The End of Oil Security

The Daily Reckoning PRESENTS: Venezuelan President Hugo Chavez recently seized control of Orinoco, the country’s last privately owned oil field, sending ripples through the world economy. Martin Hutchinson explains why this event is of major long-term importance…

THE END OF OIL SECURITY

By seizing control of the Orinoco tar sands, Venezuelan President Hugo Chavez delivered a stunning blow to US oil security. If the world economy worked in the way postulated by the globalizers his action would hardly have mattered, except to the unfortunate shareholders of the affected oil companies. However, the world economy doesn’t work that way, and Chavez’s seizure is thus of major long-term importance.

Orinoco is important, not because of current production from the region, a modest 600,000 barrels per day at a cost of $20 per barrel, economic but well in excess of the cost of Saudi or even Mexican offshore oil, but because of the size of the tar sands deposit. This has been variously estimated at between 1.2 trillion and 1.8 trillion barrels of oil, with higher estimates more recently. At the latter figure Orinoco represents 34% of all known world oil reserves, and 58 years of world oil consumption at current levels.

Since Orinoco’s oil comes in the form of tar sands, extracting petroleum is expensive, and not all the theoretically available petroleum can be extracted. However, current estimates that only around one fifth of these sands can be economically used are probably over-pessimistic; we have only been extracting oil commercially from the Orinoco tar sands and the similar Athabasca tar sands in Canada for less than a decade, so extraction technology can be expected to improve. Over the next couple of decades, production from Orinoco could be ramped up and extraction technology improved, so that the sands could take their rightful place among the world’s truly important sources of energy supply.

Thus if Orinoco and Athabasca were freely available to the world market the extreme “peak oil” theorizers would be wrong; there is enough oil supply for the world’s needs for at least 100 years at current prices. Only a sharp ramp-up in world oil usage or a disruption in the free trade patterns of world oil could prevent the United States and other major world oil users from having enough supply well past 2100. Whether burning all that oil would disrupt the world’s climate is another question (my estimate is: only modestly, provided appropriate precautions were taken) but oil supply as such should not be a problem.

Before Chavez’s action, a free world oil market seemed a reasonable assumption. There were certain rigidities, such as the US refusal to deal with Iran, but Iran is a second tier supplier and there are plenty of other countries willing to deal with it (as there were with Iraq in the days of the infamous “oil for food” program.) The main problem has been the extraordinarily rapid surge in Chinese and to a lesser extent Indian oil demand, which disrupted established market relationships and was bound to strain the system as well as raising oil prices.

In a well ordered market, other participants would have met with China and held open discussions of China’s future needs and the potential sources to satisfy Chinese demand. This would have ensured that China was reassured about the openness of world oil markets to Chinese participation, and might well have led China itself to play by the rules in a value-maximizing way. One way of convincing China that the world market was truly open to it, for example, would have been to allow the Chinese National Oil Company to buy Union Oil of California in 2005, a substantial but strictly second-tier transaction that threatened nobody.

This didn’t happen. Instead the Chinese leadership, having been brought up outside the free market system, naturally don’t expect to play by its rules. Having seen political pressure brought to bear in the US Congress to prevent them buying an oil source on the free market, China has determined to deal primarily with the “bad guys” who violate human rights or are otherwise motivated by hatred of the US and the existing world order. Since in turn Chinese checkbooks have removed any incentive to good behavior for human rights violators with natural resource deposits, human rights abuses have increased, as has anti-Americanism.

However, until now China’s actions weren’t particularly important. Sudan is not a major player in the world’s oil markets, while Iran is only a middle tier player and has other potential buyers in Europe. Human rights may thus suffer because of China’s oil purchases, and US foreign policy has taken a major hit, but the oil market itself has not been significantly affected. Even China’s deal last September to take 500,000 barrels per day from Venezuela, although economically insane because Venezuela has a much closer market in the US, was for a modest amount of oil and could not reasonably have been said to be market-disruptive.

