Why revisit this topic again? Simply because if actions against Iran trigger a shutdown of the Strait of Hormuz, through which 40% of the world’s daily seaborne oil passes, oil prices will spike, the world’s teetering economy will slump and the arrival of the next financial emergency will be hastened. Even if the strait remains open but Iran is blocked from being an oil exporter for a period of time, it bears mentioning that Iran is the third-largest exporter of oil in the world after Saudi Arabia and Russia.

Once again, I am deeply confused as to the timing of the perception of an Iranian threat, right now at this critical moment of economic weakness. The very last thing the world economies need is a vastly increased price for oil, which is precisely what a war with Iran would deliver.

Let me back up. The U.S. has already committed acts of war against Iran, though no formal declaration of war has yet been made. At least if Iran had violated U.S. airspace with stealth drones — and then signed into law the equivalent of the recent U.S. bill that will freeze any and all financial institutions that deal with Iran out of U.S. financial markets — we could be quite confident that these would be perceived as acts of war against the U.S. by Iran.

And rightly so. From Reuters:

“U.S. Imposes Sanctions on Banks Dealing With Iran

“Dec. 31, 2011

“(Reuters) – President Barack Obama signed into law on Saturday a defense funding bill that imposes sanctions on financial institutions dealing with Iran’s central bank, while allowing for exemptions to avoid upsetting energy markets.

“The sanctions target both private and government-controlled banks — including central banks – and would take hold after a two-six-month warning period, depending on the transactions, a senior Obama administration official said.

Sanctioned institutions would be frozen out of U.S. financial markets.”

The impact of this law was quite pronounced and immediate, with the Iranian rial falling sharply against the dollar in the first few days after the bill was signed into law. As reported in Reuters:

“Iran’s Rial Falls to Record Low on U.S. Sanctions

“Jan. 3, 2012

“(Reuters) - The Iranian rial fell to a record low against the dollar on Tuesday following U.S. President Barack Obama signing a bill on imposing fresh sanctions against the country’s central bank.

“The new U.S. sanctions, if fully implemented, could hamper the world’s major oil producer’s ability to sell oil on international markets.

“The exchange rate hovered at 17,200 rials to the dollar, marking a record low. The currency was trading at about 10,500 rials to the U.S. dollar last month. Some exchange offices in Tehran, when contacted by Reuters, said there was no trading taking place until further notice.

“‘The rate is changing every second…we are not taking in any rials to change to dollar or any other foreign currency,’ said Hamid Bakhshi in central Tehran.”

That represents a more than 63% decline in just a month. Assuming that Iran trades its oil in dollars, this will not necessarily cripple its economy, but the specter of hyperinflation looms large whenever a currency falls by that much. With hyperinflation come economic, social and political instability, and these are, of course, precisely the aims of the U.S. in imposing the sanctions. And of course, everything that Iran imports will become hideously expensive — quite rapidly.

The U.S. is deliberately poking and prodding Iran right now. Given the glacial pace of nuclear development, we must ask ourselves, why now?

The Story

As with most things today, there is a story created for public consumption that justifies waging war against Iran. The main narrative goes something like this: Iran is trying to develop nuclear weapons, and this is intolerable, so it must be stopped.

In November 2011, the International Atomic Energy Agency (IAEA) issued a report, long denied under the prior director’s tenure (Mohamed ElBaradei), finally declaring that Iran was unequivocally trying to build a nuclear weapon. From The New York Times:

“U.N. Agency Says Iran Data Points to A-Bomb Work

“Nov. 8, 2011

“United Nations weapons inspectors have amassed a trove of new evidence that they say makes a ‘credible’ case that “Iran has carried out activities relevant to the development of a nuclear device,” and that the project may still be under way.

“The long-awaited report, released by the International Atomic Energy Agency on Tuesday, represents the strongest judgment the agency has issued in its decade-long struggle to pierce the secrecy surrounding the Iranian program. The findings, drawn from evidence of far greater scope and depth than the agency has previously made public, have already rekindled a debate among the Western allies and Israel about whether increased diplomatic pressure, sanctions, sabotage or military action could stop Iran’s program.”

I’ve not yet read the report, but I am concerned about the gap between the headlines I’ve seen that say Iran is building a nuclear bomb and carrying out “activities relevant to the development of a nuclear device.” For example, much has been recently made of the fact that Iran has enriched some uranium to the 20% grade, but there is a huge leap between that and the 90%-plus grade needed for a nuclear device. Iran had told the world it needed the 20% grade for a medical reactor, and then created a fuel rod for that reactor. To say that enriching to the 20% grade is the same thing as trying to build a bomb is not accurate, and possibly deceptive.

As a signatory to the Non-Proliferation of Nuclear Weapons (NPT) treaty, Iran has every legal right to enrich uranium for peaceful purposes, such as making nuclear fuel rods for a research reactor, and Iran is claiming that all their current work is toward this end.

Maybe it is; maybe not. But even if a nuclear bomb is being pursued, there’s nothing in the NPT that provides for military action to pre-emptively prevent any nation-state from carrying out such development work. In fact, if a preemptive strike is carried out, it will be done without the benefit of any international laws or treaties that could justify the action.

Also left out of the narrative is any explanation of why it was OK for Pakistan to develop nuclear weapons or why North Korea is permitted to hold them.

The simple answer is because they don’t have any oil. A quick view of the U.S. military presence surrounding Iran, coupled with the Iraqi experience of being attacked for supposed weapons of mass destruction that did not exist (nor were used by Iraq to threaten the U.S.), reveals why Iran may be so motivated to develop a nuclear weapon:

If Iraq had a nuclear weapon in 2002, it is quite doubtful the U.S. would have invaded — a lesson that has not gone unnoticed.

While I am not a supporter of the current repressive theocratic regime in Iran, I strongly believe that it is up to the people of any nation to decide for themselves what sort of system they will choose to live under. The Arab Spring, as messy as it was, is vastly preferable to the blunt instrument of an externally driven war.

The most curious thing about this story is the apparent lack of awareness among U.S. officials about how the oil markets work. I know they know better, but the context-free repetitions in articles such as this next one from Bloomberg almost literally drive me crazy:

Geithner to Seek China’s Support on Iran

Jan 9, 2012

U.S. Treasury Secretary Timothy F. Geithner will urge Asia’s two biggest economies to cut Iranian oil imports and seek to narrow differences with China on trade and currency disputes on a visit to Beijing and Tokyo this week.

The idea that the world could just stop buying Iranian oil, as though it were the same thing as boycotting McDonald’s and buying Burger King, is just ridiculous. The world oil markets are far too tight for that.

How is it that China is supposed to cut its Iranian oil imports exactly? Oil is a fungible product. If China cuts its oil imports from Iran, it will simply have to buy the missing amount of oil from someplace else. The 2.6 million barrels a day that Iran exports cannot simply be instantly replaced at this time from other spare capacity elsewhere in the world. It doesn’t exist at the moment. Where will it come from?

