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Monday, 7 July 2008

Why Are Oil Prices Rising?

By: James Kingsdalec
Saturday, July 05, 2008 4:11 PM

June was a good month for energy stocks and for the EIS portfolio but the broad market tanked. The impact of high energy prices on both inflation and consumer discretionary spending is being reflected in stock prices. Energy pressures present a special risk to economic stability by coming on top of the twin collapses in the credit and real estate markets.

So far Mr. Market seems able to distinguish between the very healthy energy sector and the tenuous economy. I fear that at some point we’ll get a sustained - 1930’s style - bear market in all stocks which will take down the energy stocks along with everything else. In fact we’ve seen a few days like that already, generally followed by big pops in energy stocks later.

That fear is why I have a commodity strategy included in the EIS portfolio. It is insurance against the collapse of energy stocks as part of a general market collapse. I implement it with options on long dated crude and natural gas futures contracts. If you do not use a futures account and depend only on stocks but want to be invested in physical oil or gas, you can use an ETF like USO or OIL for oil or UNG for gas.

Despite the S&P’s 8.8% drop in June, stocks in the EIS portfolio were up 4.2% for the month which beat the broad oil ETF, IYE, but was slightly under the oil service sector’s sterling 5% gain as represented by OIH. My shipping stocks held the portfolio back. Apparently the stock market thinks the China boom is peaking. I doubt that.

My commodities strategy was up only slightly in June despite large gains in the commodity prices due to heavy-handed meddling by yours truly. Total EIS performance including the commodity strategy was up 4.4% for the month of June and the year-to-date gain of 32.9% has to be considered attractive given the 12.5% S & P loss since 1/1/08. I guess outperformance by 45.4% for the first half of the year should make my stockholders happy. I’ll go ask my wife.

What’s the Lesson Here?

June’s lesson, I think, is the value of Tsunami Investing so I’m going to spend a little time reviewing it.

Oil and gas are a perfect investment Tsunami. Oil scarcity is increasing and will be with us for at least another ten years. Natural gas will also soon become scarce. (It’s price has actually risen faster than oil so far this year.) So the short version of my advice to myself is don’t try to be clever. Keep the investment posture simple in terms of both stocks and commodities. Don’t try to trade it. Be there when oil becomes truly scarce after 2010.

A Review of Tsunami Investing

If a major trend - an economic Tsunami - is unfolding why not be invested in the companies that will be lifted by it? In fact one might dare ask why be invested anywhere else if you can stand the volatility associated with a concentrated portfolio. Why not let the vast bulk of investors who are pushed by a trained army of brokers, advisors, and lawyers to be “diversified” buy all those stocks that together by definition yield an average return?

Is Tsunami Investing Really That Easy?

Well, no. In addition to buying Tsunami stocks you have to do one other thing. You must hold on. Don’t sell when you think the stocks have become temporarily overpriced. You could be wrong about the timing. And even if you are right, the payback in trading turns out to be small compared with a buy-and-hold strategy.

There are a few other Tsunami rules also:

1. It must be a real Tsunami not just a macro-trend.

2. You must identify the Tsunami early enough in its life-cycle to benefit from it.

3. You must pick stocks that are central to the Tsunami, not peripheral.

Tsunamis vs. Long Term Trends

Long term trends are what create growth stocks and there are a lot of growth stock managers. It is a fine strategy. You pick a trend like the aging population or the growth of China or biotechnology or the internet. Then choose some companies that are benefiting from whatever trend you’ve identified.

That is not Tsunami investing. The difference between a long term trend and a Tsunami is that the Tsunami is (as the name implies) very concentrated and very powerful. It will be over within one or, at most, two decades. It is easy to identify exactly which companies are part of it and all of those companies will be successful so long as the Tsunami is gaining momentum.

Long term trends, on the other hand, are identifiable but not as strong. They contain many more companies, most of them are only indirectly affected, and some of them will not be winners. A successful growth stock manager must know his companies very well to be sure that he picks a Dell and not a Gateway, for example. You want a Genentech or Biogen, not an EntreMed.

When I was building a cable TV business in the ’70’s and ’80’s the right answer to any cable property acquisition opportunity was “yes”. It did not pay to be clever. It did not matter which company you bought. And if you were an equity investor in the stock market, it also did not matter which cable company’s stock you bought. The only thing you had to do was just buy it! Oh, and hold on to it too. The same thing held true for cellular companies in the ’90’s and also for real estate investment trusts in the ’90’s and the first part of this decade.

