EIS Newsletter #6: November 2007

ASPO Recap: Oil Supply to Fall Off a Cliff…

    Strategy Adjustment to a Changed Market

October was a satisfying month for the E.I.S. portfolio. Not so much because it gained over 7%, and is up over 39% YTD. Rather because it outperformed the energy and general market averages which indicates that the E.I.S. strategy is adding value. The strategy was adjusted last month in response to the changing energy markets. Those adjustments and the reasoning behind them are discussed at the end of this letter. First, let’s see what October brought in terms of the great conceptual evolution that is developing among energy observers, as we try to perceive and describe the underlying reality of the future of energy.

Houston, We Have…Face-Off

The annual meeting of ASPO, the Association for the Study of Peak Oil, assembled in the oil capital from the 17th through the 20th. For veteran observers, there was one piece of big news and a lot of getting our minds around the magnitude of the issues. The discussion was organized around the basic tenants of the peak oil problem:

• Rapidly growing demand for energy, particularly oil

• Stagnating oil supply growth caused mainly by rapid decline rates

• Growing reluctance of some oil exporters to maximize output, otherwise called hoarding or “resource nationalism”, and

• The rising price of oil resulting from the above and how that can and will be mitigated by demand destruction, increased efficiency, and alternative supplies.

All the peak oil stars and over 500 others were there. We were addressed by Boone Pickens, Charlie Maxwell, Mat Simmons, Robert Hirsch (co-author of the seminal Hirsch Report on Peak Oil), and by some of the independent thinkers and analysts of The Oil Drum (www.theoildrum.com), as well as by various politicians including the very impressive Mayor of Houston, Bill White.

White described how Houston has cut energy use and pollution by working with businesses to encourage flex time and work-from-home. His most interesting insight: when companies are forced to compensate employees by productivity rather than time spent in their office, it leads to improved productivity. So a company can do well and do good with the same flex-time policies.

The Guts of the Peak Oil Problem

Chris Skrebowski, Editor of Petroleum Review, tracks all major oil fields — existing and under development — and decline rates by country. Some of his analysis is available here. Among the salient points he made in Houston were:

• Global decline of existing oil fields is running about 3.3 mb/d per year. That means producers must bring on new oil fields that yield nearly half of Saudi Arabia’s production every year just to keep oil flowing at the same rate, before producing enough to supply the growth of demand, which requires another 1.5 mb/d per year.

• He thinks global oil flow will peak in the 2008 - 2009 time frame, but the most optimistic case, in his view, would put it in 2011 - 2012 at 91 - 98 mb/d.

• A new oil field takes an average of 6.5 years from discovery to the actual flow of oil. The absolute scariest thing he or anyone said — and this is the important new understanding that so far has hardly been remarked upon by any analysis I have read — is that because of this long lead time, we can now ascertain virtually all of the new oil projects that may produce through about 2014. Nearly all are projected to be working by 2010 - 2012. Therefore, what happens to oil supply after 2012? He clearly stated his view that there will be a huge fall off in oil production after 2012.

• Skrebowski, among others, noted the importance of the new hoarding mentality called “resource nationalism” among oil exporters that is holding down oil production and will do so more importantly in the future. Obviously no country will own up to it, but hoarding is the Cheshire cat grin lurking over the oil scene.

• Since transportation is 75% of oil use globally and 50% is surface transport, improved fuel efficiency for cars must be a first priority in any attempt to mitigate high oil prices.

In Houston there were oil optimists as well. On the same panel as Skrebowski were Jeremy Gilbert and Richard Nehring, both of whom carry impressive bona fides. They discussed the growth of reserves in existing fields and the increasing amount that can be recovered as technology improves and the oil price increases, making it economical to spend more for exploiting old fields. Gilbert thinks this factor is not sufficient to impact Skrebowski’s estimates of peak oil onset, but Nehring has a rosier view. He thinks that because of improved resource recovery rates, oil will not peak until the 2020 - 2030 time frame and will have a 10 - 15 year plateau after that.

Nehring’s optimistic scenario is actually less than re-assuring for the price of oil. We know that if new production and enhanced recovery does not grow fast enough to offset both the decline of existing fields and the increase in global demand, the price will increase. In such event the price will increase regardless of whether oil production has peaked or not. Nehring had no specific prediction for the future growth rate of oil production but said it would be “very slow.” Given the huge projected demand growth coming from the developing and oil exporting countries, “very slow” growth in oil supply may well be insufficient to keep prices from escalating rapidly.