With the Persian Gulf being so small, and so many tense parties crammed into that tiny arena, the chance of some sort of mischief arising is quite high. One twitchy trigger finger — such as the one that caused the USS Vincennes, thinking it was under attack by a jet fighter in 1988 during the Iran-Iraq war, to shoot down an Iranian passenger airliner — and the hounds of war may be let loose.

And it’s not just the US. Practically everybody who’s anybody has naval assets positioned for whatever may happen next:

Western forces react to Iran’s Strait of Hormuz threat

Jan 9, 2012

TEHRAN, Jan. 9 (UPI) – A buildup of Western naval forces in the Persian Gulf and Arabian Sea is a reaction to Iran’s threat to close the Strait of Hormuz, military experts say.

U.S., Russian, French and British air and naval forces moved to the Syrian and Iranian coasts during the weekend, Israeli military intelligence Web site DEBKAfile reported Monday.

The Russian carrier Admiral Kuznetsov anchored earlier than planned at Syria’s Tartus port on the Mediterranean Sunday, causing France to respond by consigning an air defense destroyer to the waters off Tartus, DEBKAfile reported.

Canada also was sending a warship, the HMCS Charlottetown, to the Mediterranean where it would take over from the HMCS Vancouver.

Meanwhile, Britain has dispatched a missile destroyer to the Sea of Oman, due to arrive at the same time as the French Charles de Gaulle aircraft carrier.

And the U.S aircraft carrier John C. Stennis and its strike group are cruising in the Sea of Oman at the entrance to the Strait of Hormuz after Tehran announced it would not be allowed to cross through.

(Source)

With all those boats chugging around in those little bathtubs, and with various other forces that would definitely like to see a shooting war develop (a false flag attack is an option here), the risk is quite high of some form of incident that would trigger hostilities.

Of course, there are those in the war rooms of the various OECD countries who think they have a plan for the conduct of that war, but no plan ever survives first contact with the enemy. The one thing we can count on is the war being messier, longer, and more expensive by at least a factor of two than whatever is currently occupying the minds of the war planners.

Iran’s Responses

Of course, Iran has been none too happy over the years at being surrounded, poked, prodded, and now finally sanctioned for having done nothing more than cloak its nuclear program in the exact same sort of secrecy that has surrounded literally every other nation’s nuclear programs, including Israel and Pakistan, Iran’s notable nuclear neighbors.

And now, with the aid of enhanced missile technology obtained from China and Russia, Iran has a credible threat to make:

Iran Has Ability to Block Strait of Hormuz, U.S. General Dempsey Tells CBS

Jan 9, 2012

Iran has the ability to block the Strait of Hormuz “for a period of time,” and the U.S. would take action to reopen it, Joint Chiefs of Staff chairman General Martin Dempsey said.

“They’ve invested in capabilities that could, in fact, for a period of time block the Strait of Hormuz,” Dempsey said in an interview aired yesterday on the CBS “Face the Nation” program. “We’ve invested in capabilities to ensure that if that happens, we can defeat that.”

Should Iran try to close Hormuz, the U.S. “would take action and reopen” the waterway, said Dempsey, President Barack Obama’s top military adviser.

(Source)

The admission here by the US military is that Iran has the ability to block the Strait of Hormuz “for a period of time,” which they do, is an extraordinary admission (even if it really is stating the obvious) by the US brass.

Anti-ship missile technology has come a long way, and an offensive missile is much cheaper than either a large ship or defensive measures. The Falklands war in the early 1980s taught me that the navy is an outmoded concept if the opponent is armed with semi-decent anti-ship missiles, and such devices have improved remarkably since then.

During the most recent Iranian war exercises, the Iranian military test-fired (more of a demonstration, really) their Qader anti-ship cruise missile, which has a range of 200 km and can be fired from a small truck. To visualize the difficulty of defending against such a technology, just imagine how many hiding places for a small truck might exist within this 200 km radius green circle :

In order to neutralize the entire missile threat, full air superiority would have to be established and every mobile launcher found and destroyed.

Further, Iran has a number of submarines capable of firing a new breed of torpedo that can achieve speeds in excess of 200 knots. As far as I know, these are extraordinarily difficult to defend against, let alone evade.

Of course, China is paying close attention to the developments:

Iranian authorities reiterate threats to close Hormuz Strait if sanctions imposed on oil exports

Jan 8, 2012

TEHRAN, Jan. 8 (Xinhua) — Iranian authorities reiterated threats to close Strait of Hormuz if Western countries impose sanctions on Iran’s oil exports, local media reported Sunday.

(Source)

Conclusion

Once again, regrettably and mysteriously, we find the developed world in lock-step in its eagerness to attack Iran. “Regrettably,” because Iran has not threatened any other country, and war should never be used simply because the current art of diplomacy is inadequate. “Mysteriously,” because this is a particularly horrible economic moment to go about risking much higher oil prices.

While we judge the risks of a war, either precipitated by legitimate escalation of frictions or by illegitimate actors seeking to cause the same, to be very high, it is our view that such a war will not go according to plan. Iran has many more powerful allies, namely Russia and China, than did the extraordinarily isolated Iraq at the beginning of the Iraq war.

Is it too waggish to suspect that certain Western political powers would love to be able to both divert attention from the crumbling economy and have a scapegoat upon which to blame the next leg of the financial downturn?

Regardless of such speculation, the risk to each of us and the economy in general from an attack on Iran that closes the Strait of Hormuz is large enough to warrant your attention. Should oil spike in price, you can practically set an egg timer for the beginning of the next leg of the financial downturn.

Regards,

Chris Martenson

Iran: Oh, No, Not Again was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I’ve given it a lot of thought, drawing on my decades of market-watching experience. In the end, I came up with three predictions for 2012, one of which I will talk about in today’s article.

[ Michael also tied these predictions to three new trade recommendations, currently only available to Agora Financial Reserve members, but which we are working on making available to Whiskey Shooters for an unbelievable discount. More on this later in the week. Keep an eye out of it. -- Ed.]

But be warned: While I believe these events have a very high probability of occurring next year, the mainstream media will likely disagree. Expect them to say I’m being absurd, or at the very least ascribe to them a very low probability of happening.

Let them whine — they were wrong in 2011, and they will be wrong in 2012. So these predictions will catch most investors off guard [...which means you have an opportunity to buy into the matching recommendations for a relatively low price. -- Ed.]

And remember, I’m not a “doom and gloom” guy. In fact, I actually hope all of my predictions do not come to fruition, as they will prove yet more detrimental to this already-anemic economy and country.

But I can’t ignore what I see…and it is my charge to find a way for you to prosper amid the coming chaos. Even if what I see isn’t 100% on the money, the plays I’ve selected should still do all right.

So sit down, strap in and prepare to be surprised, starting with my first recommendation.

It’s pretty clear that we’re going to see some sort of military action against Iran’s nuclear infrastructure, either by Israel, the United States or even NATO. Recent words from Israeli policymakers, U.S. military action and even signals from the markets made that abundantly clear.

