Hydrocarbon Man

Just because the US Army has pitched its tents in the Iraqi oil fields, that doesn’t mean that Iraqi oil will soon be flooding world markets or the price of oil is heading to $12 a barrel. Quite the contrary.

Indeed, one of the biggest post-war surprises is that the oil price has jumped back over $30 a barrel. I can’t say we’re surprised. We have stated repeatedly that the bull market in oil has little to do with Iraq specifically. Although, the politically volatile Middle Easy certainly plays a big role in the oil price trend.

Removing Saddam Hussein from power doesn’t change the fundamental fact that the world is drawing down its oil reserves at a record pace. Nor does it change the fact that politically volatile Middle East nations continue to control the lion’s share of the world’s oil supplies. Since most of the rest of the world is rapidly depleting its domestic supplies of oil, the world has become more dependent than ever on Mid East oil. Forward-looking investors should be looking to invest in oil and gas companies with substantial North American reserves.

World Petroleum Demand: Maximum Production

To predict what will happen to the world’s oil supply, you need only look at a single oil field. Whether you are talking about Prudhoe Bay in Alaska or Leduc in Alberta, maximum production of a given field is achieved some years after initial discovery as the field continues to be developed with additional step-out wells. But, after half the recoverable reserves have been pumped from a field, there is a rapid decline in the field’s oil reservoir. It becomes less and less economical to pump oil from the field until a breakeven point is reached – a point where the expense of operating the oil field equals the revenues produced by the field.

The physics that apply to a single field also apply to a region or an entire country. Consider the continental United States. The rate at which new oil was discovered hit its peak in 1957. By the early 1960s, the nation’s total proven reserves reached its all-time high. Less than a decade later, U.S. production peaked. Production was relatively stable until the mid-1980s and then began to fall precipitously.

Year after year the Americans have made up the shortfall in oil production by importing foreign crude. But what happens when the world’s output begins to fall?

Unless we find oil on Mars, there will be no outside source to make up for dwindling production. It will be then that the price impact of dwindling supplies will meet surging demand – a formula for incredible profits in oil and gas stocks.

World Petroleum Demand: Ineffectual Wildcatting

Global oil reserves have not increased since 1990. In fact, over the past four decades, wildcatting has yielded fewer results. In the 1960s, the industry discovered 375 billion barrels. In the ’70s, 275 billion barrels and in the ’80s, 150 billion barrels were discovered. Fewer barrels yet were discovered during the 1990s.

At one time, the world was blessed with somewhere between 1.8 trillion and 2 trillion barrels of oil. But beginning with the first flowing oil well in April 1861, that endowment has been consumed. By the end of 2002, humankind had pumped and burned about 900 billion barrels of oil, or about half of the total amount of oil the world has to offer.

Perhaps this year – and certainly no later than 2005 – world production will hit its apex. That means that over the second half of this decade world oil output will begin to decline – just as global oil demand is surging.

Each year the world pumps and burns 26 billion barrels of this non-renewable resource. That means that every four years, more than 100 billion barrels of oil-five times the total reserves of the United States-are consumed.

But world demand for petroleum is expected to soar by 56 percent, or 43 million barrels per day (bpd), over the next two decades due mostly to strong demand for transportation fuels. According to the International Energy Agency, global oil demand would jump to 119.6 million mb/d in 2020 from its current level of 77 million mb/d. But even today, oil is being burnt at a torrid rate.

World Petroleum Demand: Hydrocarbon Society

The implications are serious for what Daniel Yergin calls a “Hydrocarbon Society.” Despite the advent of the microchip and explosion of the Internet, petroleum is the primary economic engine powering the world. And even as world oil output peaks and then tapers, there is little evidence that the necessity of oil, and the demand for it, will wane.

“Hydrocarbon Man shows little inclination to give up his cars, his suburban home, and what he takes to be not only the conveniences but the essentials of his way of life,” wrote Yergin in his best seller, The Prize. “The people of the developing world give no inclination that they want to deny themselves the benefits of an oil-powered economy, whatever the environmental questions. And any notion of scaling back the world consumption of oil will be influenced by the extraordinary population growth ahead.”

Of course, not all oil-producing nations will experience a reduction in output at the same time. As I mentioned, in the United States production began to fall in the 1970s. Mexico and North Sea production are now in decline, and few expect a major discovery in those regions.

The only other major non-OPEC oil region is Russia. But new oil discoveries in the former Soviet Union have been in decline since the late 1980s. The expectation by most oil executives is that we are on the verge of declining Russian oil production.

World Petroleum Demand: More Power to OPEC

With reserves of around 650 billion barrels, the Middle East is the only major oil-producing region in the world that is not yet close to its oil reserve half-life.