New Psychology Is One Key to the Oil Problem

Robert Hirsch discussed, among other things, two psychological implications of peak oil, neither of which is very happy. First, given an outlook for increased oil scarcity, an attitudinal shift from maximizing production to delaying production has two obvious benefits for exporters. By extending the life of the exporting country’s oil assets more will be available for future generations or to be sold at future higher oil prices. Plus, the act of not producing as quickly as possible itself tends to raise the oil price, and thus their immediate revenue. Hirsch drew curves showing the much reduced global oil supply we can expect because of the impact of hoarding (or “resource nationalism”).

Secondly, Hirsch noted that there is very little recognition of peak oil outside the relatively small group of people who avidly study the topic (like you and me). Politicians avoid discussing it because its implications are so painful and their constituents are not yet calling for the discussion. Oil companies and car companies discourage it (and encourage various experts to proclaim that peak oil is false — reminiscent of prior misleading corporate behavior in regard to cigarettes and global warming) because they do not want greater taxation or regulation by government or a recession caused by consumer fear. Hirsch, among others, believes that when there is general public recognition of peak oil there may be a financial and economic panic.

Demand: Hard to Visualize Without Traveling

A number of speakers dramatized the size of the emerging middle class in Chindia and the Pacific Rim countries and the implications of that for oil demand growth. Others brought home the huge demand growth from the oil exporting countries themselves, OPEC, Russia and Mexico. No news here. These things have not been secrets for some time. Yet it is still hard to get one’s mind around the full extent of these trends that are driving the price of oil ever higher. Who can really imagine what an 11% GDP growth rate really entails? Yet, that is reality in China.

Other speakers focused on the insufficiency of potential solutions. There are no good lubricants or ways to make plastic other than oil, although re-cycling can help a little. There are physical limits to global bio-fuel capacity. There are time constraints to changing out our transportation infrastructure, whether it is substituting higher fuel efficiency cars or transitioning from trucks and cars to rail and electrifying the rail. As we recognize the increasing need for electrical energy to substitute for petroleum, many speakers discussed nuclear and renewable sources like wind and solar, all of which will take a long time to put in place. Nonetheless, all of the above things are required, and all the speakers despaired that there is no public sense of urgency and little government leadership to push them forward faster.

A Counter-Intuitive Relief for Peak Oil

Want to hear something hopeful? Here it is: the U.S. and China are both horribly inefficient users of energy. The U.S. is inefficient in transportation, China in industrial production. That’s good news because it means there are two opportunities to mitigate oil scarcity fairly easily by correcting those inefficiencies. Twice before when oil became scarce — in 1973 and 1979 — we were able to make important systemic changes that let us adjust to the scarcity. We substituted natural gas and coal for oil in producing electricity. Then we substituted natural gas for oil in heating homes. As a result oil demand was reduced from 1979 to1985 and the price of oil plummeted. You can only make those systemic changes one time, so it is very good luck that a couple more such opportunities still exist. Imagine how much more dangerous the coming oil scarcity would be if there were no major inefficiencies that could be corrected to reduce demand fairly painlessly.

I don’t know how the Chinese will manage their push for industrial energy efficiency. In the U.S. we can substitute a 50 - 100 mpg fleet for the current 20 mpg fleet over a decade or so. The suburban housewife will still move her kids around town all day, but instead of doing it in a 15 mpg SUV, she’ll do it in a 50 or 100 mpg hybrid diesel electric. No big sacrifice there. Some families may have to sell the suburban home and move into a more urban environment where the kids — and everyone — can take a street car or motor scooter. Even that won’t present huge problems. But the poor will be hit hard. They won’t be able to afford a new fuel efficient car unless government steps in to help.

Investment Advice from a Great Pro

Various speakers attempted to see into the future from different perspectives, but the ideas about the future that I found most interesting were those of stock guru Charlie Maxwell. A distinguished writer and speaker on energy going back many decades and the Senior Energy Analyst at Weeden & Co, Charlie is as knowledgeable and insightful on energy matters as anyone in the world - and any comparable experts are people with whom he is in contact regularly.

