May Be Closer Than We Think
That said, the next few months may be an extremely interesting period for oil-world. As we come to the normal heating oil inventory build time, experts have projected that global consumption requirements will sprint forward toward 88 million b/d. That is several million more than the world is used to providing. It is not clear to some observers that the requisite production will be forthcoming. If it is not, be prepared for much higher oil prices before year end.
The most interesting part of this story to me is not whether oil breaks $100 before year end. It is that the next few months could give us an indication of whether the spare production capacity claimed by Saudi Arabia actually exists. Or, on the other hand, whether the Peak Oil fundamentalists are right in saying that Ghawar, the Saudis’ huge reservoir of light sweet crude, is declining, thus giving them only limited spare production capacity of heavy sour crude, which is tougher to refine into useful products. In other words, the next few month may provide some important insights into how far along the road to Peak Oil the world actually is.
Like everything, though, this will not be a pure experiment. Keep in mind a couple of wrinkles. First, the UAE will be shutting down some fields for maintenance in November taking about 300,000 - 610,00 b/d of production off the world market. That may account for some of the oil price strength that has been seen recently as users build inventory and/or it may have further impact later. Also, the weather will become a factor as we get into December. Last winter was particularly warm in the U.S., which reduced demand for both heating oil and natural gas. An unusually hot or cold winter this year will exacerbate or mitigate the pressure of the UAE shortfall - and the projected 88 mb/d global requirement.
Whatever short term weather influences occur, four to six months from now there may be substantially more clarity about the world’s near term oil supply/demand balance than there is at present.
Portfolio Report Card
During September the E.I.S. portfolio allocations were increased to alternative energy, drilling/services and natural gas. A 5.3% gold component was initiated. Reductions were made in oil sands (as discussed here) and some profits were taken in shipping (TBSI) a holding that has appreciated so much that it became too large a percentage of the total portfolio. I am looking to add to the alternative energy portfolio because it is becoming a major market beneficiary of the inevitable increase in the public’s awareness of our approach toward Peak Oil. I suspect alternative fuels are in the process of becoming an investment bubble, but the peak may be a couple of years down the road.
Shorts were reduced to 41.8% from 79% and may be reduced further. It seems that the market bullishly believes housing problems may cause sufficient economic weakness to motivate further Fed interest rate cuts but will not be severe enough to cause a full fledged recession. This concept, known to some as the “Goldilocks scenario”, is viable unless inflation becomes problematic. Further dollar erosion and/or further commodity price increases could increase inflationary pressure which would be very bearish for stocks because if the Fed believes that inflation is likely it probably will not cut rates further even if the economy is weakening. That scenario would threaten equity values. Should one be short stocks in anticipation of inflation or should one wait for further evidence? Turn to CNBC nearly any hour of the day to hear the matter debated by licenced economists, of which I am not one. In the face of this uncertainty, I may eliminate shorts pending further data.
Last month my short hedges cost me about 2%, although the portfolio was still up, net, a healthy 5.24%. But the portfolio underperformed the robust spurt in the OIH and IYE energy stock ETF’s against which I measure its performance (see details here) as the oil and related services sectors had one of the best months all year in September. Such performance cannot be maintained on a long term basis at anything like this rate going forward.
In a couple of weeks I’m off to Houston for the ASPO conference. That’s the Association for the Study of Peak Oil. All the stars will be there — Simmons, Pickens, Skrebowski, Hirsch, you name them. But will they be aligned? I shall report next month.
Best wishes,
Jim Kingsdale
Editor, Energy Investment Strategies
www.energyinvestmentstrategies.com