In a pre-Thanksgiving interview on CNN, former prime minister and current defense minister of Israel Ehud Barak spelled out his country’s position:

“People understand now that Iran is determined to reach nuclear weapons. No other possible or conceivable explanation for what they have been actually doing. And that should be stopped. And under nuclear Iran, the whole region will turn nuclear — Saudi Arabia, Turkey, Egypt will have to turn nuclear. The countdown toward nuclear materials in the hands of terrorists will start, even if you take out the generation. But more than this, they will use the nuclear umbrella to kind of intimidate neighbors all around the Gulf, to sponsor terror. Try to think what happens if at a certain moment you wake up after Iran turns nuclear, three years down the stream, and you end up with a Bahrain overwhelmed by Iran — who will come to rescue? Who would have come to rescue Kuwait when it was taken by Saddam Hussein 20 years ago, if Saddam could have said credibly enough that he had three or four crude nuclear devices?”

The defense minister continued:

“It’s true that it wouldn’t take three years…probably three-quarters, before no one can do anything practically about it because the Iranians are gradually, deliberately entering into what I call a zone of immunity, by widening the redundancy of their plan, making it spread over many more sides.”

He then reiterated the time frame in which Israel has to take military action: “I cannot tell you for sure, nor can I predict whether it’s two-quarters or three-quarters. But it’s not two or three years.”

In case you couldn’t read between the lines, Mr. Barak has given us a time frame for a pre-emptive attack — sometime within the next nine months!

And that’s overt military action. The covert options may have already begun… with the United States providing a hand.

The Drone Wars

You’ve probably heard about the RQ-170 unmanned American spy plane that Iran claims to have shot down. After weeks of denial, the United States has admitted it was hunting suspected Iranian nuclear sites.

Now Iran has claimed it was able to take control of the drone during its flight, forcing it to land exactly where Iran wanted it.

Spy flights are one thing. Actual hostility would be something completely different. But the fact is that might have already started too.

Israeli newspapers declared that Israel’s war with Iran already had begun, in the form of covert action in cooperation with other groups. The Miami Herald has information backing this up.

It reports that there have been a series of “mishaps” at Iranian nuclear facilities and weapons sites. They may be part of a covert organized attack on Iran’s nuclear weapons program, according to the paper.

A recent occurrence outside Iran’s third-largest city, Isfahan, is thought to be the most-recent strike, though details on the intended target are still unclear. Intelligence officials across the Middle East say there is strong evidence that an explosion at a sprawling military base and nuclear facility outside Isfahan had done some “significant structural damage.”

But it’s not just the promises from Israel, scattered newspaper reports or signs of U.S. surveillance that indicate an attack on Iran is imminent. It’s the market indicators as well.
Consider oil prices. Logic dictates that if the global economy were slowing, the demand for oil would drop, along with its price. In fact, that’s what has been happening with most industrial commodities. But oil remains a glaring exception.

Take a look at the following charts:

The first shows the year-over-year change in oil and copper prices, and the second shows the change in both those commodities over the last 30 days.

We can see that oil prices are up 12% over the last 52 weeks and have surged 13% in the last month. But copper prices are down nearly 10% YOY and have dropped about the same amount in just the last month. As I alluded to in the last issue, falling copper prices are a signal that a global recession is just around the corner. However, oil prices are telling us that something other than just a global economic funk is in the cards.

I believe oil prices have begun to factor in the removal of the world’s third-largest exporter of oil from the market. But I think the markets are actually being too optimistic. There is much more at stake here than the 2.2 million barrels of oil that Iran exports each day.

If you know Middle Eastern geography, you know Iran sits alongside the Strait of Hormuz, a narrow body of water that connects the Persian Gulf to the Arabian Sea and, ultimately, the Indian Ocean.

Oil tankers from Bahrain, Iraq, Kuwait, Qatar, Saudi Arabia and the United Arab Emirates all travel through the strait. In fact, 33% of the world’s tanker traffic and a mind-blowing 17% of the world’s oil pass through the strait.

So with just a little effort, Iran could effectively block nearly one-fifth of the world’s oil supply. And the country knows it.

This is not speculation. This is 100% fact. As Fox News reported, Parviz Sarvari, a member of the Iranian parliament’s National Security Committee, recently warned, “Soon we will hold a military maneuver on how to close the Strait of Hormuz… If the world wants to make the region insecure, we will make the world insecure.”

Wall Street cannot ignore that threat much longer. The increasing likelihood of an overt attack on Iran will not make the situation any better. Remember that when Saddam Hussein invaded Kuwait in 1990, oil prices doubled. And that was just a fraction of the world’s oil at stake, compared with what closing down the Strait of Hormuz could mean.

But even if the world manages to avoid a confrontation with Iran, there are other reasons to have exposure to rising oil prices in your portfolio next year.

For one thing, there’s still the ever-present proclivity of global central bankers to print unlimited amounts of money. After all, oil has traditionally been a fairly good hedge against inflation. Remember back in the late ’70s when gold and oil prices soared together when the Fed under Arthur Burns sent inflation to 15%.

But couple Fed chief Ben Bernanke’s love affair with counterfeiting, er, creating new cash with the credible threat of oil shortages, and you can clearly see why owning oil-producing stocks may be a great asset in 2012.

Regards,

Michael Pento

Iran’s Desperate Gamble to Push Oil Up to $200 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

As a long-time follower of the world oil industry, I was immediately struck by how one key target of the rioters and protesters was France’s petroleum distribution system. Clearly, the protesters understand the ideas of the 19th Century military theorist Karl von Clausewitz, who advanced the concept of finding the opponent’s “center of gravity,” and then bringing force to bear on that point.

The protesters were going for the jugular of modern societies, which is the energy supply. In France this week, over 3,000 — out of 13,000 — gas stations ran out of fuel after panic-buying by motorists. Also, eleven out of France’s 12 oil refineries remain on strike. Add to this that “flying pickets” are moving around, blocking fuel distribution depots. Thus has lack of fuel shut down major sectors of the French economy.

Indeed, the Charles de Gaulle Airport in Paris — a key transportation hub for the world, and not just France — suffered from a severe shortage of fuel for arriving aircraft. French authorities advised air carriers to land with enough fuel to take off, and fly somewhere else to gas up.

Pres. Sarkozy sent riot police to confront the blockades of refineries and fuel terminals. He knows that his response to the energy-based tactics of the opposition will make or break his political power. The jury is still out, but my hunch is not to bet against the power of the French state on this one.

What’s the Real Issue?

On the surface, the French rioting seemed like a political squabble over a high-visibility social entitlement. Considering the passion of the protesters, it’s like the current retirement age in France — 60 years — is some sort of sacred number. The protesters make it sound like Pres. Sarkozy wants to destroy a deep-rooted individual right that dates back to time immemorial of which, to use an old phrase, “the memory of man runneth not to the contrary.”

But the age-60 retirement number is not exactly some icon of bloody struggle, hewn out of the rock of revolution and war. No, the age-60 retirement eligibility dates only back to 1983 when the Socialist Party, under then-president François Mitterrand, reduced the former age of retirement from 65.

That is, the age-reduction for retirement was just a vote-buying political move during a time of relative peace and prosperity in France. Which gets us closer to identifying the real core issue behind the social unrest in France. It’s a lesson for all of us, in fact.

