Last Dance for Oil?

The price of oil just keeps hitting new all-time highs…and it doesn’t look like the price is going to drop to previous levels anytime soon (or possibly ever). The oil story is no longer U.S.-centric – and that opens up a realm of new opportunities for investors. Chris Mayer explains…

Has oil hit its peak price or not? The answer to that question leads us to ask whether or not commodities are a bubble about to burst. Barron’s recent cover story on commodities came down on the side that the party was over.

I don’t put a lot of faith in macro predictions – as no one can predict the future. But you can study track records. You can look at history. History reveals some interesting clues about what the future may hold.

The quick take? It doesn’t look like the party is over just yet. But even if it is, past peaks in oil give us clues. When you dig a little deeper into those relationships, you find a great road map for making money.

If you look at the price of oil, you find something interesting. Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply, as this next chart shows:

Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.

The other thing to remember – and people forget this by worrying excessively about a U.S. recession – is that the story of oil is no longer a U.S.-centric story. You’ve surely heard about how the rapid growth in China and other emerging markets drives oil demand. Well, it’s good to keep that in mind.

China and India are only beginning to consume oil at any meaningful level. Right now, they are consuming oil at a rate the U.S. did in the early years of the 20th century. But look, we don’t need China to start guzzling oil like we do. Even if it moves half the distance between it and Hong Kong, that’s a lot of extra demand. The way I look at it is this: What’s more likely, China stays at 1910 oil usage or moves somewhere closer to, say, 1950s U.S. oil usage? I think the latter.

Mark Mobius, in a column he wrote for the Financial Times, points out that the fundamentals in emerging markets are better than they’ve been in a long time. The future looks bright. “The Chinese and Indian consumers are the world’s new consumers and they, along with consumers in Brazil, Russia, Turkey, the United Arab Emirates, Egypt, Mexico, Poland and many other emerging markets, are becoming an important force in global markets.”

All that bodes well for oil demand. But I haven’t really gotten to the best parts yet…

Even if oil has already peaked, that doesn’t mean oil is headed back to $40 per barrel or lower. In fact, if this oil boom follows history at all, we’re looking at years of oil prices right around $100 per barrel.

It is important to realize that in no prior oil boom did the price of oil retreat rapidly toward where it was before the boom began. In each case, the price of oil stayed up for years after the peak. That ought to give you some comfort about our current situation. The price of oil should stay up here for years. If his estimate of 2013 is at all close, we’ve got plenty of time left to make a lot of money.

So where do you go to make that money?

The one obvious place people will automatically look to is to own oil and gas producers. That’s not a bad idea at all. But I’ve got another angle here. The next two charts are amazing. They show you the capital and exploration spending of both Exxon (NYSE:XOM) and Chevron (NYSE:CVX) from 1928-2007. They show spending bottoms in 1948 and 1974. After each bottom, there was a long run of spending. Spending peaked nine years after 1948. Spending peaked seven years after 1974. If 2005 proves to be the bottom on capital spending – and it seems so, since Exxon only recently announced it would increase its capital spending to $25-30 billion over the next few years, a 25% increase -we won’t see capital spending peak until 2012 at the earliest.

Now, why is this important? Think about what the oil companies spend money on. Where do they go shopping? They go shopping at the oil field services and equipment companies.

So that is where we want to be. Because even if oil has peaked, we’re still looking at years of strong spending by the oil companies. You want to have some exposure to the receiving end of all that spending. Such companies will mint cash. And they give you a little different payoff than owning a straight producer. It can sometimes be better to own the picks and shovels. You don’t actually own or produce the oil or gas, but your equipment is vital to those that do.

Newmont Mining, the big gold producer, is an example of a producer that has profoundly disappointed investors amid what may be the greatest gold bull market in history. Newmont’s costs rose so fast and so much that it never really enjoyed (at least not so far) the higher price in gold. But if you were in some mining equipment manufacturer, you got paid.

So the key takeaways here are these: The price of oil has room to run yet, in part because of the growth in money supply and in part because of pressing international demand. Secondly, even if we already saw oil peak, history says that prices won’t retreat by much over the next several years. And finally, the capital spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies.

The big idea here is well servicing…

It’s really a great and kind of sneaky way to play an undeniable trend in oil and gas: the depletion of older wells past their peak production. Well servicing helps you get a little extra out of every well. A well service rig is the workhorse that does the well servicing.

