The Other Oil Crisis

There is an oil crisis coming. Except that it’s not the
crisis you’d expect. The price of oil is likely headed
lower, not higher. The next oil crisis, therefore, is the
looming sell-off in oil stocks that will send many of them
to significantly lower prices.

Today, most people feel higher oil prices are a cinch.
"Everyone" knows we are in an energy bull market.
"Everyone" knows about the supply bottlenecks and the
voracious demand from China and the hurricanes and all
that. When you start reading lead stories about a coming
energy crisis in Barron’s, The Wall Street Journal, The
Washington Post and other mainstream papers — it should
give you some pause.

Walter Deemer is a market strategist with more than 40
years of experience, and pause he has. His advisory,
"Market Strategies and Insights for Sophisticated
Investors," recently turned bearish on energy stocks. "It
actually is difficult for me to imagine more perfect
conditions for a long-term top," he says in a
welling@weeden interview. "We’ve had a huge, multi-year run
in the stocks, even though — until quite recently — the
consensus expectation was always for a pullback in the
commodity price. Now, practically all we are hearing is…
‘This time is different.’"

"This time is different" — those four little words,
arranged just so, may be the most dangerous phrase in all
of investing.

Deemer reports that the Bullish Consensus (an indicator
that tracks the buy/sell recommendations of commodity
advisories) has been running 87-88% bullish on the price of
crude oil in the last several weeks and spiked to 96%
bullish recently. "I have never seen a reading of 96%
bullish on anything," Deemer says. "That is an incredible
extreme. At 96% bullish, we just have to look back some day
and say, ‘It was obvious,’ it seems to me."

If you have any kind of contrarian streak at all, buying
red-hot oil and related energy stocks should feel
uncomfortable. But it’s more than just contrarian comforts
at play. There are sound market reasons as to why oil
prices north of $60 are not likely sustainable.

Shad Rowe, in a short piece appearing in the Sept. 9
edition of Grant’s Interest Rate Observer entitled "Bearish
on Crude," laid out the basic argument for lower oil
prices. In brief, higher prices are making alternatives
look cheaper and changing the way consumers and businesses
use energy.

Adam Smith, the great 18th century economist, created the
metaphor of the invisible hand as a shorthand way to
describe the market process of shifting supply and demand
in response to prices. It’s happening again, predictably,
in the energy markets.

Rowe, relying on Smith’s metaphor, observes, "The invisible
hand is moving fast."

Indeed it is. Rowe relies on the work of George Littell of
Groppe, Long & Littell, a Houston, Texas-based consulting
firm. Summarizing Littell’s analysis, Rowe writes:

"At $50 to $60 a barrel for oil, coal, nuclear power and
liquefied natural gas are relatively cheap substitutes for
stationary plants such as utilities…. We are already
seeing extensive fuel switching at stationary facilities
around the world."

Nearly every day, I clip out some article about energy
users switching to lower cost sources. In Asia, for
example, the search is on for homegrown oil alternatives.
Recently, there was a piece about Thai biofuel in The Wall
Street Journal. Esso Thailand, which is a unit of
ExxonMobil, is planning to install gasohol pumps in all of
its 650 stations by 2006. Gasohol is a mixture of gasoline
and fuels made from the region’s abundant crops.

Other countries are pursuing similar initiatives. In
Malaysia, don’t be surprised to see palm oil used as a base
for diesel fuel by 2007 (Malaysia is the world’s largest
producer of palm oil). China is looking at a $24 billion
coal-to-oil plan that will shave off 1 million barrels from
China’s daily consumption, currently running at around 7
million barrels a day. And even right here at home, a group
called Panda Energy is hard at work building an ethanol
plant in Kansas that will use a billion pounds of cattle
manure each year as a renewable fuel to power the plant’s
operations.

"The manure is gasified and converted into a clean bio-
gas," a recent press release explained. "By utilizing bio-
gas produced from manure instead of natural gas, [Panda’s]
facility will save the equivalent of 1,000 barrels of oil
per day."

This is not pie-in-the-sky stuff, or even cowpie-in-the-sky
stuff. You don’t need a great imagination to see how demand
for oil backs off at the margin — both from efficiency
gains and the use of alternatives.

Much of this demand for oil will not snap back. Once it
goes, it will be gone for a long time. As Rowe notes, after
the oil shock of the 1970s, it took two decades for demand
to reach the level achieved in 1978 — even though the
economy grew enormously over those two decades.

Basically, the market adjusted — Adam Smith’s invisible
hand — and the economy as a whole became far more energy
efficient. And we haven’t even talked about supply.

As Rowe sums it up, "At $55, there is room for a lot of
technology, fuel switching, conservation and exploration."
The long history on oil, and energy generally, is one where
the gloomy natural scientists and engineers are always
surprised and always wrong.

It reminds me of economist Joseph Schumpeter’s observation
(published posthumously in 1954) on Thomas Malthus’ errant
predictions. Thomas Malthus was an economist who predicted
we’d all run out of food because the growth in population
would exceed the growth in food supply.

Malthus’ original treatise, published in 1798, was utterly
wrong. Schumpeter wrote:

"The most interesting thing to observe is the complete lack
of imagination which that vision reveals. Those writers
lived at the threshold of the most spectacular economic
developments ever witnessed. Vast possibilities matured
into realities under their very eyes. Nevertheless, they
saw nothing but cramped economies, struggling with ever-
decreasing success for their daily bread."

So it is with today’s neo-Malthusians. This is not to say
the price of oil can’t go higher, or that the oil business
can’t remain a good business to be in for several more
years. The point is that oil is still a commodity and it is
still subject to cyclical swings. It seems to me, we are
nearer a top than a bottom in the price of oil.

And the Markets…