The same thing is pretty much true for today’s energy Tsunami. Companies that are central to the long term production of oil and gas will all win. It does not matter if you choose Encana or Devon or XTO. It only matters how well whatever companies you pick are able to secure oil and gas. That’s why my favorites are the oil sands plays; they have enough oil to last well beyond anyone’s investment horizon, so they are the most central to the energy shortage Tsunami.

Tsunamis Gain Speed, Then Peak, Then Lose It

Unlike a long term trend that may extend at roughly the same rate of growth for many decades, a Tsunami is like a bell shaped curve. So timing is important for the Tsunami investor. If you bought into cable in the late 90’s you were wrong. If you bought any time before the mid- to late ’80’s you were right, and the earlier the better.

By the same token, you would not have gained much if you waited until the year 2000 to figure out that cell phones were going to be the future of telephony. It was too late. You should have seen that coming by, say, 1995, when there was still enough time to make good money. Better would have been 1992. I began attending investment seminars on cellular in 1988.

What about the oil and gas Tsunami? It started in 2004. Probably it will peak some time in the 2015 - 2025 time frame. So using the cellular time frame, now may be roughly the equivalent of 1993 for oil. There is certainly still time for major gains in oil and gas stocks despite the fact that a lot of the money already has been made.

One thing about the oil Tsunami that is different from other Tsunamis is that it’s power is so enormous that it could have a destructive impact on society’s financial infrastructure similar to a real tsunami’s impact on the place where it lands. The cresting of the oil Tsunami in the 2010 - 2018 time frame could destroy stocks, including even energy stocks. That is why a position in the physical commodity seems like a necessary aspect to a strategy concentrating in energy investments.

Beware of False Profits

You also need to pick stocks central to the Tsunami, not ones that are a mini-trend or a sub-wave related to the Tsunami but not inherently part of it. For example, in the energy world today there are a lot of companies making photo-voltaic electricity generators. Some have been good investments, some not, depending a lot on when you bought the stock and which company. But PV solar is only indirectly connected to peak oil and the related demise of the age of petroleum; not all PV companies will be successful.

Tsunami companies tend be acquired as the industry matures. No matter how “expensive” a cable stock or a cellular stock seemed to be at any given time, none of those companies ended up selling out at any price other than near the highest price they had ever sold for. Granted, a few of them such Comcast and Time Warner made the mistake of buying late in the game when they should have been selling, just as the Tsunami was peaking. But the other 98% of the cable companies sold out at their peak price.

On the other hand, I managed to find some ill-fated investments that were related to cable and cellular but were not right at the center of the Tsunami. One was a “Chinese cellular” company. Back in the early 90’s China was a different animal than it is today in terms of its business and financial practices. That company went under. Why I felt it necessary to go to China to invest in cellular when there were fine opportunities right here is not clear.

Similarly, there was a television distribution technology like cable in some ways called “MDS”. Companies that chose to “bypass cable” by using MDS did not end happily, nor did their stockholders. There were “specialized cable companies” too that served sub-markets like hotels. Some of them ended badly.

Similarly there are “false profits” in the energy space today. Most of them are part of the “alternative energy” universe. Some are involved in battery technology and other aspects of electric cars (which might become another Tsunami at some point). Some, like ethanol have already fallen on their swords.

The heart of the energy Tsunami is the production of oil and, secondarily, natural gas. The companies with the largest reserves and the greatest proven ability to increase reserves of oil and gas will grow in value the most. Close to the heart of the Tsunami are those drilling and service companies that enable the production of oil and natural gas.

Sometimes I think that the smartest thing an investor can do these days is put everything into Canadian Oil Sands Trust. With a nearly 8% dividend and more oil reserves than they have even bothered to prove, what could go wrong? Well, politics for one. And the possibility that they will get bought out requiring a tax payment and reinvestment program. Plus something will change if/when the Canadian taxes on trusts are revised. So some diversification of corporate vehicles is a good idea. That’s the least a Tsunami investor can do to earn his keep.

On the other hand ,and as a final note on investing in the energy Tsunami, the S.E.C. is currently revising its rules for reporting by oil and gas companies. The revision will allow them to count oil sands as reserves which could unleash a massive oil sands acquisition program by the oil majors. Best to own these stocks before Exxon starts writing checks.

Oh, and India is another rumored buyer of oil sands properties, but because they need the oil, as discussed below.

