The Fourth Era of Oil
Investment Opportunity of the Decade
by Joseph Dancy, LSGI Advisors, Inc. | July 7, 2008Print
“No less an expert than Charlie Munger, the vice chairman of Berkshire Hathaway who is Warren Buffett’s investment partner, advises that good investments are difficult to find.” Munger notes due diligence on prospective investments is time consuming and rarely leads to attractive opportunities. Good investment ideas that you can understand and evaluate are uncommon, and present themselves infrequently.
Although academics will dispute this contention, concentrated portfolios are not necessarily higher risk according to Munger, nor is volatility an accurate measure of risk. “An investor must be patient. But when a situation finally arises where the probabilities are heavily weighted in favor of an investment, he adds, the patient investor should act decisively”
“Global energy trends are creating opportunities where, to paraphrase Munger, probabilities strongly tilt in favor of the investor.” When this situation occurs he advises to invest heavily.
“The Energy Boom is Just Starting” by Joseph Dancy, June 4, 2007 Barron’s
- The most valuable product traded in our global economy is crude oil
- Economic growth is strongly correlated with increasing energy use:
- Global economic growth accelerated for five straight years to 5.4% in 2006, the highest in
at least 27 years according to a report issued by the International Monetary Fund. Global growth slowed in 2007, but in 2008 economic growth is forecast to advance by 3.7%.
- Historically, on a global basis, energy use – coal, crude oil, and natural gas, have correlated with global economic output and growth. The statistical relationship between economic output and energy consumption is statistically significant and pervasive across different economies and time periods.
- China's economic growth in the first quarter of 2008 was 10.6%, compared to an average rate of 11.9% for all of 2007 – its’ highest growth rate in 13 years. China is expected to grow an average of 10% for the year. This puts China on course to chalk up its sixth straight year of double-digit growth. It will overtake Germany before long as the third-biggest economy in the world. China and India are entering the energy intensive phase of their development – most citizens in those countries have never boarded a plane, much less own a car.
- Per capita income and per capita energy use are strongly correlated. The statistical relationship is again statistically significant and globally pervasive.
- Chinese industries use 20 percent to 100 percent more energy per unit of output than their U.S. and Japanese counterparts, according to the World Bank. China's government says the gap is even bigger, putting energy use at 3.4 times the world average. Total energy use in China is soaring.
- China, the world's second-largest car market, produced 8.88 million vehicles in 2007 and is expected to produce well over 10 million units in 2008. While US automobile demand is stagnant at the 16-17 million per annum level, increasing only in line with population, Chinese automobile demand is rising at around the double the economic growth rate. China’s population is four times that of the United States, so the boom is expected to continue.
- China's consumption of crude oil and refined oil products both hit record highs in the first quarter of 2008 according to statistics released by the China Petroleum and Chemical Industry Association. China's consumption of oil products - composed of gasoline, diesel and kerosene - rose by 16.5 percent year on year in the first three months. Crude oil consumption rose by eight percent. There has never been a country in history that has increased its crude oil demand so quickly.
- With China's crude demand expanding at 11 per cent a year the country will soon replace the U.S. as the world's biggest oil importer. The growth of India's oil demand isn't far behind. These two nations account for a third of humanity. And as economic development continues, the energy needs of their factories - along with those in Brazil, Mexico and other populous emerging markets – will escalate. As these countries get richer the number of cars in the world, now around 625 million, is set to double in less than 20 years. The impact of that on global oil demand will be immense - around 70 per cent of current crude output is used to fuel autos.
- The average person in China consumed less than 20 percent as much energy as the average American in 2005, the latest year data is available, according to U.S. Energy Department. In India , energy use is less than 10 percent of America 's on a per capita basis. The 2.45 billion people in China and India combined used only half as much crude as 300 million Americans last year.
- China , the world's second-biggest energy user, will consume 7.89 million barrels of oil a day in 2008. India will use 2.9 million barrels of oil a day in 2008, more than is pumped by OPEC member Venezuela.
- Russia's gross domestic product grew 7.4% in the first quarter of 2008, and has quadrupled since 2000. In the past five years auto sales have tripled. By 2010, many forecasters see Russia overtaking Germany to become Europe's No. 1 auto market with sales of more than 4 million vehicles. While there are 800 vehicles per 1,000 inhabitants in the United States, there are 190 vehicles for every 1,000 Russians.
- Russia’s economy is expected to grow 7.1% this year. India’s economy is projected to grow 8.5%. Middle Eastern economic growth will probably accelerate to 6.1% this year from 5.8% in 2007, according to the International Monetary Fund. Oil demand in the Middle Eastern region will surge 5.8 percent to 6.97 million barrels a day this year, according to the IEA.