Charlie began rather somberly, noting that those who understand the facts of peak oil are relatively few at this time. They have a “special responsibility of knowledge” to spread that understanding to help society prepare for the problems that oil scarcity will bring.

He then proceeded to discuss the investment approaches he favors, which I was happy to hear are close to those which I have discussed on this site. He thinks some of the international oil companies (IOCs) have yet to catch up to reality in their view that the price of oil is only temporarily high and will eventually come down. Their assumption of lower future oil prices has kept them from pursuing development projects, so they miss opportunities to re-invest. Also the trend toward nationalizing oil resources is limiting the major IOC’s ability to replace their assets. Thus, longer term the IOCs will go into a liquidating mode; they are not the best way to play the trend toward oil scarcity.

Charlie favors companies with the maximum access to oil and companies that will consistently benefit from the quest for new oil discoveries in the frontier of oil exploration, which is deep ocean drilling. Among the oil E&P companies, he favors those who own Canadian oil sands assets, including Encana and Suncor and those national oil companies with access to substantial new fields, including Petrobras and Lukoil. In the drilling and service areas he favors the deep ocean drilling companies like Transocean and Global Santa Fe, soon to be merged, about which I have written here, Diamond Offshore, Pride, and Cameron. All of these stocks are in the E.I.S. portfolio.

On a longer term basis, Charlie thinks there will be a future for natural gas within the next year or two, that energy conservation will be huge (although he had no names there), and, echoing Robert Hirsch, that at some point when the public comes to understand the implications of peak oil there will be a panic that will be painful for all stocks and will last for a while. He said conservation will be called “energy technology” and will be an enormous growth area over the next twenty years.

Neither Boone nor Matt Simmons said anything they hadn’t been saying publicly for a while, although when Boone tells you in person that the peak of oil production has already been seen at 85 mb/d, the idea seems to have more force. Boone also re-stated his belief in natural gas propulsion for heavy vehicles but did not discuss his new company, Clean Energy Fuels Corp symbol CLNE, which is also in the E.I.S. portfolio.

Why Is Oil “So High”?

I said back in June that I wouldn’t be surprised to see oil at $90 before year end. However, I did not expect it to happen by mid-October. The Q4 test of oil’s ability to meet expected Winter demand of 88 - 89 mb/d is only just begun. As Boone Pickens has said, if we can only produce 85 mb/d and they want 88-89, that only leaves one way for the price to go. Who can say what the price could be by year-end? Of course, weather will be an important influence, but if it is even a “normally” cold winter we could see prices well above $100 a barrel. My personal guess? $125 before the end of the season if the weather is colder than normal.

Public attention to higher oil prices is growing along with explanations. If you listen to the Democrats, it’s because of Bush’s saber-rattling about Iran. Some commentators blame speculation. In fact, at ASPO some of the cocktail party chatter among wise heads suggested that many hedge funds that have suffered so much this year from the sub-prime problems are trying to “make their year” by speculating on oil futures. It does seem likely that some part of oil in the $90s is due to speculation that in fact is heightened by international tensions.

But what about the fundamental backdrop of peak oil? It is hardly ever mentioned in the mass media. The facts discussed in Houston by Chris Skrebowski and others seem to live on a different planet from those in the public mind. I do not mean necessarily that “peak” has already occurred or that there is a direct link between peak oil and the exact daily price of oil. But I think that the backdrop conflict between rising global demand and stagnating supply is necessitating the current pricing regime which is pricing poor people and poor countries out of the oil market — necessarily destroying demand through higher prices because there is too much of it for the supply to satisfy.

A good analogy is to sea levels. If global warming were to raise the sea level, there would still be high and low tides. The sea would rise and fall, but the average level would constantly rise. If some global warming analysts are correct, the rise in average sea levels will grow at a rising rate over time.

That seems to be what is happening to oil prices. Peak Oil is raising the base “sea” level of oil prices, around which there are daily and monthly fluctuations or “tides”. Sure, the oil price could back down to $80 or even $70 if there were a recession. Or it could leap to $120 or more if there were a war, a severe hurricane, or a very cold winter. But the more important price to watch is the longer-term futures prices which indicate the “average sea level” of oil. Just a week ago you could buy oil for delivery in 2010 for $75. Now it is $80.

