Paper Money and Energy Demand, Part 2

In Part 1 of this essay, I explored the question of whether an energy market built upon a foundation of fiat currency can ever really be free. In modern popular democracies, an economy’s energy consumption is no longer limited by its ability to produce and export the world’s most highly valued goods and services. Rather, it depends first and foremost on the paper currency of the realm. How else can one explain the U.S. privilege of reaching per capita oil consumption rates that are 10 or 20 times greater than that of the rest of the world’s population?

Having one of the most competitive, flexible economies in the world certainly helps, but productivity measurements are highly subjective and this cannot fully account for the enormous discrepancy in oil consumption. Since the end of World War II, the U.S. dollar has been the dominant global currency. But the perception that the dollar is a stable store of value is waning. This has important implications for the future prices of oil, gold, and other valuable natural resources.

An inflection point will eventually be reached where the international demand for dollars plummets. If demand for dollars falls hard enough, a temporary bout of hyperinflation may ensue. Under this scenario, dollars would exit fixed income investments and bid up the price of anything tangible — particularly anything in short supply. Suppliers would remove inventory from shelves, choosing to hoard scarce resources, rather than trade them for rapidly depreciating dollars. This will likely characterize the Saudi royal family’s behavior post-Peak Oil.

The Inflationary Endgame

Inflation — defined as excess money printing — feels good to almost everyone in its early stages. Everyone in this new “ownership society” comes to believe they are getting rich by trading stocks and houses with each other. Academic economists eventually develop entire new branches of research dedicated to the idea that saving, investing, and producing no longer matter as long as stock and housing assets can be traded in unencumbered markets (and the multiplier effects of spending capital gains trickle down to the working class through the “service economy”).

Then comes the big surprise when demographic waves reverse the asset inflation tide — a mass retirement rebalancing process shifts demand toward bonds and smaller abodes. Must a deflationary bust of similar severity and duration correct an irrational boom? According to the Austrian School of economists, the answer is yes, but according to Fed Chairman Ben Bernanke and nearly every other policymaker, the answer is no. The Fed has unlimited power to nip a deflationary spiral in the bud, and it will not hesitate. You can almost sense in the new Fed chairman the desire to don a cape and come to the economy’s rescue against the evil forces of, in his words, “an unwelcome fall in inflation.”

This puts foreign dollar holders — most of them central banks — on the spot. The Chinese leadership in particular must decide between two choices: 1) stoically fund the massive upcoming housing bailout and suffer an enormous erosion in the value of their dollar holdings (and in the process keep their export-oriented economies humming) or 2) try to “beat the rush” and be first in line to sell Treasury bonds, using the proceeds to secure the strategic resources demanded by their people. While the second choice involves the consequences of cutting off credit to the No. 1 customer of the Chinese economy, it makes the most sense in a post-Peak Oil global economy.

The timing of Peak Oil will be the greatest factor in determining when this unsustainable international vendor-financing scheme ends. Many mainstream economists argue that the Chinese must keep financing the U.S. trade and budget deficits in order to maintain a large enough customer base for their export economy.

But this virtually ignores the fact that oil is priced in U.S. dollars internationally and further oil price increases represent direct devaluation of Chinese dollar reserves. To assume that the Chinese will just sit on these Treasury bond losses and not act to secure the oil that their economy will need is too optimistic. Dollars will simply be too plentiful and tradable oil will simply be too scarce — even central planners can anticipate this and react by selling what will be plentiful and buying what will be scarce.

This will characterize the ending stages of a multidecade U.S. dollar inflation cycle:

Newly printed money trickles down into physical goods and services — potentially reaching the flood stage if “inflationary psychology” takes root. The goods and services that had received very little investment during the asset inflation party will be bid up the furthest in price. (Energy and base metals? Geologist wages?)

I believe that the widespread recognition of Peak Oil will mark the early stages of a mass exodus out of paper dollars and Treasury bonds. The parabolic move preceding the most recent intermediate-term 2006 peak will be looked back upon as a “mid-cycle slowdown” in the energy bull market. The timing of these occurrences is difficult to nail down, but if the status quo is maintained, it will likely transpire within 10 years.