- The International Energy Agency updated their 2008 energy forecast. They project world oil demand would grow by 1.7 million barrels per day (b/d), up from 0.9 million b/d in 2007. The IEA projected demand would average 87.5 million b/d in 2008 – a record. The agency noted that transport fuel demand in China remained “very strong”. Year-on-year imports of crude oil to China increased more than 12% in 2007, and the trend continues into 2008.
- In 2008 China, India, Russia and the Middle East for the first time will consume more crude oil than the U.S., burning 20.67 million barrels a day this year, an increase of 4.4 percent over year earlier levels, according to the International Energy Agency. U.S. demand will contract 2 percent to 20.38 million barrels daily, the IEA forecast.
- The growth in global oil demand over the last five years has dwarfed the increases in global oil supplies from non-OPEC nations. As demand continues to rocket upward the incremental excess global productive capacity continues to shrink, which helps support higher prices.
- As global demand for crude oil rockets upward – demand is estimated to increase 1.7 million barrels per day in 2008 – the excess productive capacity of OPEC producers has fallen to around 1.8 million barrels per day. The lack of excess capacity supports the higher global oil prices we have seen the last few years. (see chart)
- Governments in many crude oil importing countries subsidize fuel costs, reducing economic incentives to conserve. China recently revised its subsidy program to increase subsidies for heating oil and fuel prices, Vietnam froze oil prices to stem inflation, and Taiwan, Thailand, Indonesia, Malaysia, also adopted price controls or subsidies to reduce the impact of higher prices on consumers.
- In major exporting countries such as Iran, Russia, and Mexico internal consumption of oil products is growing briskly. If supply does not increase substantially in each of these countries the amount of product available for export could shrink. Some estimate that the amount of oil on the global market will shrink by 2.5 million barrels per day over the next five years due to this internal demand. Mexico, a major exporter to the U.S., could see exports end within the next decade.
- U.S. natural gas prices are poised to head higher over the long term as commercial and manufacturing demands increase according to a report issued by the Federal Reserve Bank of Dallas. The report noted that domestic natural gas prices are depressed compared with the fast-rising prices commanded on the international market for liquefied natural gas, selling for between $18 and $19 per million cubic feet, about twice the domestic price.
"Much higher natural gas prices seem likely even though U.S. producers are thought to be sitting on sizable supplies of undeveloped resources," the bank said. "A recovery in U.S. manufacturing should sharply boost natural gas demand. Once LNG imports become the marginal source of U.S. supply, much higher international natural gas prices should prevail."
- Electrical usage in the U.S. correlates with economic growth. For environmental reasons the majority of new capacity added to the grid over the last decade has been natural gas fired. Due to the fixed costs, lack of substantial alternative generating facilities and the permitting issues involved with a coal fired facility, the demand for natural gas from these electrical generating units should continue to increase for the next decade. Summer months, the period of peak air conditioning use, have seen substantial upward peaks in demand for natural gas to service the grid.
- The National Weather Service (NWS) has a mid-term model that forecasts conditions several months out. The NWS model forecasts a higher probability of hot conditions this summer in the highly populated Northeast and Western states compared to the last 30 years. The model outputs for the June, July and August months (periods when air conditioning loads will generally be at their peak) are set out above. Electrical generating peaker plant use, fired by natural gas, may be above average if this forecast is correct.
One model we follow uses a supercomputer located in the U.K. to digest millions of pieces of observation data. They then run numerous simulations. Over time the results begin to vary – but at some point the models point to a general consensus. Using statistical measures of the variance of the results, and the consensus conclusions, the model has been quite accurate – a major improvement in mid-term weather forecasting.
Running the latest data in the U.K. supercomputer, the model is now forecasting a hot summer for Western North America (see map). If so, this has bullish implications for the natural gas market. Since extreme heat and drought conditions tend to have a high degree of correlation historically, the heat also has implications for the grain harvests in the U.S.
- The International Energy Agency estimates global petroleum production is at 86.8 million barrels per day, which matches the latest estimate of global oil demand for 2008. Demand estimates have been lowered several times due to the slowdown in the U.S. economy. Of that global supply, more than ten percent comes from four major fields.
- After ramping up production volumes from 1 million barrels a day in 1980 to 2.1 million barrels a day in 2004 using nitrogen injection enhance recovery methods to maintain reservoir pressures, production at Mexico’s Cantarell fell by a shocking 12% in 2006 and fell an additional 15% in 2007 to an average of 1.5 million barrels per day.
In the first quarter of 2008 production has fallen to 1.2 million barrels per day, less than forecast, and Mexican exports have declined 12.5% from year earlier levels. The decline is expected to continue at double digit rates even with additional expenditures to stabilize production.
- In 2007, oil production fell in Norway, in the United Kingdom, in Mexico, and in Venezuela, all major producers. Production from the North Slope also declined. In all of those cases, the rate of decline is accelerating. These problems are geological associated to aging fields.