The combination of Chavez’s visceral anti-Americanism with Chinese paranoia, when applied to the Orinoco oil sands is uniquely damaging to the stability of the world’s oil market; it is a marriage truly made in the nether regions as far as the United States is concerned.

If Chavez did not have access to non-US technology, even the simplest of embargoes would prevent him from exploiting Orinoco beyond its current state of development. The natural inefficiency of the state-run petroleum combine Petroleos de Venezuela would cause oil output to decline, particularly in the technologically complex Orinoco projects, while attempts to divert sales away from the United States would reduce Venezuela’s oil revenues. Chavez would run out of money fairly rapidly, and in the next oil price downturn would either be deposed or would return to the United States, cap in hand like Libya’s Muammar Qaddafi. Either way, disruption to the world oil market and to US energy security would be minor and short-lived.

With Chinese help, however, Chavez is in a very different position. Chinese technology is probably not currently state-of-the-art in its ability to extract oil from sands. However China’s ability to backward-engineer technology and the resources it has available to devote to the problem would, with the US facilities already in place, quickly bring a Chinese “technical assistance” crew up to speed. At that point, there would be no further need for Chavez ever to sell another barrel of oil to the United States; he could simply ship Venezuela’s entire output to China.

Again, if the world oil market were truly free in the Adam Smith sense, this would not matter. If China bought its oil from Venezuela, and used its technological abilities to ramp up Venezuelan output, the United States could simply divert its purchases to other sellers. However, in a tight oil market this runs into a problem: in the long term, the major oil suppliers outside Orinoco, Athabasca and Russia are all in the Middle East. As it has shown in the gas market and again with its attempted suspension of deliveries to Estonia, the Russia of Vladimir Putin is a fairly unreliable supplier. In any case Russian oil production is beginning to decline, and is unlikely to be increased sharply while the country is mired in its current corruption.

Thus instead of China being forced to rely on unpleasant and unreliable Sudanese and Iranians for the additional oil it needs, the US consumer will now be subject to the tender mercies of the three major Middle Eastern oil producers, Saudi Arabia, Iraq and Iran. While the US has troops in Iraq, there probably isn’t a problem; Iraq is now believed to have oil reserves of 200 billion barrels, little more than a tenth of Orinoco but still enough to be ramped up to supplement other sources. If and when the US withdraws from Iraq, and that country either collapses into civil war or aligns itself with US-hostile Iran, the US suddenly has a frighteningly large number of economic chips placed on the fragile political stability of Saudi Arabia.

Absent a major world recession, this is a problem that is only going to get worse. The United States currently imports 58% of its oil needs; that percentage is forecast to rise to 68% by 2020. Athabasca will supply some of the excess, but environmental considerations and the difficulty and cost of extraction mean that Athabasca may not be able to be ramped up as quickly as the US would wish – the US Energy Department’s 2006 International Energy Outlook has Athabasca production at only 2.8 million barrels/day in 2030, less than 10% of US consumption in that year. China’s consumption, on the other hand, is expected to have quadrupled by 2030, with the country importing 11 million barrels/day.

If Venezuela were democratic, the United States would not need to worry – Chavez would be out of office at the latest by 2015 or so, as even the impoverished Venezuelan masses wouldn’t elect him indefinitely. If he didn’t have China to help him, an undemocratic but economically incompetent Chavez would also undoubtedly fall from power well before then. However, as Chavez moves towards dictatorship his potential longevity increases – Fidel Castro, after all, has been in office 48 years and counting. In 2030 Chavez will still be only 76, five years younger than Castro is today and with Chinese-derived oil revenues he is very likely to be still in power. The United States, desperate for oil imports, may well by that year be begging Vladimir Putin’s thuggish successors and the revolutionary regime that replaced Saudi Arabia’s monarchy for oil market mercy.

The Iraq war was not about oil. It didn’t need to be; the world oil market under the control of the United States, Japan and the EU was more or less free, so that a hostile Iraqi regime could easily be countered by a partial oil embargo and purchases elsewhere. The next war in which the United States is involved may well be about oil, however, and if the United States seeks to preserve its essential interests by assaulting the largest source of supply, with the most irredeemably hostile regime, Islam will have nothing whatever to do with it.

