A Surprise Solution

World oil demand is currently surging far higher than normal rates…and nobody knows how high oil prices will go. What does this mean for the U.S. economy? John Mauldin explores…

Oil prices may temporarily spike to $80 a barrel during the next two years if there is a major supply disruption, said OPEC’s Acting Secretary-General, Adnan Shihab-Eldin, last month. "I can stress that the probability that the price of a barrel of crude rises to $80 in the near future is a low probability," Shihab-Eldin told leading Kuwaiti daily al-Qabas in an interview in Vienna.

"However, I can’t rule out the rise of a barrel of oil to $80 in the coming two years," he said. "But, if the price rises to this level for one reason or another (for example a shortage of supplies from a producer nation by one or two million barrels per day), it’s not expected that this spike will last long."

Prices around $50 or $60 a barrel, if they continued for two years or more, would increase investment to expand supplies and curtail demand, pushing down prices in the end, he added. "This is an essential law of economics," Shihab-Eldin noted.

OPEC is becoming increasingly comfortable with $50 oil. Only a few years ago, the consensus was that $50 oil would reduce demand and create the potential for a worldwide recession. Since a global world recession would not be good for world demand, and thus oil prices, OPEC leaders targeted $22-$28 oil. They were not being nice. They simply wanted to make sure their customers would be financially sound enough to keep paying. This is somewhat like cocaine dealers being concerned about their customers in order to keep up their business.

Since $50 oil has not created a recession, there is no constraint upon OPEC to work to reduce prices from here. However, the fact is that OPEC can do little about bringing down oil prices even if they wanted to.

OPEC Oil Production: The Way It Used To Be

Here’s how it used to work. During the 50s and 60s, America produced all the oil it could use and essentially controlled the price of oil. Much of U.S. oil was then produced in Texas. The Texas Railroad Commission had (and still maintains) regulatory authority over the production of oil in Texas. They limited the production of oil so as to maintain a price that would allow oil companies to make a profit and thus continue to be able to pump oil.

In 1971, the Texas Railroad Commission allowed oil producers to go to full production, as demand had outstripped supply. That gave control of oil prices to OPEC and they moved to increase prices dramatically in 1973-74. Up until then, the TRC could raise or lower the price of by simply increasing or decreasing their production.

World oil demand is around 80 million barrels of oil a day. If you increased oil production by, say, 2 million barrels a day over world demand, within three to four months there would simply be too much oil sloshing around and no place to put it. Prices would drop, and if production did not also drop, the price of oil could go down dramatically.

The consensus view is that OPEC has maybe-possibly-potentially the ability to produce an extra 1 million barrels of oil a day. Given that much of the world’s oil producing capacity is in politically unstable countries – the various tribes and factions in Nigeria are constantly threatening war with each other, Iran, Iraq and Saudi Arabia are not paragons of political stability, and then there is the madman that runs Venezuela – it is quite easy to imagine a disruption will affect far more oil production than this estimated 1 million barrels of oil a day.

World oil demand is currently surging far higher than normal rates. During 1991-1999, annual world oil demand growth was about one million barrels a day. In 2004, that spiked to an additional 2.5 million barrels per day. The Energy Information administration (EIA) in Washington, DC estimates that world oil demand growth will be more than 2 million barrels per day for the next two years.

OPEC Oil Production: China’s Demand

A third of that oil demand growth comes from China, which is no surprise, of course. The need for oil comes from two primary sources. First, China now has 20 million cars. That demand is only going to increase as estimates are that China will have between 120 million and 145 million cars in a mere 15 years from now. (China’s air pollution is already among the worst in the world. It is going to get worse.)

Secondly, all the new industry in China creates a huge demand for electric power. Electricity is primarily produced by coal in China. The problem, however, is that there is simply not enough electric power production capacity, and thus much of Chinese industry has resorted to buying their own generators, most of which are powered by diesel fuel. Optimistically that means that as China brings on more power plants, it is possible that the diesel generators will be replaced. This will more than be offset, though, by increased demand for oil brought about by new cars and an emerging middle-class lifestyle.

It is clear the demand for oil is only going to rise. And this is just China. When you factor in India and the rest of Asia, there is a real potential for global demand to out-produce near term potential supply.

Any increase in demand over supply by 2 million barrels a day will ultimately mean much higher oil prices.

Now let’s be clear that nobody really knows how high oil prices will go in the rest of this decade. Personally I think that a rise to $70 oil would start to negatively impact the American economy, and increase the likelihood of a recession. The U.S. recession will affect the rest of the world negatively, and thus we should see a drop in the price of oil.