- Saudi’s Ghawar field, the world’s largest, was discovered in 1948 and began producing in 1951. The condition of the reservoir and productive capacity of the field are not transparent to the global markets. From an age standpoint the field is ‘ancient’.
- Even with higher energy prices, crude oil production continues to decline in the U.S. Increased drilling activity and technological advances in drilling and completing in shale formations has allowed domestic natural gas production to stabilize.
- Political issues in major producing countries such as Nigeria, Venezuela, Iran, and Iraq have reduced available supplies. The problems in these countries will most likely not solve themselves quickly.
- OPEC has gone from a demonstrable 10 million barrels per day excess productive capacity 15 years ago to what some claim is less than two million today. Supply constraints in the face of rapidly growing demand add to price volatility, and could trigger hoarding behavior.
- For the last two decades the world has consumed more oil each year than has been found. Some estimate that 80% of the crude oil consumed today was discovered before 1973 – most of the major oil fields are ‘old’ from a discovery and production standpoint.
- Experts speculate the EPA mandates reducing the amount of sulfur allowed in diesel fuel has had the unintended consequence of causing more refinery outages. Removing the sulfur requires operators to run the refining units harder and at higher temperatures and higher pressure, possibly leading to equipment failure. A third of the country’s 150 refineries have reported substantial operational disruptions in 2007, a record. Many refineries are older, complicating operational upgrades.
Big Spring, Texas, Refinery Fire - 2.18.08
• A long-term study of global crude oil supplies and resources prepared by the U.S. Geological Society in 2000. The study was “the most thorough and methodologically modern assessment of world crude oil and natural gas resources ever attempted. This 5-year study was undertaken ‘to provide impartial, scientifically based, societally relevant petroleum resource information essential to the economic and strategic security of the United States.’"
The U.S.G.S. study concluded that between 1996 and 2025 roughly 21 billion barrels of oil would be found in new fields every year. Actual exploration results from 1996 to 2003 indicate only 9 billion barrels per year have been found – 60% less than forecast. (Chart courtesy of the Financial Times). For such a detailed and essential strategic study we find the shortfall in exploration results to date absolutely stunning.
• Figures released by the Russian government show that the country's crude oil production fell for a fourth straight month in April, confirming pessimistic forecasts for the year. Most analysts forecast a gain in production for 2008 to over 10 million barrels per day, one in a long series of production increases.
Output in April was 9.72 million barrels per day, more than 2 per cent lower than the post-Soviet high of 9.93 million barrels per day in October, 2007. Declining production resulted in Russia's crude oil exports declining 3.3% year-over-year in the first quarter of 2008
- Natural gas storage levels are at the lowest levels for this time of year that we have seen for the last three years.
Storage levels the last two years was much higher at this point in the ‘shoulder season’ than we have today, so the ability to fill the storage facilities before the next winter season was much easier last year than we will face this summer and fall.
- In addition to the relatively low levels of storage, the independence Hub in the Gulf of Mexico has been shut down for two months while contractors deal with a leak. The shut in effectively removes 2% of U.S. natural gas supply, and 10% of Gulf of Mexico gas supply, from the system.
Offshore Gulf of Mexico production rates have been declining, and are forecast to continue to decline as many of the fields are mature and also decline quickly.
- The flow of liquefied natural gas (LNG) into the U.S. is averaging about 900 million cubic feet a day this month, down from 2.9 billion cubic feet a day a year ago.
Higher prices for natural gas and LNG in Asia and Europe draw cargoes to those regions. Imports by Japan, the world's biggest LNG buyer, grew 19.4 percent in March from a year earlier. The decline in LNG imports will make the challenge of filling storage all that more formidable.
• The U.S. obtains roughly 25% of its crude oil and 18% of its natural gas production from offshore fields in the Gulf of Mexico. Roughly one-third to one-half of the nation’s refining capacity is located on the Gulf Coast.
Both production and refining can be easily interrupted by hurricane or tropical storms. Three long term forecasters we follow are predicting an above average hurricane season – which begins to ramp up in eight weeks.
Regardless of how accurate or inaccurate these forecasts prove to be the fact is we have seen eight Category 5 Atlantic hurricanes in the past 5 years.
And last year, two Category 5 hurricanes -- the most intense on a five-tier scale -- made landfall in the Atlantic Basin for the first time in recorded history. The frequency of intense storms is off the charts statistically when compared to historical records.
An anomaly perhaps, but should a Category 5 storm strike in an area populated with a high density of oil refineries, oil and gas fields, or for that matter people, the outcome could be catastrophic.