Regards,

Martin Hutchinson
for The Daily Reckoning
May 17, 2007

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Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) — details can be found on the Web site www.greatconservatives.com

Sotheby’s has just had another record sale. A painting by Mark Rothko went for $72 million.

Somewhere…the gods are laughing.

We observed yesterday that Richard Russell has changed his tune. Now he warbles an almost up-beat melody; the Dow is entering the third and final stage of its great bull market, he says. A top is yet to come.

Russell is one of the great old-timers of the guru trade. He has been interpreting Dow Theory for 40 years.

The theory can be described so simply that it sounds ridiculous:

The stock market runs in big, long trends…it goes up, up and up – until it reaches the top. Then it goes down, down, down – until it reaches the bottom.

In theory, that makes it easy to invest. You just have to identify the primary trend. In practice, you are still stumbling around in the same fog as everyone else, because you can never know for sure which direction the trend is really going or when you have hit the extremes.

We have followed Russell for many years. What we find useful about his analysis is that it emphasizes the long-term trends, which are visible, at least, in retrospect. And it focuses on values. How do you know when stock prices have reached a peak? Just look at the values. Major peaks come when you don’t get much value for your money. At major bottoms, you can buy a share for five to ten times earnings. At major tops, you have to pay much more – three to five times more. At bottoms, it’s not hard to find stocks paying dividend yields of 5%-8%. At tops, you’re lucky to get 2%.

Based on values alone, we judge the U.S. stock market – and the worldwide art market – to be at peaks, or dangerously close to them.

Russell may be right about the exact position of the major trend…and the coming Third Phase…but we will stick to the values.

The trouble with investors, if we may steal a line from a dead man, is that they know the price of everything and the value of nothing. What is the value of a Rothko painting? We don’t have any idea. We just have an opinion. And in our opinion, whoever spent $72 million for it should seek treatment…immediately.

But, at least in the world of real investments, there are numbers to help. We have Return On Investment (ROI) numbers, for instance, to guide us. An investment that gives us a 10% return is a better investment, we figure, than one that gives us only 5%. Since you can’t really know which way the market is going, you shouldn’t count on capital gains.

Even Russell, with his formulae and his long experience, has often been wrong, as anyone who stays in the business is proven wrong sooner or later. It is simply not given to man to know his fate. Look at earnings…or the yield. If you’re lucky enough to get anything more than that, well…bully for you.

Betting on the direction of the market is a mug’s game that violates our most obstinate prejudice, announced in this space as Bonner’s Law:

The quality of information declines by the square of the distance from the source.

When you buy a company – especially one that is next door to you – you can study it in detail and make a fair guess about its earnings. But when you are merely ‘in the market,’ you are nothing more than a patsy for the financial industry. You are buying something you don’t understand from someone you shouldn’t trust. And if you make any money at all, you don’t deserve to.

Chris Mayer adds in his two cents: “You don’t need to invest in ‘exciting,’ flash-in-the pan companies that the rest of Wall Street is buzzing about to make a ton of money. You just need stocks that sweat. You want overlooked stocks that are rich in tangible, physical assets that support the stock price (covering our downside), and sweat cash – big time.

“By paying close attention to tangible assets that sweat, you build in a healthy margin of safety to protect your money from any downturn. Because tangible assets are physical, useful things that don’t disappear when the market heads south, unlike paper assets, which can lose money faster than you can say ‘wiped out.'”

“A good business is the best asset there is, aside from your personal talents,” Warren Buffett told us, when we sat down with him in Omaha to interview him for the documentary.

“The best investment is a good business,” he continued, “one that does have durable competitive advantage and that will be around 10 or 20 or 50 or 100 years from now, turning out something people want at a profit.”

You are better off following the Oracle of Omaha’s advice and studying your investments carefully…individually…and focusing on value. At least then when you lose money, it’s your own damned fault.