Until recently it has been oil production from non-OPEC countries that has kept oil prices in check. But as production in these regions enter into decline, more power falls to OPEC, particularly Arab OPEC.

In 1988, Saudi Arabia was happy with an OPEC benchmark price of $20 a barrel. But given the falling value of the dollar as measured by the CPI, it takes $31 to buy the same amount of goods and services that $20 bought in 1988. So even if Mid East OPEC would accept the kind of pricing policy that the Saudi’s implemented 15 years ago, they would insist on $11 more a barrel to keep pace.

Trouble is, Mid East OPEC wants nothing to do with the conservative pricing that the Saudis instituted in the late 1980s. Here’s why: Most Mid East nations expect maximum oil production to happen within a decade. Under such a timetable – they want to maximize short-term revenues. That means a more aggressive OPEC pricing policy.

Fifteen years ago, world crude demand had slowed to a crawl. At the same time, millions of barrels a day were being harvested from the Soviet Union and the North Sea. Saudi Arabia understood that if it set OPEC prices too high, the cartel was certain to lose market share.

Not much chance this will happen today. World oil demand is growing by more than 2 percent annually. The only region rich enough in oil to satisfy this demand is the Middle East.

In the 1980s, Saudi Arabia was getting arms and financial assistance from the United States. In turn, the Saudis exercised their influence to keep oil prices affordable. Following the War on Iraq, that type of goodwill towards the United States no longer exists in the Middle East, or even in Saudi Arabia.

Rather than making life easy for the United States, most of Arab OPEC would like to see things get more difficult… and that means higher oil prices.

Sincerely,

John Myers,
for The Daily Reckoning
April 23, 2003

P.S. The bottom line is we could see another three or even five dollar correction in crude prices. But low oil prices are not part of the future. In fact, I am as convinced as ever that we are headed past $50 a barrel oil by 2006. My advice: don’t buy any gas-guzzling SUVs. Do buy oil stocks with significant domestic production.

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It is all behind us now.

The war…the hard feelings…the bear market — all is forgiven.

The American proconsul arrived in Baghdad, proclaiming his coming as a great day for Iraq. (Really…we read it in the paper.) The Iraqis are going back to whatever it is that they do. The stock market is rising. And now, in the spirit of letting bye-gones, be bye-gones, George Bush has given Alan Greenspan a slap on the back, letting the world know that as long as the Fed chairman keeps the money flowing, he can stay on the job until he drops dead.

The Fed chairman resisted Bush’s tax cuts the way he first resisted the stock market bubble. “Irrational exuberance,” he called the bubble. We can’t remember what he said about the tax cuts, but whatever it was, it sounded like he neither expected nor wanted to be re-appointed Fed chairman.

But the Fed chairman is nothing if not a get-along, go-along kind of guy. And he seems ready to go along with almost anything.

The problem with the tax cuts is that the federal government is already running deficits of somewhere between $1.2 trillion and $4.5 trillion over the next 10 years. And the tax cuts make them even worse.

One of America’s structural economic problems is that it doesn’t save enough money so it has to rely on foreign lenders for capital. Despite the rising personal savings rate — recently running at 4% per year — the federal government has moved from surplus to deficit, taking the net national savings rate down to an all-time low of 1.3%. Even throughout the devil-may-care ’90s, the rate averaged about 5%.

So now, the U.S. relies on overseas lenders as never before…and is exposed to a sudden decline in its standard of living — if the foreigners ever decide to stop accepting its little green I.O.Us.

Gold rose again yesterday. The dollar fell. The Australian and Canadian dollars both hit 3-year highs. The euro continues to gain ground too; it’s now above $1.09. The euro’s great strength is that its backers can’t agree on a foreign policy…so it has no military adventures to support. And Europe, as a whole, is a net lender of capital, not a net consumer, like the U.S.

But Alan Greenspan has once again decided that no matter what is best for the nation, it is best for Alan Greenspan to look the other way.

And here’s Eric, with more news from Wall Street:

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Eric Fry in New York…

– The Dow Jones Industrial Average soared 156 points yesterday to 8,485, while the Nasdaq gained nearly 2% to 1,451. Sparking the market’s advance was the news that President Bush would like to keep Alan Greenspan on the job for another term. If Bush has his way, Greenspan will continue to head up the Federal Reserve until death – or a dollar crisis — do us part.

– The 77-year old Greenspan originally took office as chairman on Aug. 11, 1987. His current four-year term runs through June 20, 2004. More than any other government bureaucrat, Greenspan personifies the bubble-era bull market in stocks. He nurtured it and applauded it as the natural outgrowth of our “productivity miracle.” Incredibly, the fact that the productivity miracle turned out to be a fraud has not diminished the chairman’s popularity or esteem…or self- image. If the bubble is to be successfully re-inflated, there is probably no one better suited to the job.