- The IEA is in the process of analyzing data on existing oil fields to assess the average depletion rates and productive capacities in major producing fields. Estimates range from 4% to 8% declines per year in many oil fields. Conventional natural gas wells decline at a much faster (and increasing) rate due to advances in fracturing and completion technology. The IEA study will be released in November of 2008.
- Ethanol production gains, while significant, will add little to the total liquid fuel equation.
The increasing use of biofuels has created a convergence of the energy and agricultural sector – and the supply and demand relationship in both sectors is compelling.
• The price of some fertilizers has nearly tripled in price in the last year. A squeeze on fertilizer supply has been building for roughly five years. As demand has grown the fertilizer manufacturers of the world were unable to keep up. Some dealers in the Midwest ran out of fertilizer last fall, and they continue to restrict sales this spring because of a limited supply.
• Overall global consumption of fertilizer increased by an estimated 31 percent from 1996 to 2008, driven by a 56 percent increase in developing countries, according to the International Fertilizer Industry Association.
Manufacturers are scrambling to increase supply. At least 50 plants to make nitrogen fertilizer are under construction, many in the Middle East where natural gas is abundant. Without nitrogen fertilizer, there would be insufficient food for 40 percent of the world’s population.
• All-time high prices for soybeans and wheat, and near-record high prices for corn, have pumped up U.S. farm incomes by 50 percent since 2006. The value of Indiana farmland has soared from an average of $3,500 an acre to more than $4,000 in the past two years.
• Record-high grain prices are fueling a rural economic boom in U.S. farm states. Farm equipment dealers have a backlog of several months in orders for new machinery. Cropland rents are rising, along with agricultural land prices.
A telling barometer of the farm economy is the rising number of orders for new farm machinery. New combine sales were up 15% nationwide in 2007, sales of 4-wheel-drive tractors rose 23%, and sales of large-scale, two-wheel-drive tractors were up 26%.
The Fourth Era of Oil: Investment Opportunity of the Decade
Last month we delivered a lecture to our Oil & Gas Law class at Southern Methodist University on the 'New Era of Oil: The Age of Scarcity'. This is not a standard law school topic, but relevant when discussing the legal history and development of market demand prorationing, allowables, unitization, the rule of capture and related conservation regulations.
Our thesis is that we are entering the fourth era of the oil age – one the world economy has never experienced before. This era will cause many disruptions, but will also create investment opportunities that arise only once every few decades.
From the 1859 discovery of crude oil in the Drake well in Pennsylvania until the 1930’s East Texas Field discovery we had a situation where supply was growing exponentially. Increases in demand did not keep pace, so the price of crude oil plummeted. Governors shut in oil fields to prevent overproduction and waste. Arising from these problems the Texas Railroad Commission and other regulators obtained the statutory authority to restrict incremental oil production to better match global demand.
The second era lasted 1930 to 1972 as state regulators like the Texas Railroad Commission restricted production to stabilize the price. When the production of crude oil peaked in the U.S. in 1972 the role of the Railroad Commission in restricting production passed to the Organization of Petroleum Exporting Countries – the third era of oil. In each of the first three oil eras we had excess productive capacity to meet the rising global demand and any short term shortages that occurred.
Going forward we find ourselves in the position where global demand for crude oil is now approaching the ability of the world’s producers to extract production – and soon demand will exceed productive capacity. For the first time ever we will have no excess global productive capacity to meet growing demand.
In such an era – never seen before in the global economy – we expect the following:
(1) wildly volatile crude oil prices - mostly to the upside,
(2) resource nationalization - the material is too valuable to export,
(3) irrational hoarding behavior by consumers,
(4) a spillover of price volatility into the markets for other energy sources (natural gas especially),
(5) a wild frenzy to acquire domestic oil and gas resources (property deals and deals on Wall Street),
(6) a melt-up of the energy and energy services sector,
(7) a focus on energy conservation,
(8) new opportunities in the solar and wind energy sectors,
(9) more focus on biofuels (emphasized by the 2007 Energy Act) - which incidentally will drive grain prices to record levels, and
(10) as a result of the extreme increases in food and fuel prices we expect to see food shortages, instability, riots, and the like in less developed and less stable countries.
One of the most significant developments we expect to see, besides much higher energy prices and volatility, will be the interconnection of the global energy and agricultural markets – tied together by biofuel initiatives.
Adequate capital has not been allocated to the energy and agricultural sectors in the face of global physical and political challenges – and that historic misallocation creates great opportunities for business in these sectors. The energy and agriculture markets are quickly converging, which points to much higher prices for both commodities.
Because of these trends we remain heavily over-weighted in the energy and agricultural sectors. If we are wrong on our assessment we sell our losers quickly, insuring our losses will be somewhat limited. But the evidence of a new era for both energy and agriculture – reflected in global production and demand data – is compelling.
© 2008 Joseph Dancy