Here’s the life cycle of a typical oil well…

Every time somebody drills a well, it creates an annuity for the well service industry. That’s because the maintenance work follows the life span of a typical well. If you don’t service your well, your production rate declines much more rapidly. So if you want to stay in business, you keep servicing your existing wells. You may not drill new ones, but you keep what you have.

The second key to remember is this: The more mature the oil or gas field, the more well servicing work needed. Well servicing doesn’t typically have the same ups and downs as exploration. Well service fleets provide much more durable and predictable cash flows. I expect all that money the big majors spend on exploration will lead to a lot of new drills and a long tail of new business for well servicing companies.


Chris Mayer
for The Daily Reckoning

May 21, 2008

P.S. The company I’m recommending is the largest well servicing company in North America. Don’t dismiss North America. There are plenty of hot zones with plenty of drilling..

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.

We are sitting here this morning, in our office, looking at a fat woman – stark naked – sleeping on a couch.

Of course, how rich people spend their money has always been a source of interest and entertainment. That an apparently sane and sensible man like Roman Abramovich spent $33,641,000 for the painting of the “Benefits Supervisor Sleeping,” must also be a comfort to the poor. At least, they don’t have to look at it.

But the world of money is a world of wonder…today, as everyday. We could begin today’s reckoning wondering why the rich are so eager to part with their money, for example…or why the poor are so eager to have it; they can see that it clearly impairs one’s judgment and degrades one’s tastes.

Instead, we will wonder why those who constantly praise the virtues of capitalism seem to have so little faith in it.

What brings this wonder to mind is the latest legislation to clear the Senate Finance Committee. Congress is preparing to improve the way capitalism functions, by authorizing the Federal Housing Administration (itself an improvement of an earlier Congress) to insure $300 billion worth of home mortgages. Up until now, federal housing agencies could work all sorts of mischief; you could argue that without the implicit guarantees of Fannie Mae and Freddie Mac, or the explicit efforts of these quasi-public companies to create a huge market for derivatives based on mortgage finance, the whole housing bubble would never have occurred in the first place. Now – if this legislation becomes law, that is – new mischief is about to appear on the scene. The FHA will be empowered to help patch up America’s housing bubble.

The goal, said Senator Chris Dodd, is to keep people in their homes. He did not mention that these are the same homes whose owners demonstrably cannot afford them. Nor was he especially concerned that his meddling with the corrective machinery of capitalism was likely to throw a monkey wrench into the gears. Instead, like God on the 6th day of creation, he looked upon his handiwork and thought it was pretty good.

Everyone is perfectly happy to let capitalism do its stuff – as long as they like the results. But cometh a correction and all of a sudden the press is full of whining pundits and meddling politicians. Every correction brings forth new improvements until there are so many of them the system collapses under the weight. That why we have revolutions and bankruptcies, after all, to blow away the accumulated impediments.

And that is why the emerging markets have such an advantage. In many ways, people swing their arms and their hammers more freely in, say, Russia or China than they do in the United States of America or Britain – simply because there is nothing to stop them. These countries have already had their moments of violent desperation…their bankruptcies…and their revolutions. Both tossed out their entire economic systems in the late ’80s and early ’90s. They’ve been rebuilding – fast – ever since. The leeches haven’t had a chance to get their suckers attached.

America’s war against Iraq had its roots in many improving impulses. According to John McCain and Alan Greenspan, however, the taproot sank into Iraq’s oil fields; America wanted to secure its access to cheap oil, they say.

Unfortunately, this program – like all government meddling – backfired. The price of oil was only $25 a barrel when the war began in September of 2003. Yesterday, it hit $130 a barrel. And the war itself is expected to cost the nation $1 trillion or more. For all its efforts, the United States secured the most expensive energy in world history. (And then pushed food prices up to their highest levels in modern times too – keep reading…)

China, meanwhile, decided to take the capitalist road. Instead, of using military force to get oil, it simply bought it on the open market. It has sent its agents to secure, peacefully and honestly, long-term contracts for oil and the other natural resources it needs to feed its ravenous economy. Its buying is driving up prices for everything. But what would you expect?

Meanwhile, having completely failed in the Mideast, America’s improvers turned to the Midwest. Yes, dear reader, if we can’t get oil from the sands of the Gulf and Mesopotamia, we will squeeze it out of our own farmland. At least, that was the promise of the program to subsidize the production of ethanol. Capitalism could not be relied upon to fill America’s energy needs, said the kibitzers.

Capitalism had already pronounced its verdict on corn-based fuel: it was a bad idea. Later, environmentalists came to the same conclusion; it actually caused more damage than petroleum. But the U.S. Congress, in its majestic wisdom, saw something in ethanol that capitalists and environmentalists had missed – campaign contributions and votes!

