The Quest for Oil

As the disaster that Iraq has become continues, the oil services industry looks elsewhere to replenish dwindling supplies of crude. Just as it was in software 20 years ago, opines John Myers, picking the eventual winners will lead to incredible investment fortunes.

Oil is the largest single traded commodity in the world. It supplies about 95% of all transportation fuels and 40% of the world’s commercial energy. It also provides feedstock for thousands of manufactured products and is critical for food production.

While global consumption has continued to rise steadily, worldwide oil discoveries have declined progressively since the 1960s. The challenge for oil producers is that each year, the world consumes more than three times the amount of oil that is discovered.

"The time has come for a rational response to the inescapable reality that oil is finite and available supplies will soon be insufficient to satisfy growing demand," writes Dr. Colin J. Campbell, a petroleum geologist at the London-based Oil Depletion Analysis Centre.

A growing number of analysts predict that global oil production will peak within the coming decade and then start to decline, leading to higher energy prices with major economic consequences.

Global Oil Discoveries: Petroleum Technology

Big Oil acknowledges the increasing difficulties of finding new sources of petroleum to replenish reserves. In an effort to reverse this trend, petroleum companies are turning to technology. The oil service industry is providing the instruments to locate previously undiscovered reserves and the tools to glean existing reserves from abandoned wells.

Since petroleum technology and service companies hold the keys to the world’s remaining oil reserves, that puts them at the top of the investment chain, in my opinion. And just as it was in software 20 years ago, picking the eventual winners will lead to incredible investment fortunes.

Moreover, the petroleum industry, and the companies that service it, have the full weight and support of the federal government [for what it’s worth…]. Early in his presidency, George W. Bush announced that one of his administration’s priorities was to provide the nation with secure energy supplies. The president insisted that part of his strategy was to maximize North American production.

Washington’s Oil Doctrine was announced in a May 2001 National Energy Policy report. The report concluded: "America must build strong relationships with energy- producing nations in our own hemisphere, improving the outlook for trade, investment, and reliable supplies… As a result, the United States will rely increasingly on imports of both natural gas and oil from Canada."

Big Oil has admitted that finding large oil pools has become a major problem. One remedy that has worked at the corporate level has been a rash of takeovers. In May 2001, Conoco announced that its Canadian unit would buy Gulf Canada Resources for $4.33 billion; in August of the same year, El Paso Energy acquired Canadian-based Velvet Exploration Ltd. for $228 million. These are just two acquisitions in a string of Canadian petroleum companies that fell into U.S. hands.

Global Oil Discoveries: Aggressively Searching

But although buying reserves might look good on a balance sheet, it doesn’t add a drop of new oil to the world’s reserve base. The only way to do that is through exploration. After years of falling exploration budgets, oil companies are once again aggressively searching out new reserves.

According to a 2003 survey, Canada will set the global pace for exploration and development spending this year. The money will be fueled by U.S. majors and independents shifting capital to Canadian activities, says investment banker Friedman, Billings, Ramsey & Co. Inc. The Virginia- based firm projects U.S. exploration and development spending will edge up by a mere 0.2% to $32.08 billion, while Canadian spending will race ahead by 12% to $11.9 billion.

Oil exploration companies are fulfilling Friedman & Co.’s prediction. The total U.S. count of working rigs at the end of June was 1,067 – up from 838 units that were working in June 2002. Renewed exploration is even more remarkable in Canada, where 337 rotary rigs were working at the end of June compared to 210 in June 2002.

The petroleum industry is more optimistic about its chances of finding new oil and gas than Washington is. I will get to why Big Oil has high hopes in a minute. But first let’s look at the energy quagmire that our federal government has gotten us into.

In June, Energy Secretary Spencer Abraham called for more conservation and fuel-switching by utilities. His concern is over low gas inventories and high summer demand, limiting storage injections ahead of next winter. In a letter to 30 U.S. lawmakers, Abraham wrote that in the Department of Energy’s view, there are only ‘limited opportunities’ to boost supplies over the next 12-18 months.

Global Oil Discoveries: A Tangled Mess

Of course, the federal government has good reason to fret about oil. The Middle East, home to two-thirds of the world’s oil reserves, remains a tangled mess with America taking pot shots from the world press while our GIs are taking rifle fire from irate Iraqis.