More news:

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Addison Wiggin, reporting from Baltimore…

“‘In the long term [his approach] is destabilizing,’ Pimco’s Bill Gross said of Alan Greenspan’s tendency to lower rates when the going got tough.

“‘It promotes speculative activity. That’s the corner that Greenspan has painted the economy into.’

“We wonder what he’ll say now that the two are going to be cubicle mates?

“Pimco announced yesterday they’ve hired Greenspan for his first post-Fed consulting gig. Gross’ track record at the helm of the world’s largest bond fund has been ‘meh’ of late.  For the first quarter, the Pimco Total Return fund was up just over 1%, ranking near the bottom of the market for comparable funds. Over the last year a return of 6% put it in the bottom quarter.”

For the rest of this story, and for more market insights, see today’s issue of The 5 Min. Forecast

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And more thoughts…

*** Historian Paul Johnson once commented that steel magnate Andrew Carnegie argued, “The business cycle was not an accident or anyone’s fault: It was a fact of life and provision should be made for it…Anybody could make money in a boom – making it at the bottom of the trough was the real test of ability.”

Johnson went on to describe Carnegie’s thoughts: “Once you understood the principle of unit costs, he argued, you could isolate the problem of productivity – output per man-hour employed or capital used – and thus raise productivity at the same time as production. By raising productivity, you could slash prices.”

“And that’s exactly what Carnegie did,” explains Free Market Investor’s Christopher Hancock “Between 1875-1898, Carnegie’s mills reduced the price of a steel rail from $160 a ton to $17. His ingenuity cut prices by roughly 90%. He devoured the European steel industry.

“Johnson notes that these enormous savings worked their way into every aspect of public life: ‘No president, by miracles of administration, no Congress, by enlightened legislation, was capable of bringing comparable material benefits to all Americans in this way.’

“Carnegie’s mills produced the lowest cost steel where it was needed most: the American industrial machine.

“The same business principles that proved true more than 100 years ago remain just as sound today. And I believe you’ll be hard-pressed to find another steel producer operating in the heart of the world’s newest industrial boom more conscious of costs and operating efficiency than the one that I’m recommending to my Free Market Investor subscribers.”

*** One thing that makes the whole world of investing difficult to penetrate is that the rod we use to measure value is as loopy as wet spaghetti.

If you’ve been following the strange story of the U.S. dollar, you have noticed that it’s being beaten by some unlikely competitors – namely, the Brazilian real, the Israeli shekel, the Turkish lira and the Philippine peso. What gives?

It’s hard to know. We measure our wealth in our national currencies. We adjust for changes in the cost of living. But we don’t really know what the currency itself is worth.

Gold used to provide a fixed scale…something that was sure, and universal. Gold used to give money real value. Not in terms of earnings…but in terms of something solid that couldn’t be counterfeited, inflated, or readily debased.

But now, in the name of protecting national sovereignty and national currencies, governments insist upon being able to pass off as “money” whatever noodles they’ve got in stock.

An article in Foreign Affairs explains:

“Capital flows were enormous, even by contemporary standards, during the last great period of ‘globalization,’ from the late nineteenth century to the outbreak of World War I. Currency crises occurred during this period, but they were generally shallow and short-lived. That is because money was then – as it has been throughout most of the world and most of human history – gold, or at least a credible claim on gold. Funds flowed quickly back to crisis countries because of confidence that the gold link would be restored. At the time, monetary nationalism was considered a sign of backwardness, adherence to a universally acknowledged standard of value a mark of civilization. Those nations that adhered most reliably (such as Australia, Canada, and the United States) were rewarded with the lowest international borrowing rates. Those that adhered the least (such as Argentina, Brazil, and Chile) were punished with the highest. “

Yes, faithful DR reader. That is the way it ought to be.

But as we have been telling you – and any one else who will listen – that is not the way it is these days. Instead, however absurd the status of the U.S. dollar may get, there are even more absurd foreigners willing to take it off our hands…and return it to us in the form of loans.

Which is why we suggest you ignore even Richard Russell this time. Keep your eye, instead, on our Crash Alert flag – the Bonnie Blue…and Black.

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