Times Have Changed — An Earthquake Across History

Neither France, nor the Western world generally, is living in a time of relative prosperity. Not anymore. Maybe not ever again.

Things have changed in this world, probably forever. The economic rise of China has caused an earthquake across history. That, coupled with the self-inflicted collapse of much of the Western way of running capital markets and managing economic growth over the long haul.

In just the past 15 years or so, China has evolved into a nation of immense demand. China has become the key player in a world of fierce resource competition. Look around. Things like energy, minerals, water and food are scarce, and getting scarcer. China is driving a long-term bull market in resources of every sort, from oil to iron, copper to cotton, cement to soybeans.

No “Value” in Value-Creation

On the other side of the coin, China is a land of mind-boggling, low-cost productivity. In almost every industrial arena and sector, the overall competition from Chinese firms has driven costs for many things. How low? Well, often down to right around the intrinsic value of the inputs — the plastic, the copper, the steel. As for the labor input? It’s not too much to say that Chinese competition has removed much of the “value” from value-creation.

Indeed, one of the major global economic issues today is that when Western businesses go head-to-head against Chinese competition, in almost any industry, nobody makes much money anymore.

So if this is the world in which we live, how can France remain a wealthy country? How can the West retain its status and historical standards of living? Tough questions, eh? But well worth asking.

What Can Nations Afford?

It takes us back to those French retirement riots. In France — and in the U.S. as well — government has promised far more than it’ll ever be able to deliver.

Retire at age 60? Who can afford that? Who’ll pick up that bill? Where’s the money? The government will collect taxes from who, exactly?

Really, when it comes to the French riots, it’s NOT just that the age-60 retirement idea lacks any sort of serious historical pedigree. Not at all. The problem is that the days of an entire nation retiring early are over.

Age-60 retirement is an idea that’s ridiculous and unsustainable in a world of Peak Oil — and Peak “Everything Else,” for that matter. We in the U.S. — and Canada, U.K, Australia, and so many other places across the world — need to take heed.

Until we meet again,
Byron King
Whiskey & Gunpowder

November 15, 2010

Riots in France a Symptom of Declining Western Wealth was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In this portion of the interview, Mr. Moshiri and I discuss what’s going on 6,000 miles south of the U.S., offshore Brazil. There, over the past couple of years, we’ve learned about gigantic oil resources, buried many miles under the deepwater seabed.

To date, the most prolific oil-bearing locales offshore Brazil are in the “pre-salt” zones of the Campos and Santos Basins. Looking forward, there are many more basins left to explore along the Brazilian coastline.

In short, the future for energy development is bright down in Brazil. Here’s more of my discussion with Mr. Moshiri.

BWK: There’s news coming out of Brazil almost every week, from Petrobras and other companies that are working down there. Chevron has a large presence in Brazil. Where do you see things going now that Brazil is coming towards the end of rewriting its offshore oil laws, creating a pre-salt development entity? What do you see happening down there?

AM: First of all, the Santos and Campos Basins of Brazil are very attractive. Geologically, (these are) fantastic basins. Petrobras has done a marvelous job of handling this, in the fashion that should be an example for others.

BWK: How is Petrobras setting an example?

AM: Even as a pioneer in the deepwater, Petrobras invited IOCs (international oil companies) in a very systematic manner, starting around 1996 — and I’ve been involved with that for about 15 years. It’s (a model for) how to get IOCs involved, how to work with them closely, how to expand the relationship. We (at Chevron) have a relationship with Petrobras not just in Brazil, but outside of Brazil, where we are partners in West Africa as well. So from Brazil’s point of view, I think they’re taking the right steps since the late 1990s.

BWK: What about the new laws concerning development of the pre-salt oil resources?

AM: Regarding the pre-salt itself, and the new terms and conditions that they’ve put forward (i.e., the government of Brazil), there is a change from what it was before. But at the moment, (the pre-salt) is still an exploration play. There are going to be good surprises. There are going to be not so good surprises. To be honest, that’s exactly what happened in the U.S. Gulf of Mexico (GOM).

Until we understand the geology better, until we know what it is, (then) I think we, Petrobras and others can move ahead.

What we know today is that the petroleum system is there. The right parameters are there. Some of them probably, in some areas, will be higher or lower from the reservoir characters’ sake.

It’s a carbonate, deepwater. You can drill one well, and the next well may not be as good as the last one you drilled.

Until we assess that? Whether or not Petrobras is going to do it, or we are going to do it, is … a decision that will be up to the government of Brazil. But nonetheless, those are the two basins (Santos and Campos) that have been our focus.

BWK: Can you discuss Chevron’s major efforts in Brazil?

AM: As you know, we have Project Frade on the street.

BWK Note: Mr. Moshiri didn’t go into details in our recorded discussion. But according to Chevron’s web-site, Chevron holds a 51.7% interest in the Frade deepwater oil development project, which it also operates. The oil field lies in water depths of approximately 3,700 feet, 230 miles northeast of Río de Janeiro in the Campos Basin. Frade is a subsea development with wells tied back to a floating production, storage and offloading vessel (FPSO) — see image below. The project has an estimated price tag of $2.8 billion. Development is ongoing. The estimated output should be 68,000 barrels of crude oil and 25 million cubic feet of natural gas per day, starting in 2011.

BWK: And other large projects?

AM: (In addition to Frade), we are committed to another project called Papa Terra, which just went through E&D (engineering and design) earlier this year.

BWK Note: Chevron holds a 37.5% interest in Papa Terra, with Petrobras as the operator. Papa Terra has a planned capacity of 140,000 barrels per day of oil from a field that lies under about 3,900 feet of water.

AM: And the other thing we value a lot is our relationship (with Petrobras), and how Petrobras complements what we know and what they know to get the best out of every development and every activity.

We are hoping that the sub-salt selection activity (after the new oil law goes into effect), and to be able to work with the terms and conditions that put forward, will help get where we are for the post-salt. The same attitudes will be there, that help to collaborate on the post-salt.

BWK Note: When Mr. Moshiri references “post-salt,” he means the shallower projects, above the massive salt zone, where Chevron was working before the pre-salt discoveries of the past three years. Here’s a seismic illustration of the layers.

BWK Note (cont.): These earlier, post-salt projects — seen above in representative seismic cross-section — will remain subject to Brazil’s previous oil development law.

AM: What I mentioned about Mexico (earlier in the interview), versus Brazil, is that Brazil is very focused on production and capital efficiency. And it’s very unique.

I know that Mr. Gabrielli (Sergio Gabrielli, CEO of Petrobras) probably doesn’t want me to call his oil company a national oil company, which it’s not.

Petrobras is very focused on (capital efficiency), and it’s very much in line with what we think. If Petrobras knows that something is not working, or it’s too much, or whatever? I think they do build flexibility into the system to make sure they do the right thing. Therefore I’m optimistic about Brazil.

I feel like it’s not totally petro-politics (in Brazil). In some other countries, it is totally petro-politics. (In Brazil), it is petro-economics. If economics doesn’t drive them where they want to go, they would bring in other companies. They’ll create flexibility. I’ve seen that for 15 years.

BWK: So you believe Chevron has a solid relation with Petrobras?