And so it came to be that a large portion of the U.S. corn crop is diverted into fuel tanks. And so it comes to be that a large number of the world’s people – including Americans themselves – find their food much more expensive than it used to be.

*** In Haiti, people are eating mud.

We’re not making this up. There’s a photo of a miserable woman making mud cakes in Port-au-Prince, in yesterday’s Daily Telegraph newspaper.

For the benefit of readers who wish to cut their food budgets, the Telegraph gives us the recipe: you simply mix clay with salt and vegetable fat and lay it out in the sun to cook – like mud pies. Then, you call them “biscuits.”

Last time we looked, mud was not one of the main food groups recommended by dieticians. But all over the world, poor people have to make do with what they can find. Rice is the staple food in Haiti, and it’s trebled in price in the last year, says the Telegraph. Other grains are not far behind. Since January of 2007, wheat has gone up 200% and corn 150%.

Desperate poor have already rioted in 34 countries this year. The ghost of Thomas Malthus, if he bothers to read the paper, must be saying, “I told you so.” Malthus predicted that population would grow faster than food supplies. Millions of people would starve, he predicted. Now, it looks like he might have been too optimistic. He died in 1834. Since then, a series of happy events and technological developments greatly increased the supply of food…while war and family planning reduced the number of mouths to be fed. Now, it appears that the gains from mechanization, bioengineering, chemistry and land clearing may have reached their limits. We may soon reach “Peak Food”…the point at which the world can produce no more food. But the human population – especially the part of it that doesn’t eat at the Tour d’Argent in Paris – keeps growing. Experts predict that the world’s population will grow by 3 billion people over the next 40 years – a 50% increase. Where will the world get 50% more food? At what price? Who knows…but one thing is sure: there will be plenty of opportunities for the world-improvers to make things worse.

*** Proving us right before we even made our argument, last week, the U.S. Senate approved the latest farm bill by the largest margin since 1973. The bill got widespread, bi-partisan collusion for the very reason that dooms the U.S. economy – it stifles capitalism. There is something in the farm bill for almost every scoundrel and bounder in the country. Poor people get more free food. Rich people get more subsidies. There was talk of restricting the payouts to people with incomes of $200,000 or less…but in the end, the legislation allows people with incomes up to $1.25 million to feed at the public trough. The total cost of the bill is $307 billion over five years – with free money to grain farmers, dairymen, fruit growers, school lunch programs, food stamps, land conservation, rural development, and every other special interest whose lobbyists could suborn and pervert the lawmaking process. There are said to be twice as many lobbyists in Washington than there were 5 years ago; the trough has been extended proportionately.

Did anyone…anywhere…mention that capitalism could be relied upon to sort out the agricultural sector? Did anyone recall that a free market – with prices set by willing producers and consumers – works more efficiently than one that is rigged by lawmakers? Did anyone even notice that the farming industry has been corrupted by government money…or ask where the money would come from to corrupt it even more? Apparently not. Apparently, Americans don’t think they can trust free enterprise to feed them. They think every bid needs to be checked with a bureaucrat and every ask should be cleared by a Senate committee.

But that’s where we are, dear reader, circa 2008…in the greatest show on earth. At every interval the clowns rush in.

Which takes us back to where we began – looking at the naked fat lady on the couch.

This from Fred Sheehan:

“It is said that artists speak for the ages. In 1951, Pablo Picasso described the end of our age when interviewed by Giovanni Papini: ‘From the moment that art ceases to be the nourishment of the best brains, the artist can use all the tricks of the intellectual charlatan. The refined people, the rich ones and the professional layabouts, only want what is sensational or scandalous in modern art. And since the days of cubism I have fed these boys what they wanted and pacified the critics with all the idiotic ideas that went through my head. Whilst I amused myself with all these pranks, I became famous and very rich. I am just a public clown, a fairground barker.’ The quotation is disputed. Whatever he said, Picasso’s reputation suffered no harm when this confession was published.”

Abramovich’s reputation suffered no harm when he laid out more than $33 million for the fat lady – more than had ever been paid for any work by a living artist.

The painting “Benefits Supervisor Sleeping,” was done in 1995. It shows a woman who works for government; her job is handing out money to people who never earned it. The woman is still alive too. She woke up last week and wondered how come she got paid only a few sheckels for posing for such a famous and valuable painting. Looks like she needs a lobbyist.

Until tomorrow,

Bill Bonner
The Daily Reckoning