Baghdad fell to U.S. forces in early April. Since then, efforts to restart Iraq’s oil industry have been delayed by looting, sabotage and technical problems. According to The Wall Street Journal, "Continued attacks threaten to set back U.S. efforts to pacify Iraq’s restive populace. Long lines are again a common sight at Baghdad gas stations, with drivers waiting hours to fill up at prices still higher than before the war."

In June, two Iraqi oil pipelines exploded – merely the latest violence that has occurred in an occupied, but not yet conquered, country. The first explosion shut down a key fuel pipeline 150 kilometers west of Baghdad. The second pipeline carried crude oil to Syria.

Saudi Arabia, the world’s oil kingpin, holding one-third of the world’s conventional reserves, has also been experiencing unprecedented terrorism.

Global Oil Discoveries: Arabian Oil Choke Points

The Saudi Ras Tanura oil terminal, the largest in the world, used to be a stop on sightseeing tours. But today, the facility that processes 4.5 million barrels per day – or half of the oil that the kingdom produces – is surrounded by elite security troops. The tightened security follows a string of attacks by extremists in the country, including a June gun battle between al Qaeda and police in the holy city of Mecca.

But blanket security may be an impossible proposition in this desert nation where oil is almost as plentiful as water. A retired oil engineer who spent 30 years working in Saudi Arabia told me that there are many choke points inside the country where a bomb could disrupt the flow of Saudi oil.

Al Qaeda understands that petroleum is America’s Achilles’ heel. In June U.S. intelligence warned that al Qaeda may be targeting petroleum facilities and pipelines in Texas. Ironically, an attack on Texas would do less strategic harm to the United States than an attack on Saudi Arabia.

As of this past April, the United States imported a record 12.3 million barrels per day (mb/d), almost 6% more oil than it was importing in April 2002. Meanwhile, U.S. oil production continued to slide down the slippery slope of decay. Our nation is producing 5.8 mb/d of oil, down from the 1970 peak when America produced 11.3 mb/d. Over the past few years, U.S. production has declined at a rate of 4% per year.

Yet new technologies promise not only the discovery of new oil and gas fields but also the ability to extract new hydrocarbons from abandoned oil fields. Just how important is this endeavor? A study completed in 1995 showed that in the United States from 1983 to 1992, about 85%, or 20 billion barrels, of proved oil reserves were from old fields.

To recover old oil and discover new oil, the petroleum industry has armed itself with a bevy of new technologies. The big oil companies are betting that they can reverse the decline of America’s petroleum production and boost Canada’s production. If they are successful, the companies that deliver effective oil service technologies will generate windfall profits.

Good investing,

John Myers
for The Daily Reckoning

August 27, 2003

John Myers – son of the great goldbug C.V. Myers – has been helping readers earn surprisingly lucrative returns in stocks largely unknown to Wall Street’s wunderkinder since his early 20s. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits – including oil, gas, energy and gold.

"The optimist," wrote the writer James Clabell in 1926, "proclaims that we live in the best of all possible worlds; and the pessimist fears this is true."

In our vain search for something profound to write about the rising stock market this morning, we found only this: fear is good.

Fear stops a child from sticking his hand in a strange dog’s mouth…or at least it ought to. Fear keeps a married man from sleeping with a beautiful woman he meets on the bus. Or, at least, it ought to…

Fear ought, too, to stop investors from buying overvalued stocks during a grandiose ‘secular’ bear market.

It ought to. But it doesn’t.

"Lack of fear is ill omen," confirms a headline from this morning’s Financial Times. Or, at least, lack of the right kind of fear.

"Investors are [still] afraid of missing the boat," the FT quotes Rich Bernstein, Merrill Lynch’s chief investment strategist. "Portfolio managers are under such intense pressure to perform minute-by-minute and fundamentals don’t change quickly enough to keep up. They need higher frequency data and higher frequency data are called stock prices. They follow technicals at the expense of fundamentals."

"Despite our best efforts to explain to our clients what we perceive to be a very, very high level of risk in the stock market," explains a financial advisor from Denver, "we are starting to meet with deaf ears."

Following technicals, traders tend to expect the market will jump in the final hours of trading. Yesterday, the Dow recovered from an 81-point deficit to finish 22 points in positive territory. And the illusion of recovery continues. (Strategic Investment’s Dan Denning offers an entirely different explanation for yesterday’s late day boost in today’s market coverage, below.)