Why Are Oil Prices Rising? “The Answer” Comes into Focus

Recent information and analysis has clarified the dimensions of the energy Tsunami - what is causing the price to rise and how future prices and supplies will behave. The distinguishing characteristic of the picture is complexity. People want simple answers which is why so few of them understand oil. The oil world is huge and its behavior is multifaceted. Understanding it takes more than a simple minded idea like “blame the speculators.”

The reality is that the oil market is undergoing a sort of “perfect storm” of many different factors, including:

1. A group of countries that together produce 13% of the world’s oil are mismanaged or infested with political violence causing them to produce far less oil than they could if they had a stable government and market economy. The underproduction could be as much as 5 to even 10 mb/d.

2. Russian oil production is declining. That fact has dire implications for the amount of oil available to future export markets, as discussed in the link. When you combine declines in Russia with those of Mexico and the North Sea, the extent to which non-OPEC supply could decline in coming periods becomes significant.

3 Within OPEC it is uncertain as to whether Iran and Nigeria will increase or decrease their oil exports in future years. Saudi Arabia, Angola, and Libya are the only OPEC countries likely to increase oil production near term. Iraq is a potential bright spot starting in a few years at best.

4. Old oil fields produce less oil each year, which is called the decline rate and the amount by which they decline must be made up by production from new fields. Global decline is estimated to be about 3.5 - 4 mb/d per year, a much greater number than additional oil demand that is estimated to range from 1 - 2 mb/d per year.

Decline rates for existing fields have been rising and will probably continue to rise as more extreme methods of recovery are applied to old wells. The geological rule is that as efforts to increase the output of a field by extraordinary pressurization and drilling efforts becomes greater, the field will decline much more rapidly once the decline starts. For that reason, there is a a risk that the largest Saudi fields - and others such as Russian fields - may decline more rapidly than currently is projected and such increased declines could start to happen fairly soon.

An additional important fact regarding decline is that newer fields tend to be offshore and offshore fields exhibit much higher decline rates than land based fields. Offshore fields often decline by 8% - 15% per year compared with 5% - 8% for land fields.

5. Megaproject analysis indicates oil supplies coming from new oil fields will substantially drop after 2010 and will drop even more steeply after 2013. Some projects scheduled for the next few years could face substantial delays. If so, some of the projects now projected to start up in 2008 - 20010 will be delayed into the 2011 - 2015 time frame. That will add to price pressures in the near term. The megaprojects work is the most tangible evidence of a coming oil supply crisis.

6. New oil fields are located in increasingly difficult environments such as deep offshore or difficult fields like Kashagan. Costs of oil recovery in these fields are much higher. Higher costs are partly due to the fact that it takes more energy to recover the oil from these fields, so the Energy Return on Investment is declining.

This means the amount of net oil recovered after oil expended in the process of recovery is lower in these new, more expensive fields. If you project this trend into the future, at some point there would be no net gain at all from the process of extracting oil from new fields. At that point, which is well out into the future, there could be no more oil available at all.

7. In addition to the real historical phenomena discussed above, oil prices reflect to some degree whatever fears there may be that future political events may reduce oil supplies. The most important risk today is clearly the possibility that military action will be undertaken to keep Iran from having nuclear weapons. There are clearly no good choices for the West. An Iranian bomb would be a very clear and present danger to the security of the developed world but a military attack would clearly bring immediate instability and the risk of even greater future conflicts.

8. At the same time that all the above factors are influencing oil prices, higher oil prices are moderating demand somewhat, particularly in OECD countries. But while demand is declining in developed countries it is continuing to increase from developing countries, particularly in oil-exporting countries where fuel prices are subsidized and therefore market mechanisms do not impact consumer oil demand. The enormous - almost unimaginable - new wealth of oil exporting countries is being used by many of them to develop new industrial bases, which growth adds to their enhanced consumer demand to yield huge increases in their own use of their oil and thus decreases in their ability to export it.

It is not clear that the reduction in subsidies in developing countries that do not export oil such as China will reduce demand. In fact it could have the perverse impact of increasing usage in developing countries if higher prices cause an increase in the supply of fuel available to their consumers.

9. One way to sum up the outlook for the oil supply available to importing countries is to look at all the countries which produce more than one million barrels per day and which together supply 88.4% of world oil. An analysis of these countries that accounts for the projected internal use of their own oil production projects that their exports (which is not the same thing as production) are likely to decline going forward from today. If true, that would account for an increasing price of oil.

I’m sorry this discussion was so long. Unfortunately, there are simply a great many influences on the price of oil. It is quite wonderful that all this complexity gets boiled down into a single price that changes minute-to-minute. Oh well, blame the speculator.

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