But as noted above, there are numerous unpleasant political possibilities. Some of the less stable oil-producing parts of the world could seriously, even if temporarily, spike the price of oil to $100. Anything is possible, but not everything is likely. While I do think we will see $100 oil in the coming decades, I would be surprised if we see it that high in this decade.

Ironically, in my opinion, $100 a barrel oil is the solution for high oil prices. Has anybody noticed that ethanol is selling for less than unleaded gas on the futures market? Today, unleaded gas on the futures market is $1.66. Ethanol June futures are "only" $1.21. In the future, it may be cheaper to run you car on environmentally friendly emission free ethanol. And yes, I know the government subsidizes ethanol. But a $.45 differential is huge. Who would have thought that would be the case five years ago?

OPEC Oil Production: Grown in Kansas, Mined in Canada

Dennis Gartman tells me the Athabasca Sand Tars in Canada is roughly three Saudi Arabias. They can now get oil out of the sand at a cost of roughly $11 a barrel.

In the future, instead of buying oil from OPEC we will grow it in Kansas and mine it in Canada. $100 oil will force market solutions for other energy sources and whole new industries and technologies.

The Cassandras who predict that the world will run out of energy simply don’t get it. Yes, we will eventually see oil production peak and then begin to fall. But it will not be a calamitous over the waterfalls type of event. It will simply be a gradual lessening of production.

That need for energy will be replaced by other energy sources. Such a change will be disruptive, but then most change usually is. That change will of course increase the number of potential opportunities for investors. This is a sector that I want to keep a close eye on.

Regards,

John Mauldin
for The Daily Reckoning

April 14, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

We know that a fool and his money are soon parted. We also know how. What amazes us is how they ever got together in the first place.

There is money everywhere. Is it any wonder? You can borrow at around 6% on a mortgage and the property rises at 10% to 20% per year. A colleague reports that people are buying lots in the Galapagos Islands – sight unseen – for $65,000. We don’t know if they are a good deal or a bad one; what surprises us is that people are so adventuresome with their money. They must have a lot of it.

Elsewhere that money is still flooding into mutual funds and hedge funds. The Carlyle Group, associated with the Bush family, raised $7.85 billion for one new fund, $2.2 billion for another. And Goldman’s new "Pot O’Goldman" fund brought in an unbelievable $8.5 billion.

"What’s the difference between a mutual fund and a hedge fund?" we asked our old friend John Mauldin.

"Mostly just the fee structure," he replied. "You typically pay a small percentage on the money you put into a mutual fund…and some other management charges. In a hedge fund, 2 and 20 is common – 2% on the capital…and 20% of the gain."

"With such heavy fees, can you really expect to make money with hedge funds?" we wanted to know.

John has been studying the hedge fund industry for many years. He makes a business of finding the best performing ones.

"Investing is like anything else," said John over dinner last night, "there are some people who are better at it than others. There are guys who have beaten the indexes for the last 20 years in row. They have systems that work. Or they have some kind of instinct. There are guys who can hit a 95 mph curve ball; most guys can’t. Likewise, there are guys who are good at making money. Those are the guys whose funds you want to be in. Of course, those are also the funds you can’t get into…because they already have enough money and are closed to new investors."

Also with us last night was Merryn Somerset-Webb, editor of MoneyWeek.

"But John," she argued, "the figures we’ve seen show us that most hedge funds don’t make investors money. And their fees are so high, it seems almost impossible that the average investor would come out ahead."

"The numbers you’ve read are nonsense. Hedge funds are completely private. Many of them – and I’d guess the best of them – never report numbers to these tracking services. Nobody knows how much they make. And I’m not saying that all hedge funds make money all the time. I’m just saying that the best investment pros are running hedge funds…and the best pros are making money. Some of them are making obscene amounts of money. That’s why they can charge such high fees. There’s a lot of value added. The average person – even the average very rich person – can’t hope to do as well. He’s glad to pay for the service."

"But John, there are so many thousands of hedge funds. They can’t all make money. In fact, there are so many that a person who puts his money in hedge funds can’t hope to beat the market. Hedge funds as a group can’t expect to beat the market; they are the market. On the other hand, since they are the market, it’s not possible for them to under perform either."

We recalled another friend, James Ferguson, who had raised the same issue recently. "It is barely possible that hedge funds, as a group, could do worse than ‘the market’," James mused. "They are too large…they are the market. And yet, the numbers show that they under perform. There must be some sort of ‘dark matter’ out there in the investment universe…some investment activity that is very profitable and yet invisible."