AM: For us, we (Chevron) operate Frade. Papa Terra, our new development, will be operated by Petrobras. I have full confidence in Petrobras, that the project will be delivered and operated. Therefore we are complementing each other. That’s the reason that development in Brazil gets handled at a much faster pace than what we’ve seen in other places in the world.

BWK: One last point about Brazil. Last year, about July 2009, a senior member of the National Petroleum Agency (ANP) of Brazil said that “there’s no risk in the pre-salt.” Do you agree or differ with that assessment?

AM: As a geologist, you know that Mother Nature will always give us a surprise. Even in mature basins, we’ll always get some surprises. We hope always for the better. But I think his comment was aligned with knowing the basins. His comment was misunderstood in the form of ‘no risk.’

BWK: A lot of people use the word risk, but don’t really understand its meaning in the world of oil exploration.

AM: (The) comment goes back a few years ago. None of us knew that (the pre-salt) basin was existing there. We drilled a couple wells below the salt, but everybody’s focus was post-salt. But a couple discoveries? And continuing exploration? Petrobras and others? We are finding out that yes, this could be a significant basin.

It wasn’t a matter of drilling the well. It’s a matter of knowing the basin. Like with the Wilcox in the GOM.

BWK Note: Wilcox is a highly productive, oil-bearing formation, covering a vast area, that’s a target for many shallow, deep and ultra-deep wells in the U.S. part of the GOM.

AM: One of the things we focus on is understanding the prospectivity of a basin. I think he (the ANP man last year) was referring to that. Yes, there are several prospects in here. If you do your homework, your geology, your technical work, probably your risk is extremely reduced.

No doubt about it, (offshore Brazil) pre-salt is a basin. A basin (with) carbonate reservoirs that can perform very well. You need to find where the oil is, and where the productivity is going to come from.

Therefore I put it (the comment of the ANP man) in the framework of yes, we identify a basin, and the more work we do, the more risk will come down.

This last comment pretty much sums up Chevron’s approach to energy development. Do the work. Then do even more work. Don’t be afraid to spend money and apply technology to obtain the data you need. And the more work you do, the more the risk comes down. It’s what makes Chevron a successful oil finder.

Great Opportunities Offshore Brazil

The bottom line is that there are phenomenal opportunities for future energy exploration and development offshore Brazil. Developing Brazil’s pre-salt energy resources will require hundreds of billions of dollars of capital. Brazil will need hundreds of modern drilling ships and related service vessels. The long-term effort will require world-class exploration and development technology. And it all has to be operated by superb and skilled people.

Chevron is one of the world’s best-run independent oil companies. It has a solid record, over the past century, of successful exploration and development. Chevron has great financial strength, and a deep pool of technical competence. Chevron’s success — certainly in deepwater development — is built upon its highly skilled and talented people.

I expect that, as things unfold, Chevron will be right in the thick of things offshore Brazil, working closely with the Brazilian government, Petrobras and other partners.

Until we meet again,
Byron King
Whiskey & Gunpowder

September 8, 2010

Still Profiting from Deepwater Drilling was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

One particular oil field is central to the problem. It’s called Cantarell. It’s a super-giant, offshore oil field that was discovered in 1976 — based on a natural oil seep under about 150 feet of water, by the way.

After decades of production, Cantarell is getting long in the tooth. Oil output from Cantarell, is declining rapidly. Cantarell is depleting at an astonishing rate. Meanwhile, the yield from new Mexican oil fields is simply not making up the difference.

The Mexican government obtains about 40% of its national receipts from oil-related revenues. Yet due to falling oil output, especially from offshore, Mexico will likely cease being an oil exporting nation by 2015. This looming problem holds dire implications for the national balance sheet of Mexico, as well as — by implication — for U.S. energy and national security.

One obvious question is, Can Mexico rebuild its oil industry? Right now, there’s not nearly enough internal Mexican investment in exploration and new oil development. It’s quite evident that Mexico has under-funded what’s called “maintenance capital,” the funds necessary just to keep the day-to-day operations and equipment working.

Another problem is Mexico’s lack of success in discovering and developing new oil resources, despite its national jurisdiction over a large slice of the oil-rich Gulf of Mexico.

One major element of this lack of exploration success is that Mexico’s constitution severely restricts foreign participation in Mexico’s energy development. That is, foreign oil companies are banned from exploring for and drilling for oil in Mexico. Considering Mexico’s crashing oil output, it’s fair to ask if Mexico should change its approach to development.

Recently, I discussed these important issues with Ali Moshiri, President of Chevron Africa and Latin America Exploration and Production Company.

Here’s what I asked Mr. Moshiri about Mexican oil development, followed by his reply.

BWK: In the U.S. we’re seeing remarkable discoveries in the deepwater Gulf of Mexico (GOM). Could you share your views about what’s happening across the GOM, down in Mexico? Is there hope for deepwater oil helping Mexico reverse it’s decline rate for oil production?

AM: With Mexico, the new government reforms are in a positive direction. The fundamentals have to be decided by the Mexican government, which has to decide how they want to risk exploring their basin.

The Mexican government has to decide if they want to risk future exploration via Pemex (Petroleos Mexicanos, the Mexican national oil company — NOC), or via the private sector. They need to recognize that if the private sector is going to get involved, it has to be via a meaningful way. A meaningful way would be via sharing the risk and the upside.

BWK: Do you think we’ll ever see large, new discoveries in the Mexican GOM areas?

AM: I personally believe that Mexico is under-explored. They’re lagging behind on exploration offshore, and they underestimate the complexity and what is required. It all needs to be reassessed.

If you look at the U.S. deepwater GOM, there was a long era (to get to) where we are today. And you cannot look at today, and say you are going to take the U.S. GOM and image it into the Mexican area.

BWK: So what do you think it will take for Mexico to accomplish the exploration, and find the potential resources that are out there?

AM: Number one is that (Mexico needs to allow) the flexibility that is required for private sector, for IOCs (international oil companies). It’s IOCs that are the ones who really know how to go from phased exploration into development.

Yes, you can find companies that can explore. But when you explore, and then you find hydrocarbons in 8,000 feet of water, the next step is how you can develop it. How much money do you need? You can say, well, you need X-millions of dollars (to) develop it. But how do I finance it?

It gets into capital efficiency. Capital efficiency would be, how do I go ahead and finance this project? By production sharing? Finance it by myself? Some other way? How do you finance the development? Those are things that we think need to be addressed in Mexico.

BWK: What about contractors? Do you think Mexico could accomplish its energy goals by hiring, say, service companies, or using large oil companies as contractors, to do the exploration, the seismic, the drilling and such?

AM: The IOC has to be perceived as a partner. You cannot perceive the IOC as a contractor. This is my personal opinion.

Working with the IOC as purely a contractor will slow down the process. You have to look at the IOC as a partner, and a partner meaning sharing the risks as well as the rewards.

If Mexico gets this concept, and understands it, I think the progress and the basin is good enough to do things in the right way, and (Mexico) can be able to catch up the U.S. GOM and the U.S. sector.