Portfolio managers may continue to ignore fundamentals… but sooner or later, say your editors, they get what they have coming. The New York Post’s John Crudele predicts that when 3rd quarter economic data is released, the economy is going to look a whole lot worse than it does right now.

Why? Well, admittedly, for an entirely different reason than the cranks who write the Daily Reckoning believe. We actually think a job-less, profit-less recovery is a bad. Crudele predicts the bad news will come as a result of a wrinkle left in Government economic models due to the effects of 9/11. Huh?

That’s what we thought.

Crudele’s theory is fairly intricate. We summarize: The rapid downtick caused by 9/11 was statistically factored into government economic predictions as "normal." Without the same downtick in 2002, and goosed by zero-percent financing of cars, the fall numbers of last year actually exceeded expectations, and gave some credulity to last year’s round of "second-half recovery" shenanigans.

This year, however, just when higher interest rates and skyrocketing energy prices will be slashing their way through corporate balance sheets, the computer models will be predicting an unusually strong second half. Which, of course, won’t be any truer than the excessively pessimistic forecasts of the year before.

Okay…so what does it all mean? Well, more of the same, as far as we can see. "Interest rates should come down," says Crudele, "but so will stock prices. Wall Street is once again getting irrationally exuberant about the prospects for corporate profits at a time when companies will be hurt by the same things you and I are – the rise these past two months in interest rates and the more recent jump in fuel costs."

Gasoline prices jumped yesterday to their highest point since the pre-Iraq run up in March. Natural gas is hovering at a healthy $5.08 per BTU…oil is still a tough $31. These are not helpful prices for those trying to stage the recovery. (John Myers fills us on what to expect from the quagmire in Iraq and the rising price of oil, in a guest essay below…)

But first, Strategic Investment’s Daniel Denning covers the markets for us today. Dan?


Mr. Denning writing from the Paris HQ of the Daily Reckoning…

– The mythical Plunge Protection Team is good work…if you can get it. Lucky for them, we’re in a bear market. There’s plenty of work. And they’re pretty good at it.

– If you work for the PPT, you can reverse an entire day of selling on the Dow by buying futures contracts on the big indices during the last two trading hours of the day. Suddenly, what looks like an 81-point loss for the Dow becomes a modest 22-point gain – and within striking distance of the 14-month high set last week. More on the PPT below.

– GM and Ford – or the ‘Stealth Financial’ stocks, as your vacationing New York editor calls them – did well for themselves. GM was up 1.5% and Ford was up 3%. Mr. Fry calls them ‘Stealth Financials’ because both stocks are surprisingly sensitive to interest rates, due to either excessive use of debt, or enormous exposure to the consumer credit market.

– Yet Ford is up an astonishing 76% since March 11th. Since May of 2002, Ford has been Wall Street’s automotive whipping boy. And even at yesterday’s close over $11, it’s STILL down 36% from its May 2002 price of $18. But with a debt to equity ratio of 20.96 (compared to an industry average of 2.92), it’s not exactly a buy – even with yesterday’s durable goods report, which revealed a 5.5% rise in auto sales in July.

– Still, why worry about ‘Stealth Financial’ stocks when there are so many more obvious stocks in trouble…including Fannie Mae and Freddie Mac? But perhaps these two have become TOO obvious to short profitably.

– Macro-data detective Greg Weldon reports that short interest in Fannie Mae has nearly doubled from March to August. Over 19 million shares – 2.3% of Fannie’s float of 818 million shares – are sold short. With these kinds of numbers, as things could get for Fannie Mae if rates keep rising, you should also be wary of a short-squeeze – like the kind that sent Fannie Mae up 5% on Monday.

– The key for the stealthy and the not-so-stealthy financial stocks is interest rates. The ten-year Treasury bond rose yesterday, driving rates down modestly to 4.47%. The 30-year Treasury was also up.

– The rebound in bond prices will only be temporary though, and that’s because the dollar is still in trouble. Despite gaining a little ground on the euro, the dollar can’t shake gold, which traded up to $361. COMEX traders are still net- long gold. Either they are speculatively over-extended, or they’re waiting to hear the giant ‘crackle’ in the global monetary system…the sound of trillions of dollars in paper (debt and currency) going up in flames.

– Even the imperturbable IMF is concerned about the dollar. Reuters reports that it obtained a draft of an IMF report due next month, which states, "The IMF sees further potential for a depreciation of the dollar given the high current account deficit." Not quite panic mode for the world’s most serious lenders…but with U.S. deficits (fiscal, current account, consumer) running at record highs, it’s only a matter of time before those holding dollar-denominated debts realize they aren’t worth the paper they’re printed on.