– But what if share prices don’t re-inflate? What if expensive stocks don’t become even more expensive? What then?

– The more that one considers what to do with one’s investment capital, the more that one might be inclined to do nothing at all. 2000 years ago, Jesus heaped scorn upon the metaphorical servant who “buried his talents” in the ground. But we suspect that if Jesus were preaching on the corner of Wall and Broad today, he’d praise SELECTIVE talent-burying, or at least not frown upon it. Like Warren Buffet, he might praise the virtue of inactivity at certain times and in certain market environments.

– Today’s investor faces the triple terror of a richly priced post-bubble stock market, a bubble-like bond market and a bubble-like housing market.

– “Once you get to below 4% on the 10-year note, and you’ve got the beginning of a bull market in government – explicitly aimed at reflation – you ain’t going to get double-digit returns in bonds,” says PIMCO’s Paul McCulley. And it’s true, the current custodians of the US dollar are promising to print as many as necessary to reflate the economy.

– “Because modern central banks date from the 17th century,” says James Grant, “virtually every monetary policy has been tried before, many more than once. Inflation has been given an especially thorough test run.”

– A central bank that promises reflation is like a spouse that promises infidelity…The promise is a guarantee. And that guarantee is trouble for bondholders, as Grant illustrates: “We should try to imagine ourselves in the shoes of a foreign holder of the 10-year Treasury…We have rubbed our eyes and performed a calculation. If the 10-year rallied to yield 2.5%, the implied 150 basis-point rally from the now-prevailing 4% would deliver a 13-point price rise in our holdings. We are, provisionally, delighted. But the dollar is not our native currency. We decided it is the part of prudence to sell some dollars to hedge our exposure. And we’re not alone. Many other people reach the same decision. The selling snowballs and the dollar exchange rate slips. The gold price shoots up. Interest rates not under the thumb of the Fed begin to lift (as do prices of imported merchandise, reflecting, after a short lag, the weakened dollar exchange rate). All at once, a latent deflationary crisis becomes an actual inflationary crisis.”

– Very well, if inflation is resurgent, shouldn’t real estate provide a kind of safe haven? Indeed, it may prove to be exactly that, assuming inflation flourishes like a bamboo grove. Even so, the housing-bubble contingent is not without legitimate cause for concern.

– Merrill Lynch economist David Rosenberg notes that “residential real estate has quickly become the asset class of choice,” making up 31% of household assets versus 23% three years ago. (Of course, the big jump has as much to do with falling stock values as with rising home values.) If home prices hold steady or appreciate, no harm, no foul. But Rosenberg estimates that a 10% drop in home prices would shave about $1.4 trillion from household net worth, or roughly 20% of disposable income…and that WOULD be a problem!

– Furthermore, as Alan Abelson reports in this week’s Barron’s, Rosenberg sees a number of red flags. Namely: “Inventories of unsold homes are rising quickly and, measured in months, are now at their highest level since December 1996; The median number of months a home has been on the market has jumped to 4.8, from 3.8 last fall and the highest in nearly a year; New home sales have fallen sharply since the start of the year and are growing at the slowest run rate since August 2000.”

– Hmmm…maybe it’s time to get out the shovel and start digging a hole for your talents!

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Bill Bonner back in Paris…

*** EBay sells for 81 times earnings. TheStreet.com calculates that earnings would have to rise 40% per year for the next 5 years to justify the price. How likely is that?

*** From Denver comes news that the housing boom may be blowing up — at least in the Rockies. Apartment vacancy rates are over 10% — the worst figure since the ’80s housing bust in Denver.

*** The sun has been shining for weeks with scarcely a let- up. It has been so eerie, so unnatural…and so hard for us to maintain our normal gloomy vigil when the weather has been so nice. But now, we have found the cloud in all this silver lining. Yesterday’s paper told us that Europe is as dry as a Texas teetotaler. Drought and late frost threaten this year’s wine and tree-fruit crops.

*** “Well, why don’t you just admit you were wrong? The war went fast…the victory was relatively easy…and now the threat has been removed…what is the matter with you people, anyway?”

The above comment amalgamates those of hundreds of Daily Reckoning readers who have written with questions, insults, and kvetches. And more insults. We write today not to apologize to them…but in keeping with the mood of post-war healing, we write to thank them. Despite serious questions about our loyalty or our sanity, during this wartime period, they have kept reading.

Here at the Daily Reckoning headquarters in Paris, we are glad the war is over….and glad that it ended with so few casualties. But we still wonder if it was worth a single life. And maybe we are just born worryworts…or maybe it’s from reading too much military history….but we note that people learn less from victory than from defeat….and the gods of war rarely grant an army or an investor a swift, easy victory…unless they intend to destroy them later.