So according to Chevron’s Ali Moshiri, there’s hope the Mexican energy sector. If Mexico opens up to foreign risk-sharing, and makes a good use of the expertise of international oil firms, then the nation can increase its future oil output.

But Mexico needs to permit outside, independent oil companies to participate as partners in exploration and development. That means to share the risk and rewards. In other words, Mexico should leverage foreign capital and technology, while sharing the eventual oil production in an equitable manner.

Even then, if everything goes right, it’s going to be a multi-year project to restore Mexico’s oil output to what we’ve seen in previous years. From where things are now, it won’t be easy.

The Overall Strength of Chevron

Chevron is one of the world’s largest and most capable independent oil companies. Chevron has great financial strength, and a deep pool of technical competence. Chevron’s success — certainly in deepwater development — is built upon its many highly skilled and talented people.

I can say these good things about Chevron based, in part, on my first hand knowledge. I’ve had the opportunity to visit a Chevron deepwater drilling project in the GOM. From what I’ve seen, Chevron exhibits a strong culture of safety and technical excellence.

Other Investment Opportunities in Deepwater Energy

There are, of course, other companies working on deepwater oil exploration and development projects across the world. If you’re interested in learning about another deepwater development, I can tell you about a small, Canadian company that has acquired a remarkable play offshore Africa. Just follow this link and listen to a presentation on this investment idea.

Until we meet again,
Byron W. King
Whiskey & Gunpowder

August 9, 2010

Mexico’s Crashing Oil Industry was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In our talk, Mr. Moshiri and I looked at the future of offshore oil and gas exploration and development. Here’s part of what we discussed, with more to come in future articles.

BWK: Mr. Moshiri, you run a division of Chevron that includes Africa and Latin America. How much oil and gas do you pull out of the ground every day?

AM: For Africa and Latin America, on a gross basis, Chevron is producing somewhere around 840,000 barrels per day.

BWK: That’s about 1% of all the oil that the world uses every day, at 85 million barrels per day. Can you say some more about what’s happening in the areas with which you deal?

AM: (My area is ) the Atlantic Basin. … If you look down at the southern part of the Americas and Africa, people are ignoring the contribution it’s making worldwide.

The basins in this area are different. It’s not necessarily like the Middle East, that they are huge fields. But there are many accumulations. On the aggregate, they’re significant. Not only to the Chevron portfolio, but overall to the supply of oil to the market.

If you look at this area, they’ll always be a net exporter. They’ll always produce more than they can consume. My personal view is that if they continue their level of economic growth, that they assume is going to be above global, they’ll still be an exporter.

It creates an environment for industry to include them as part of the energy equation. The barrels can move to other locations where they don’t have that balance.

BWK: Are you only looking for oil? What’s the larger hydrocarbon picture?

AM: The (Atlantic) basins have similarity, but at the same time the basins have both oil and gas. It’s not just oil. At the moment, the focus has been tremendously towards oil. I believe that both basins in West Africa as well as in Latin America have tremendous potential for gas for the future. But because of lack of infrastructure, they haven’t got to the point similar to Asia Pacific of the Middle East yet.

But if you look ahead 15 years, they’ll get to the point of contributing natural gas, through LNG (liquefied natural gas) or pipeline. … That’s the next phase. Today it’s very much focused on the oil side.

BWK: In the Middle East, you’re looking at a mature, 60-70 year old concept of exploration. Also, culturally, you’ve got similarities of climate, ethnicity to some extent, religion too. Not that everybody’s the same. But by comparison, if you’re moving from the Caribbean Basin to West Africa to Brazil to Angola, you’re going to see a lot of different people and different governments and different cultures that you’re going to have to work with. Can you comment?

AM: Absolutely. If you look at the Chevron operations, we deal with ten different countries. Three of them are in OPEC. Two of them are observers in OPEC. Therefore five of them are very much within the framework of the OPEC community. That shows that each of them have (their) oil policy and different view compared to when you look at places like the US, Australia, UK and Europe.

For that matter, you have to deal with each country separately. You have to understand, first of all, the geology, the technical aspects of it. And also the policies. The policies vary.

I’m not saying it’s good or bad, whether it’s in the hands of the government or the private sector. That’s what we deal with in this area. Not only do we have to worry not just about the technical side, but about the fiscal, commercial aspects of it as well.

BWK: Can you comment about what you’ve seen over the past 20 years, with the rise of the national oil companies (NOCs) in these regions, and how you’ve had to adapt from the way you used to do business to the way you have to do business now in the NOC environment?

AM: The reality is that with the truly conventional aspects of oil and gas, the technology is there. The know-how is there. Whether or not we have it, or a service company has it. It’s there. So the view of the NOC is that they have more than one option on just the conventional (development).

For example, (what) if you discover an oil field on land, say light oil? Then building it, developing it, putting it into the market is relatively conventional. So what we would focus on is increasing the recovery factor. We focus on getting more out of the ground.

The next phase is what I’d say depends on technology. You get into deepwater. The technology is different. The incremental cost is significant. Room for efficiency becomes a greater part of how we develop things. Yes, everybody (says that they) can develop deepwater. But how you manage expensive wells that you’ve got to drill? How do you test the basin? How do you commit to the investment? Those are significant.

As you see in the market today, it’s almost becoming like there are a lot of people who can explore. But there are not a lot of people who can develop deep water.

BWK: I had a chance to visit a Chevron operation in the Gulf of Mexico (GOM) in March. Chevron had the Transocean vessel, Discoverer Inspiration, drilling in over 6,700 feet of water, about 200 miles off the Louisiana coastline. The target depth was over 30,000 feet. It was quite an operation.

AM: I’m glad you took a visit to some of our operations. (You should see) some of the other remote places like offshore, deepwater off Nigeria. You can see how those places are highly technically driven.

And for as much as we’ve gone so far into developing these (deepwater) fields, the technology is not there to work over the wells when there are problems. The technology is not there to create efficiency for working over some of these wells. For example, if a well goes off production in West Africa, and it’s in the swamp, or in Block Zero, off Angola, in shallow water, we move a rig in and we know how work over the well.

But if a well goes off production and it comes to a work-over, if it’s in deepwater, in say 8,000 feet of water, then you almost have to spend as much to work over a well, as you spent to drill the well. Therefore we are looking for the technology, and expanding our expertise, how to go back and do some of that work. To work those kinds of wells over.

BWK: Can you describe how Chevron’s relationships are changing over time, with the NOCs?

AM: Yes, our relationship with the NOCs is changing, moving to a different direction. The next phase goes several years down the road, gets into the non-conventional hydrocarbons. Like tight sands and shale gas. I always use the U.S. as the base, where we started.

I’ve been in this business 32 years with Chevron. I remember when 500 feet of water was deep water. But now 500 feet of water is a conventional development, or work-over, with high recovery factor. And I think we need to expand that one all the way.

In some of the other regions, especially my region, we are not to that point yet. Again, it’s because some of these basins have not matured yet.

BWK: Can you elaborate on that concept of maturity? How are things different between, say the U.S. and further south in the Atlantic Basin?