I believe, when the reality of peak oil becomes well understood — which could be only a matter of months from now given increased public focus — we will see much higher base levels for the price of oil. After all — going back to Chris Skrebowski’s view that oil production will fall off a cliff sometime after 2012 — if traders really understood why that vision is likely to be fulfilled, would they really be willing to price a barrel of oil for 2012 delivery at anything less than $250 — or maybe even $500? No, I don’t expect that price level soon. But I do expect it to happen.

The Chimera of “Spare Capacity”

Will the Saudi’s or the U.S. SPR come in with new supply to contain oil prices? Not likely when you think about it for a minute. Assume the Saudi’s have their claimed 2 mb/d of “spare capacity” that could quickly be brought on stream. The reason to have it is so that if a political emergency (various examples spring easily to your mind) or a natural disaster like Katrina occurs, the spare capacity can be activated and oil will not suddenly become unavailable to the global economy. What would traders do to the price of oil if there were absolutely no reserve capacity left in the entire world to deal with such potential disruptions? Oooops. Did anyone say $150? So if the Saudi’s did use their claimed reserve potential to keep near term prices down, the impact could be exactly the opposite of what is desired as analysts focus on the reduced margin of safety that would result from a world without any spare oil production capacity.

Thus it is absolutely fascinating to me that oil analysts keep talking about the spare capacity of the Saudi’s coming in to the market to lower the price of oil. By definition, that cannot happen.

As for the U.S. Strategic Petroleum Reserve — who knows what Bush could do? So far, he has never taken any action that would tend to lower the price of oil. Thus, it does not seem likely he would start now — particularly when he seems willing — if not anxious — to bomb Iran. In which case the SPR might actually come in handy.

How About a U.S. Recession?

Would a U.S. recession bring down oil? Well, it probably would cause traders to bring down the oil price for a few months. But the history of the last two U.S. recessions is that they actually had very little impact on U. S. oil consumption. Besides, these days the real demand growth comes from Asia and the oil exporting countries, which would be marginally impacted by a mild U.S. recession. Eventually, traders would come to recognize these facts and the price of oil would quickly rebound.

If there were a major global depression the price of oil would come down for a significant time period. However, with central governments much more knowledgeable about tools for inflating their economies than they were in the 1930s, and with the underlying strength of demand growth by Chindia and oil exporting countries, that’s not a bet I would make.

E.I.S. Strategy Re-adjustment

At some point during the month of October I became convinced that an inflection point has been reached in what I expect will be the “hockey stick” shape of the oil price chart over the period of 2000 - 2015. It is not the final inflection and it does not preclude a pull-back of the oil price on an intermediate basis if the U.S. economy tanks over the next twelve months. But it is the start of much higher oil prices over the next 8 years, I believe.

If that vision is accurate then I think it says one needs to own more companies that own oil directly and fewer service companies. Oil price leverage has shifted from the drillers and service companies to the ownership of oil or alternative energy. Drillers and service companies, as represented by the OIH ETF, have had a huge year — up over 37% through 9/30 — because the market began to realize they were no long cyclical businesses but were in a secular growth trend and the market has repriced many of them accordingly. But in October the OIH was actually down slightly. I think that is because the price of oil is already high enough to justify the case for drilling and service companies to grow profits virtually as far as the eye can see. $75 was enough for that. $85 or $95 or $105 will not make that case much stronger. On the other hand, the owners of oil or alternatives will continue to benefit proportionately from future higher oil prices. Therefore, I have shifted a substantial portion of the E.I.S. portfolio from the drilling and service sector to oil companies that have access to major reserves and to alternative energy companies whose prospects vary directly with the price of oil.

Moreover, I have taken a direct lesson from the ASPO show theme, which was “Time for Another Great Leap.” For some time during the show, I pondered those words, so suggestive of one of those Chinese 5-year plan slogans, and for a while I was frankly not able to figure out what they meant. Then it finally dawned on me: it was “leap” as in “LEAP” — the long term equity option securities. That made it clear: what was needed, given my view of the price of oil, is to buy LEAPs on oil itself and/or on companies that own a lot of oil. I will close with that thought for your consideration.

Happy Thanksgiving. We have much for which to be thankful as the storm slowly approaches,


Jim Kingsdale
Editor, Energy Investment Strategies
www.energyinvestmentstrategies.com