The Reaction of Energy Suppliers to Dollar Erosion

If the demand side of the oil market can be artificially inflated by fiat currency, the supply side can certainly be impacted by the recognition that the intrinsic value of fiat currency is little more than zero (since it only retains its value as long as it is perceived as scarce). Place yourself in the shoes of a Saudi or Russian oil minister. Why trade your increasingly scarce oil for a limitless future stream of paper money? This paper money only has value to the extent that it can buy scarce goods and services.

If the global paper money supply is mathematically guaranteed to grow faster than the supply of goods and services, it sure seems like a bad idea to keep adding to one of the world’s largest U.S. Treasury bond portfolios. Perhaps the Saudis will continue recycling petrodollars back into Treasury bonds, but with the precaution of diversifying into gold as a portfolio hedge. Yet this may not be practical, since diversifying even the smallest fraction of a trillion-dollar Treasury bond portfolio into the tiny gold market is enough to send bullion to stratospheric prices.

This is a geologic fact: The most prolific Saudi oil reservoirs, which have produced enormous quantities of oil for generations, will eventually peak. The matter open for debate is when the peak will occur and whether production from new reservoirs can ramp up in time to offset declines. At some point, the Saudis will admit that they cannot reach their long-term production goals, due to uncontrollable decline rates in mature reservoirs.

The Chinese Communist leadership is not sitting around debating the timing of Peak Oil. They are being proactive, recognizing that the cost of acting early matters far less than the consequences of doing nothing. This is evident in their aggressive push to secure future energy supplies that their nascent consumer economy will need in order to mature into a more balanced, self-sustaining one. While the Chinese must continue recycling a fair amount of their export earnings into the Treasury market, they clearly have higher long-term priorities than financing a spendthrift U.S. federal government.

Interesting comparisons can be made between the incentives and strategies of private exploration and production (E&P) companies and E&P companies that are majority-owned by a government. PetroChina (PTR) and Petrobras (PBR) are two prominent companies from the latter category that are aggressively growing their reserve bases.

These companies must strike a delicate balance between free market incentives and government-mandated initiatives. So they present investors with unique opportunities and risks. Since the governments of China and Brazil are the majority owners of these companies, will they be strong-armed into profitless overexpansion or be subject to “windfall profits” taxes?

PetroChina: A Quasi-Private Enterprise

PetroChina is a major, fully integrated oil company operating across the entire chain of production. At year-end 2005, the company had independently audited proved reserves of approximately 11.5 billion barrels of crude oil and 48.1 trillion cubic feet of natural gas. Counting the gas reserves as oil on a Btu-equivalent basis (6,000 cubic feet of natural gas = 1 barrel of oil) yields 19.5 billion barrels of oil equivalent (BOE), placing the company well above ExxonMobil in size (see chart). PetroChina also owns 25 refineries, thousands of service stations, and a large pipeline network:

While PetroChina may have enormous scale advantages due to its dominant position in the Chinese retail energy market, it has the challenge of managing the production decline underway at Daqing, one of the older super-giant oil fields in the world. This field began producing oil in the early 1960s and produced at a rate of 915,000 barrels per day in 2005, well below its peak level. It accounts for 38% of PetroChina’s proved oil reserves and will grow gradually more expensive to maintain. Sophisticated investments, including “artificial lift” and reservoir pressure maintenance, can greatly decrease the return on invested capital at the Daqing operations:

PetroChina has 247,000 employees in its E&P division alone, so there is undoubtedly political pressure to not abandon older fields that a 100% private company would otherwise deem “uneconomic.”

PetroChina shareholders have another reason to be concerned: the refining segment of the business. In August, the company announced impressive first-half earnings. But the report included a few discouraging details. According to the AP:

“The strong first-half earnings came despite a 10.3 billion yuan ($1.3 billion) windfall profits tax the company paid due to high crude oil prices.

“China imposed the tax of 20-40% on domestic sales of oil priced above $40 a barrel in China by companies with both onshore and offshore oil operations.

“PetroChina reported a first-half operating loss for its refining and marketing segment of 13.89 billion yuan ($1.74 billion) because of government controls on domestic oil product prices, compared with a loss of 5.95 billion yuan ($746.5 million) in the first half of 2005.”

