The Cheap Oil Mirage

The Daily Reckoning – Weekend Edition
February 10-11, 2007
Baltimore, Maryland
by James Howard Kunstler

MARKET REVIEW: THE CHEAP OIL MIRAGE

The American public is understandably happy to see the bottom fall out of the oil futures market. But temporary circumstances are only sending them another false signal that everything is perfectly okay on the oil scene. And it only reinforces the foolish belief that when prices go up it is solely because corporate finaglers tweak them up on purpose. In fact, these days it’s the other way around: often prices go down because corporate finaglers are tweaking the markets, dumping positions, playing shorts rather than acting like real oil users bidding on real contracts for delivery for real purposes like making gasoline. When oil goes up, as it certainly will again, it is primarily because of geology – what’s left in the ground – and secondarily because of geopolitics – where it’s left in the ground (and what’s happening ther

The supernaturally warm (up until now) winter temperatures have also played a part, keeping inventories high while the home furnaces idle. There is surely some demand destruction in the background. Third World nations are increasingly dropping out of the bidding (meaning their generators quit making electricity and their trucks stop running). And a contracting U.S. economy may also play a part. But even these circumstances may not overcome the supply problems in the real oil world. Here’s what’s going on:

As a baseline, it helps to understand that the four largest super-giant oil fields of the world are now in decline. They have been responsible for producing 14 percent of the world’s oil supply. They are now old and tired (thirty years is old in the oil world) and they are in depletion. These are The Cantarell field of Mexico, the Burgan field of Kuwait, the Daqing field of China, and the granddaddy of them all, the Ghawar field of Saudi Arabia.

The Cantarell field is a horror story. Pemex, the Mexican national oil company, tried to conceal the dire developments, because Cantarell alone is practically the whole Mexican oil industry. But it is now self-evident that Cantarell is crashing, with a 40 percent annual decline rate projected ahead, meaning a couple of years and it’s out. Mexico is America’s second largest source of oil imports (after No. 1 Canada and before No. 3 Saudi Arabia). When Cantarell crashes, the Mexican oil industry will crash and the United States will be out a major source of imported oil. The United States will also be out of imports that were so conveniently close they could be shipped by pipeline rather than tanker ships. For its part, Mexico will be out of a major source of export hard currency revenue and as its economy crashes will probably become even more politically unstable – meaning more Mexican citizens desperately seeking to get out. Guess where.

Burgan is in decline. The Kuwaitis announced it themselves last year. Daqing has been the major source of China’s domestic oil, which is otherwise paltry, meaning Daqing’s decline will only make China more desperate for imports. Ghawar remains shrouded in mystery, since Saudi Aramco does not welcome outside audits. But at 50 years old it is well past the mean age of peak production for oil fields and that alone probably tells the story. Beyond that, we know that Ghawar is producing with a (best case) 35 percent “water cut” (and perhaps much higher). They have to pump seawater into the field (a standard practice) to keep the oil coming out under pressure. The trouble is that they are getting this substantial water cut after redeploying their equipment for horizontal drilling – an ominous sign. Saudi Arabia declared last year that it would increase production to 12 million barrels a day by 2009. By close of 2006, it appeared to have trouble producing 9 million, with prospects for a 4 percent annual decline rate in the years just ahead.

Elsewhere, Iran is not only past peak, but its domestic demand is so high that it cannot maintain its export levels. The North Sea, which saved the West’s ass through the 1990s, is now crapping out at a steep decline rate. Iraq is on track to Palookaville, despite substantial reserves, and even if, by some miracle, its tired old oil infrastructure survives the war, the United States may lose access to future production for geopolitical reasons that should be obvious.

Venezuela is past peak for conventional liquid crude and hurting badly for technical expertise to work its oil fields since Hugo Chavez purged the state oil company’s management. Last year, Venezuela had to import Russian oil to avoid defaulting on contracts. Whatever the true condition of Venezuela’s industry, Chavez is not disposed favorably toward the United States – he hosted Iran’s president Ahmadinejad last week to signal that both of them were on the same page where the United States was concerned.

The situation in U.S. production is grim. We peaked in 1970. East Texas is near total depletion, with a 99 percent water cut (it produces “oil-stained water). Prudhoe Bay in Alaska now has a 75 percent water cut. We’re on track to produce under 5 million barrels a day in 2007 (down from a 1970 high of about 10 million), and heading relentlessly further down year-on-year. We burn through more than 20 million barrels a day. Do the math and see above (re: potential imports) for our prospects.