– So…is there REALLY a PPT run by a shadowy government group that intervenes in the markets to keep stock prices high and investors solvent? Alan Greenspan isn’t saying. But the maestro and his merry men COULD orchestrate a reversal by buying an enormous amount of S&P or Dow futures contracts late in the day. How would it work?

– The easiest way would be to buy front-month futures contracts on the S&P and increase the ‘spread’ between the futures market and the cash index. The ‘spread’ is the difference between the fair value of the cash index and the price at which the futures market calculates it to be. By buying S&P futures, you increase the ‘spread’ between the futures market and the actual cash index. And if the spread gets big enough, program trading kicks in to buy the cash index rather than the futures.

– Could you prove this is happening? Well…you could look at prices for front-month futures contracts on the Dow and S&P and see what kind of buying took place between, say, 1:52 and 2:18 yesterday.

– THEN, you could check to see what the program trading statistics were for the day in question. The Wall Street Journal publishes program trading stats on a weekly basis. And according to the Journal, in the last four weeks starting on July 25th, program trading has accounted for 38.5%, 42%, 45.5%, and 39.9% of the total trading volume for the NYSE.

– The August 22nd Journal reports that for all the program trades on the NYSE during the week ended August 15th, "13.6% involved stock-index arbitrage" and that "Some 53.9% of program trading was executed by firms for their clients."

– Is Uncle Sam a client? And is he pumping money to accounts set up with the big brokers on Wall Street to buy futures and cause program trades to kick in and buy the cash index? We report…you surmise.


Addison Wiggin, back in Paris…

*** "Housing’s last hurrah," reads a CNNMoney headline, confirming our suspicion that the story has captured the imaginations of mainstream financial writers. What’s the problem, according to this one?

"Though household income has been climbing slowly and steadily," the staff writer writes, "despite the longest stretch of labor-market weakness since World War II – it can’t compete with the abrupt jump in mortgage rates, driven by a 42 percent surge in the 10-year Treasury yield since mid-June. If wages can’t keep up with rates, then first-time buyers will simply be able to afford less house, putting further downward pressure on demand…"

And pop goes the bubble. "When that happens," we quote ourselves from yesterday, "there are going to be a lot of angry people."

*** The Chinese yuan is emerging as a "tough business issue," another headline from the NYTimes tells us. Anger is rising in America’s heartland, claims the paper, which also purports to publish all the news that’s fit to print.

Since the yuan has been pegged to the dollar, the trade deficit with China has exploded. While Chinese exports to the United States doubled to $125 billion in the period 1995-1997, American exports to China inched up a mere $6 billion over the same period. Now, the deficit now stands at over $100 billion a year.

"We can compete against China’s low labor costs," a man who makes plastic for a living in Pennsylvania told the Times. "and we can compete with them if they play by the rules. But we cannot compete with them if they have a 20 percent to 40 percent currency advantage."

This is exactly the kind of garbage sentiment politicos will feed on in the next election…and it can come to no good. Expect an increase in protectionist proposals by Congressman and state-level politicians, who more often than not wouldn’t stand a spin-the-bottle’s player’s chance in the closet of finding China on a globe.

If the twentieth century serves as any model for the next, first we’ll see trade wars…then shooting ones. China makes at least as healthy an adversary as al Qaeda, don’t you think?

*** You’ll be happy to note that Bill’s project to get his son Jules installed in the American school here in Paris is complete. "He’s not exactly ‘firmly’ installed," Bill reports, "but there it is…"

Finding one’s way through the intricate web that is France’s education system – or even through the equally complicated league of foreign schools that have set up shop here – is just one of the many joys of family life in Paris. We have come to know quite a few others, of varying degrees of enchantment.

France is a good place to visit. But it is a better place to live.

The City of Lights reveals its more obvious delights to tourists…just as the French countryside embraces them with its vineyards and chambres d’hôtes…but as those who make their home here know, France’s true beauty – and imperfection – are found in the small things.

If you’ve ever thought of living in France, you might be interested in an event our friends in the Paris office of International Living are hosting this October. They promise to provide attendees with a comprehensive guide to making one’s home in France (we sure wish there had been a conference like this when we moved here!).

The Daily Reckoning