The company may continue its impressive reserve and production growth, but there is clearly a cap on how much profit margin the Chinese government will allow in the refining business. In my view, investors should follow PetroChina for its strategy in pursuing reserves, not for its potential as an investment.

At the same time, the Chinese realize that the country’s future oil needs can only be met through expanding imports; through its controlling ownership positions, the government will continue pressuring PetroChina, Sinopec (SNP), and CNOOC Ltd. (CEO) to remain as aggressive as possible in acquiring foreign reserves. Using the tax code and regulations to make exploration and production more attractive than refining can clearly add to the pressure that originates from the government end of the boardroom table.

Oil Must Be Imported Into China to Fill the Gap

According to the latest SEC filings, China National Petroleum Corp. (CNPC) holds an 88% ownership interest in PetroChina. CNPC is essentially the “Energy Department” of the Chinese government, but in addition to its regulatory role, it is the parent company of the entire Chinese energy complex. Its Web site details how CNPC has evolved from a centrally planned government organization to one that is exposed to, and promotes, market forces.

Through its influence over PetroChina, the government pushed management to be aggressive in replacing reserves and growing production. This includes last year’s $2.7 billion acquisition of a 67% share in PetroKazakhstan, capping a six-year run of replacing over 150% of production.

This impressive feat is being accomplished with the advantage of acting without regard for international humanitarian concerns; the Chinese government has not hesitated in striking deals with controversial leaders in order to secure energy resources. Management has announced that PetroChina’s reserve-replacement ratio will be over 100% in oil and over 300% in natural gas over 2006-2009.

This contrasts with ExxonMobil, whose management team has consistently maintained a belief that speculation and geopolitics, not long-term fundamentals, are driving energy prices. Only once over the past six years has Exxon’s reserve additions surpassed even 50% of production:

China’s net imports will continue growing at a high rate, as consumption growth far outpaces local production growth. Government leaders are likely to extend China’s ownership position in reserves spanning the globe. According to the EIA, imports from Chinese-owned oil company assets abroad accounted for only about 9% of total imports in 2005. This should prompt the country to develop even closer investment ties to its key trading partners in the Middle East and Africa:

The development of a Chinese strategic petroleum reserve (SPR) over the next several years is currently under way and is expected to ultimately provide at least a 30-day supply (about 200 million barrels at the current consumption rate of 7 mbpd). This can easily add 50,000-100,000 barrels per day to global oil demand over the next several years, making an already tight market even tighter:

State-Controlled Companies Provide Growth, But Profits Are What Ultimately Matter

Market sentiment toward PetroChina and Petrobras has improved considerably. Long, stable reserve lives and impressive reserve replacement records are the characteristics valued by professional energy investors.

As recently as five years ago, the investment community was not very sure that these majority government-owned companies would be run as private enterprises. But the performance of these stocks relative to industry bellwether ExxonMobil reflects optimism about their continued growth and profitability. It also reflects the fact that the market rewards companies with high reserve-replacement ratios, not companies like Exxon or BP, which risk becoming viewed more as bonds than stocks:

Would I recommend PetroChina or Petrobras as investments?

I think that at their current prices, the potential returns do not quite compensate investors for the risks — the foremost among them being a radical change in the policies of their respective governments. But I do expect both state-owned companies to continue outperforming ExxonMobil over the next five years.

Exxon’s poor reserve replacement performance reflects its executives’ belief that oil and gas reserves will remain easy and cheap to find and develop. They are making a big gamble that sub-$40 prices will return and remain in place for years. If they are wrong, they will be stuck in fourth, fifth, or sixth place in the race to develop the most promising future international producing basins. Decades ago, national oil companies and developing countries relied on companies like Exxon for their capital, expertise, and technology. But capital scarcity is no longer an issue in their thriving export-oriented economies, and they can now gain technology and expertise from the major oil service and drilling companies.

There are plenty of cheap, privately owned E&P companies with reserves in politically stable countries. If you are looking to take advantage of the panicked flight of hot-money traders out of the energy complex, now is the time to identify those companies that are investing for further growth in long-term energy demand.

In Part 3 of this essay, I will examine how the growth plans of Petrobras are balanced between the priorities of the Brazilian government (its majority owner) and its pursuit of profit.

Good investing,

Dan Amoss, CFA
October 9, 2006