So, the financial markets are doing a triumphal dance in expectation of soaring equity values. And the news media is lumbering along with its head up its you-know-what.

Recently, however, the U.S. Senate Committee on Energy and Natural Resources, in an extraordinary session, heard testimony that the nation is in grave danger of a permanent oil crisis. Some of these senators affected to be shocked and surprised. What planet have they been living on? What is the nation getting for the hundreds of million of dollars paid to their staffers? Outgoing Republican chair, Senator Pete Domenici (R-NM), said to the witnesses that “what you told us today is absolutely startling with reference to the future.” Is it too early for a dumbass of the year award?

Perhaps the most valuable message the committee got came from Dr. Flynt Leverett from the New America Foundation, who said: “…there is no economically plausible scenario for a strategically meaningful reduction in the dependence of the United States and its allies on imported hydrocarbons during the next quarter century.” That’s the straight dope and we’d better stop pretending otherwise.

We’d also better stop pretending that alt.fuels such as ethanol, bio-diesel, coal liquids, or hydrogen will allow us to keep up the happy motoring. We have to make other arrangements for daily life. We don’t have a moment to lose. Our “to do” list is very long. If we waste our time in recrimination or hand wringing we are going to lose the things we value most, including an orderly society.

James Howard Kunstler
for The Daily Reckoning

P.S. So, don’t be fooled by the temporary fall in oil prices. We’re in the zone of the long emergency. In fact, Outstanding Investment’s Justice Litle says that if (and when) oil soars past $100 per barrel… crashes through the $125 ceiling… and careens toward a shocking, history-making $150, the dollar gets destroyed. Energy-dependent industry goes bust. Many stocks go down.

— The Daily Reckoning Book of the Week —

Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy
by Matthew Simmons

Investment banker Simmons offers a detailed description of the relationship between Saudi Arabia and the U.S and our long-standing dependence upon Saudi oil.

With a field-by-field assessment of its key oilfields, he highlights many discrepancies between Saudi Arabia’s actual production potential and its seemingly extravagant resource claims. Parts 1 and 2 of the book offer background and context for understanding the technical discussion of Saudi oil fields and the world’s energy supplies. Parts 3 and 4 contain analysis of Saudi Arabia’s oil and gas industry based on the technical papers published by the Society of Petroleum Engineers. Simmons suggests that when Saudi Arabia and other Middle East producers can no longer meet the world’s enormous demand, world leaders and energy specialists must be prepared for the consequences of increased scarcity and higher costs of oil that support our modern society.

Without authentication of the Saudi’s production sustainability claims, the author recommends review of this critical situation by an international forum. A thought-provoking book.

THIS WEEK in THE DAILY RECKONING: This week’s issues of The Daily Reckoning has it all…the theory of stupidity…commodity market mystique…the Goldilocks economy…and, of course, The Mogambo. Read it all below…

A General Theory of Stupidity                                     02/09/07
by Bill Bonner

“Us here at the Daily Reckoning is not stupid, but we do have an idea of what makes people ignorant to the major problems we face on a daily basis. As Bill Bonner explains, it has nothing to do with brain size, and everything to do with a lack of evolution. Read on…”

Resources, Naturally                                                            02/08/07
by Kevin Kerr

“The commodity market mystique is alive and well. Stellar successes and dismal failures in these markets are the stuff of legends. From an outsider’s perspective, commodity markets can be intimidating, even scary. In this excerpt from his new book, Kevin Kerr aims to dispel some of the common myths and misconceptions about these markets…”

Who’s Been Sleeping in Our Beds?                                    02/07/07
by Dan Amoss, CFA

“Wall Street and the financial media have hijacked the children’s story of Goldilocks and the Three Bears to use as a metaphor to explain the current economic environment. Dan Amoss points out that if we take this metaphor to its logical conclusion, we see that it has big, positive implications for precious metals investors…”

The Speculation of a Lifetime                                     02/06/07
by David Galland

“According to our pals at Casey Research, there are three different types of investors: those who invest in ideas, those who let the roll of the dice decide their investments, and the rational speculator. Which group do you fall into? Find out below…”

Extreme Umbrage                                                             02/05/07
by The Mogambo Guru

“To say that the Mogambo is ‘angry’ is like saying that the sun is ‘a little hot.’ This week, he is FURIOUS about what some people are saying about retirement. Read on to see what has caused our enraged economist’s umbrage meter to skyrocket…”

FLOTSAM AND JETSAM: One argument certainly plays a prominent role behind the widespread denial that the housing downturn might drive the U.S. economy into recession, and that is the perception of overabundant liquidity sloshing around in the United States and the world at large. Read on…

Borrowed vs. Earned Liquidity
by Dan Amoss, CFA

Can there be a serious economic downturn with so much liquidity around? In short, there can. The U.S. economy and its financial system were drowning in liquidity when the stock market and the economy collapsed in the late 1920s and the early 1930s, and so was Japan’s economy in the early 1990s when the markets there began their collapse.