AM: (The U.S.) Gulf of Mexico shelf is mature. But if you look at it south, from Mexico down to Argentina, or West Africa or sub Sahara or East Africa, we are still at the first phase of understanding the basins, understanding the potential, developing the technology around it, and being able to transport it.

Some of the discoveries (that) some of the companies have, in sub Sahara Africa, the transportation is going to be the issue. That region is going through a different phase. The transportation is about one phase behind where we are in the U.S.

According to Chevron’s Mr. Moshiri, there’s great potential for future energy development in the Atlantic Basin. The hydrocarbon resource is there — both oil and natural gas — and development is at an early stage.

The future will see more exploration and development, moving from oil into gas. The local markets will doubtless expand, but there’s still quite a bit available for export. But to accomplish this, the transportation infrastructure needs to expand. In short, there’s much left to accomplish in an immense swath of the world.

The Future Challenge of Energy Development

There are great opportunities for future exploration and energy development in Latin America and Africa. This will require trillions of dollars of capital over many years. That, plus world-class technology, superb and skilled people, as well as close coordination between developers and the national host governments.

Chevron, the subject of this article, is one of the world’s best independent oil companies. From its roots in the California oil patch of more than a century past, Chevron has a solid record of successful exploration and development. Chevron has great financial strength, and a deep pool of technical competence. Chevron’s success — certainly in deepwater development — is built upon its highly skilled and talented people such as Mr. Moshiri and the many members of his extensive team.

Other Energy Opportunities

There are many other companies working on deepwater oil exploration and development projects across the world. They range from very big to not very big, from independent to nationally-owned and operated.

If you’re interested in learning about another aspect of deepwater development, I can tell you about a small, Canadian company that is developing a remarkable play offshore Africa. Just follow this link for more information on this investment idea.

Until we meet again,
Byron W. King
Whiskey & Gunpowder

August 4, 2010

Africa, Latin America and Energy Development in the Atlantic Basin was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

We need to consider what it means for our future investment strategy — indeed, there are more lucrative opportunities if you look in the right places.

Certainly in the U.S., and doubtless the world over, the GOM disaster will spark tighter restrictions and higher costs for deep-water development. So let’s look at what’s going on with deep water and then compare it with what’s happening far from the sea, in the interior of the North American continent, up in Canada’s oil sands country.

The bottom line is that the GOM oil disaster will benefit energy development in Canada — and you can profit. But this gets ahead of the discussion…

Declining Support for Deep-Water Development

First, the BP (BP: NYSE) oil well blowout caused a decline in public support for deep-water development. The political forces simply are no longer aligned for strong growth in U.S. deep-water development, at least for the next few years. In other parts of the world, things may be better for offshore development. But even that is yet to be determined. We’ll have to watch, on a country-by-country basis.

Second, the U.S. government has just closed down the GOM, one of the world’s great oil provinces, to further drilling. We have a “six-month moratorium” on U.S. deep-water development, hastily enacted by the Obama administration. It’s already the subject of fierce litigation in federal court, but these things typically don’t play out quickly or smoothly. Thus, the moratorium will likely prove to be long. We’re already seeing upstream oil operators declaring force majeure and breaking contracts with drilling companies for GOM-based rigs. That kind of drastic legal remedy wouldn’t occur if people thought the moratorium were going to end anytime soon.

Third, the GOM blowout and oil spill will surely lead to stronger, more adversarial and more expensive regulatory scrutiny. Everything will take more time. Everything will cost more to accomplish. This will include industry having to obtain more permits. We’ll see more frequent, and more intrusive, inspections. Overall, there will be much more stringent environmental control.

Altered Risk-Reward Profile

The long and short of it is that deep-water energy development — in the GOM, and possibly worldwide — will face increased costs and extended project timing. We’ll see this at every step, from the regulatory approval process for new drilling to project construction, commissioning, operations and decommissioning.

In the U.S. for sure, the entire risk-reward profile for the deep-water GOM has altered dramatically. And in this world of mobile capital, we’re sure to see capital shift to other locales where the resource potential offers a better return. That new balance favors Canadian oil sands.

There’s “Peak Oil,” and Then There’s Canada

That term “Canadian oil sands” is truly loaded. Some people hear it and go ballistic, ripping into the amounts of water and natural gas and environmental impact there is in recovering “bitumen” — the correct term — from the frozen north. Other people hear the same term and smile at the geological fact that there are a lot of other hydrocarbon molecules out there in the rest of the world besides conventional crude oil.

Which gets us to another point. For as much as the term “Peak Oil” has made it into the common language, we need to keep in mind what we’re really discussing. The global energy production curves show conventional crude oil output peaking in many parts of the world. U.S. crude oil output, in fact, “peaked” in 1970. But you need to understand that the oil output that’s peaking is the old-fashioned kind of oil, like what Col. Drake was drilling back in 1859.

That is, the light, sweet, easy-flowing oil is getting harder and harder to find, certainly in significant quantity. It’s one big reason why the energy industry has moved offshore into deep water. That’s where the big new oil finds are.

But in addition to deep-water oil resources, the onshore world has immense amounts of unconventional, “heavy” hydrocarbon molecules. See the graph on the facing page from oil services giant Schlumberger that shows the world’s heavy oil and bitumen resources.

Canada has about 400 billion cubic meters of bitumen — most of it in Alberta (with some in Saskatchewan). That number translates to something like 1.4 trillion barrels of oil equivalent. How much is that? About SEVEN times the total oil reserves of Saudi Arabia. In other words, the Canadian oil sands may be the single largest hydrocarbon deposit anywhere on earth.

Reevaluating Oil Sands Risk

So yes, there are a lot of hydrocarbon molecules up in Canada. But these molecules are harder to get out of the earth than conventional oil. To produce bitumen from the oil sands requires large investments of capital, technology, energy, water and labor.

Thus, in recent years, Canada’s oil sands developers have faced increased public scrutiny. Much of it has to do with the perception of “dirty” oil, particularly the water usage and carbon dioxide (CO2) output required to extract oil from oil sands.

Then again, with the GOM disaster, and oil washing into sensitive environments along the Gulf coast, peoples’ viewpoint of “dirty” oil will likely change.

The fact is that the total CO2 emission profile for the entire Canadian oil sands operation — from one end of Alberta to the other — is about the same as the CO2 footprint for one large world-class city, such as London. And the water usage? Recent technical advances allow each barrel of water to be recycled and reused up to 19 times, for a 95% efficient process. It’s almost a closed system.

The bottom line is that obtaining bitumen from Canadian oil sands is not nearly as “dirty” as the opponents would like you to think. For investors, the environmental downside is a diminished risk factor.

Then there’s the issue of geologic risk tied into development. If you drill a well in deep water, for example, you may or may not find oil. By comparison, the oil sands resource is well established. The oil sands are well mapped. There’s really no real risk there. When you acquire an oil sands claim, you know what you’re getting. And the technology has progressed to the point that you can predict with great accuracy what you’ll ultimately recover from the ground.

Further along these lines, the experience with offshore projects is that the high-productivity wells last for only a few years at best. Then the wells and oil fields begin to enter conventional decline. In contrast, oil sands projects offer flat, stable production profiles over many decades. The historical record is that some surface-mining oil sands projects have reserve lives well north of 50 years.