Everywhere you look, the lumpeninvestoriat is losing money – except in real estate. But someone must be making money in stocks. Everyone can’t be doing worse than average. There’s "dark matter" somewhere.

It’s the hedge funds that don’t report, says John. They’re making fortunes…and nobody knows about it.

"The hedge funds are the Alpha Males of the investment world," says John. "They’re the strong hands. They take money from the weak hands – mostly mutual funds open to the public." (More from John Mauldin below…)

More news, from our team at The Rude Awakening…

————–

Eric Fry, reporting from Wall Street:

"In California, 30-year fixed-rate mortgages are becoming as rare as 30-year old females with real breasts – a phenomenon that bodes ill for consumer spending…if interest rates continue rising."

————–

Bill Bonner, with more views of varying quality and pertinence…

*** Globalization and its discontents were on display in San Francisco this week. "Chinese immigrant workers marched through the streets of downtown San Francisco on Tuesday, shouting slogans and waving signs to protest the loss of garment jobs they say are being shipped to China," says a news item.

"Only in America," said the accompanying note from a colleague.

"Only in America?" wondered our Pittsburgh correspondent, "Yes, that is what is worrisome. Would any other nation permit its industrial base to be hollowed out to the extent and degree that has happened in the United States in the past two decades? It seems that what took 200 years to construct, is being wrecked in a tenth of the time. Mines, mills, factories are disappearing. Management teams are being disestablished. Design and engineering associations are dissolving. Workers with irreproducible technical skills are hitting the bricks. And peoples’ attitudes towards the role of basic industrial production is changing, being replaced with some sort of ‘new economy’ paradigm that is at root just political-sociological, poisoned Kool-Aid. Only in America."

*** Oh, and here’s our favorite columnist, Thomas L. Friedman, with further hallucinations. Friedman has never met a situation he didn’t want to improve…and never heard of a country in whose affairs he didn’t want to meddle. The man is so full of good intentions he could practically pave the road to Hell himself.

We have been reading about the WWI. Once again, we are stand still, struck by the majestic foolishness of it all. In public affairs, nobody ever seems to know anything. Before the war, people thought that technology, modern industry and commerce, and interlocking military alliances would prevent war. After the war, they were the "reasons" proposed to explain why the war happened!

Before the war against Iraq, Mr. Friedman claimed the attack was necessary to protect Americans from terrorism. Now, he says, "we may be entering the most dangerous period since the Sept.11 attacks." Why? Because we are winning the war in Iraq! "The more the jihadists lose in Iraq, the more likely they are to use their rump forces to try something really crazy in America to make up for it."

The other thing you notice when reading the history of WWI is how readily the great mass of people goes along with war – no matter how preposterous the reasons for it.

"My Darling One & Beautiful-," Winston Churchill wrote to his wife on the eve of war, "Everything tends towards catastrophe & collapse. I am interested, geared up and happy." People would rather happily die for a cause than actually think about it. Dying is easier than thinking, we conclude, and for most people, preferable.

*** Chris Mayer has announced his top pick for 2005 – slabs of concrete? We’re intrigued…

"It’s actually a company that owns and operates 120 concrete hydroelectric dams in the United States and Canada. And these low maintenance concrete slabs produce electricity for one cent per kilowatt hour and sell it for four! That works out to a 300% profit margin.

"But it isn’t the only wealth-producing asset this company has. In fact, it is only the beginning…"

*** Irrelevant family news: Jules applied to five colleges. He was accepted by three, rejected by one – NYU’s film program – and on the waiting list for another.

"Well, Jules, that’s about as good as you could hope for."

"Yeah…it’s not bad. "

"So, where are you going to go?"

"I have no idea."

"Don’t you have to decide?"

"Yeah…"

"How are you going to make up your mind?"

"I’m going to flip a coin."

*** April is the cruelest month…warm spring rain stirring dull roots…

But there are the young roots too…stirred up in spring…

"Oh Daddy, I don’t know if I did the right thing or not," began the conversation with Maria last night. " I mean, I guess I shouldn’t have invited him here. He’s very nice…and I like him very much. But I like him as a friend. He wanted more than that. But I just didn’t feel like I wanted more than that. At least, not now…it was very awkward. And I’m afraid I hurt his feelings…"

"He’s gone?"

"Yes, he left…I feel awful…"

"He was very handsome…"

"Yes…I know…"