Please recall Minsky: “An emphasis by bankers on the collateral value and the expected value of assets is conducive to the emergence of a fragile financial structure.” It is typical of bubble economies that rising asset values dominate borrowing and spending in the economy. Measured by its level of indebtedness, today’s U.S. economy is the worst bubble economy in history.

History tells us that every major economic and financial crisis has had two main causes. Excessive credit is one, and excessive optimism is the other. Both exist in unusual abundance in the United States today.

Available liquidity is, of course, most important. Nevertheless, we find it most important to distinguish, first of all, between two different sources of liquidity: borrowed and earned liquidity. Present excess liquidity in the United States and several other countries is of a peculiar kind.

It does not come, as would be normal, from unspent current income – in other words, from saving. In the absence of any new savings, all the liquidity creation occurring in the United States is borrowed liquidity, generally borrowed against rising asset prices, in diametric contrast to earned liquidity from savings out of current income. By definition, this is liquidity from credit inflation.

One thing is certain about borrowed liquidity: It depends on rising asset prices. Once asset prices stop increasing (see current U.S. house prices), this “liquidity” suddenly evaporates. Moreover, ever larger credit injections are needed to keep asset inflation – like any other inflation – rising. Nevertheless, there inevitably comes a point at which asset prices for some reason or another refuse to rise further, and then the big selling without buyers begins. There has never before in history been an exception from this disastrous end of asset inflation.

Well, this counts for the long run. Unfortunately, it is never possible to predict when this starts. The U.S. economy, in particular its financial system, has proved to have a superior ability to drive financial leverage to unimaginable excess. However, this has required rapidly increasing accommodation by foreign central banks. In Germany or France, such asset and credit bubbles would have burst long ago. Then again, they would not have been possible in the first place.

The other day, we read with great awe in the Financial Times about the finances of a hedge fund, Citadel. It had paid more than $5.5 billion in interest, fees and other costs last year. This compared with a net asset value of only about $13 billion and gross assets of $166 billion at the end of August 2006, implying a leverage of 12.5 times. Costs are sky-high because its managers trade frequently and operate with huge leverage.

This pattern is most probably typical of the numerous existing hedge funds. Mr. Greenspan has repeatedly hailed that hedge funds, with their large turnover, improve the efficiency and the liquidity of the markets. This was certainly also true of Long-Term Capital Management before it burst. That a central banker uses these two criteria is utterly strange. His main concern about markets should definitely be that financial assets are properly priced in line with available savings.

It should be clear that the heavily leveraged asset purchases by hedge funds grossly distort asset pricing in the United States, among which the resulting artificially low long-term rates play the greatest role. A few years ago, Mr. Greenspan wondered publicly about the “conundrum” that U.S. long-term interest rates were falling while he was raising short-term rates. There never was a secret about the source of this “conundrum”: persistent large bond purchases by foreign central banks, and, in addition, heavily leveraged bond purchases by hedge funds and financial institutions, funded by low-yielding currencies, above all yen carry trade.

Still, all this leaves us with the question of whether this system is sustainable forever. Our answer is a categorical no. As emphasized earlier, the decisive condition for a credit-driven asset bubble is the sustained expectation of rising asset prices, and this is flatly impossible. There inevitably comes a point at which even the wildest expectations are met and new asset purchases abate or cease.

Take the case of 10-year U.S. Treasury notes. They have declined to 4.55%, from 5.25% at their high for the year, on June 28. Including the capital gain, this gave investors in the period a return of 7.5%. From this yield, the leveraged speculators have to deduct their interest expenses. In the case of yen carry trade, they were minimal. But even when financed at an annual rate of 5.25% in dollars, this was highly lucrative when leveraged 10 times or more.

The obviously critical question here is when the speculators will liquidate their positions because they think that the interest rates of 10-year Treasury notes have hit their lowest possible point. We have no idea where that point is, but we know that it exists somewhere. Moreover, there is the looming risk of a falling dollar. A sharp slowdown of the U.S. economy, or even recession, would certainly trigger such a fall, as happened in 2003-04.

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.