For underground projects (called in situ projects, using steam-assisted gravity drainage or cyclic steam stimulation), the record is that projects can run at design rates for 20–40 years.

Thus, it’s time for investors to reevaluate the prospects for Canada’s oil sands. For many years to come, Canada’s oil sands are and will be a dominant contributor to future growth in global oil production.

Until we meet again,
Byron King
Whiskey & Gunpowder

July 21, 2010

Oil Crisis to the South, But Oil Opportunity to the North was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is O’Malley’s playground. He has probably bought and sold more refineries than any man alive. He knows them like an old chef knows the inside of his kitchen.

O’Malley got rich by following a reliable formula. He bought refineries when they were cheap — castoffs, unloved by Big Oil — trading for less than the cost to build them. Later, he sold them for billions.

For example, in the aftermath of the 1987 crash, he picked up a 26% stake in Tosco, then a tiny refinery. O’Malley eventually turned Tosco into the largest independent refiner in America. He sold it to Phillips Petroleum (now ConocoPhillips) for $7 billion.

Two weeks after he closed that deal in 2002, he took over Premcor, becoming its top executive. He did it all over again, using Premcor as a vehicle to buy refineries on the cheap. Four years later, he sold Premcor to Valero for $6.9 billion.

His is the Midas touch in the refinery space. And he’s mostly laid low since 2007. But now he is back again, buying a Delaware refinery he once owned and sold to Valero. The deal is worth $220 million and is the first purchase of a new $2 billion fund created to buy U.S. refineries. O’Malley says he’ll look at any U.S. refinery on the market.

In other words, it looks like O’Malley is going for the hat trick — trying to get rich three times in the same game.

It’s a contrarian bet, as most people think ill of the refining industry. It’s plagued by costly regulations, weak profit margins and lower demand for motor fuel. But you don’t get to buy stuff below replacement value when times are rosy. As David Foley, an investor with O’Malley put it, “Last time we did it, we made six times our money.”

Based on his track record, I would not ignore O’Malley’s play here. Clearly, he thinks the industry has hit bottom. And there are good reasons to think so, as we’ll see.

One reason comes from Barry Bannister, an analyst at Stifel Nicolaus. He shows how peaking oil prices on a year-over-year basis are usually a catalyst for better refining margins. (See chart below. “WTI” is “West Texas intermediate,” a common benchmark for crude oil.)

Higher refining margins means more profits for refiners. Higher profits usually mean higher stock prices follow. Valero, the bellwether refinery stock, is down about 75% from its all-time high in 2008, which reflects the collapse of refining margins. So an uptick in refining margins will likely work wonders for Valero’s stock price, like rains greening a desert.

Besides owning a refinery, another way to play the revival is by owning stock in a company which builds and upgrades them, an E&C, or engineering and construction, company. There is one such stock in the Capital & Crisis portfolio. It has more exposure to the downstream, or refining sector, than other E&Cs. Yet it has a better balance sheet and is more consistently profitable than the refinery stocks. It also has greening potential, as it is also about three quarters off its 2008 high.

It also has its own favorable cyclical winds working, as Bannister shows. Bannister does the best work on the E&Cs in the business that I know of. What I enjoy is his study of past cycles. In one of his historical studies, he found a reliable pattern in our stock’s book-to-bill ratio.

Book-to-bill means how much work a company books (or sells) over how much it bills (or completes). A book-to-bill ratio over 1 means the business is expanding. If it is under 1, it is shrinking.

Bannister found that the book-to-bill ratio for our company experiences major peaks followed by about two-year sharp declines, followed by about two-year sharp recoveries. Such a dating puts the bottom somewhere in mid-2010 — right about now — as a backlog shows signs of picking up. Bannister believes the bottom is in. Such dating also puts the next peak off in 2012, plenty of time to make hay now.

Another way to see this is in the E&C firms as a family. Take a look at the chart below. Note where we are today, lingering in the basement. But if history follows — and this history goes way back — then we are looking at a move to the penthouse ahead.

Bannister forecasts a total backlog of $5.75 billion in 2011. Backlog correlates well with the stock. (More work on the backlog implies higher future earnings.) A $5.75 billion backlog would equate to a solid 40% gain.

If O’Malley, the refining investing whiz, is right, as I think he will be, refinery margins will rebound. That will warm the hearts of refinery owners everywhere, but it will also put a smile on the face of this stock’s owners too.

Regards,
Chris Mayer
Whiskey & Gunpowder

July 14, 2010

Taking Advantage of the Oil Refining Slump was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Run, and Don’t Look Back?

Still, that “blood in the streets” line is intimidating. There’s blood in the streets because something really bad is happening. People are dumping their shares. They want out. They’re running away and not looking back.

Often as not, people make tracks for a darned good reason. There might be a war or revolution in some area. That could lead to seizure or destruction of assets, and massive investment losses. Think of Iran in the late 1970s, or Venezuela more recently.

Then there are business sectors that crater, such as we saw with the asbestos business about 20 years ago. The class action lawsuits hit so fast and furious that many old names, like Johns Manville, were belly up before you could blink an eye.

Sometimes there are terrible events that just wreck a company’s stock. A few months back, for example, Toyota cracked up. This iconic Japanese firm got hit by a rash of news reports of unsafe vehicles, with bizarre acceleration problems and bad brakes. The lawsuits went national, indeed viral. Within days, Toyota went from one of the most admired companies in the world to being the butt of jokes from late night comedians like Jay Leno.

Or look at BP — also known as “British Petroleum,” when U.S. politicians speak its name. BP blew out a deep-water oil well in the Gulf of Mexico, and even two months later is unable to control the well or clean up the oil slick. BP stock crashed, and now it’s turning into an ATM for damage claims. As you surely know, BP even had President Obama ripping into it, in a speech from the Oval Office. How much worse can the bad publicity get? (I just hope they stop that gushing oil well!)

Opportunity Inside Misfortune?

In this article, I’m not going to dwell on foreign revolutions, or how an industrial product has fallen out of favor, or how BP is a reviled name anymore. But this kind of discussion is as good a way as any to lead into a new real-time recommendation for ESI.

Where am I going with this? Is there blood on some street somewhere? Not exactly. It’s more like there’s oil on the water — BP’s oil. And we have a chance to profit from it. Just so you understand, I’m truly sorry about the Gulf of Mexico oil disaster. But it’s giving us a chance to profit.

Yes, fate has offered us an offshore energy opportunity. Of course, BP has made a mess of its deep-water well. In turn, President Obama has banned new deep-water drilling in the Gulf of Mexico for six months (yeah, right, try indefinitely). Plus, we’ll surely see tighter regulations over drilling in shallow waters.

Point is the Gulf of Mexico has now picked up the reputation as a problematic locale for future offshore energy development.

So what are we going to do?

We’re going to invest in a beaten down natural gas driller in the SHALLOW waters of the Gulf of Mexico. The shallow water drilling will come back soon, I believe, and it offers some incredible investment potential.

In the wake of the BP disaster, the Obama administration banned new deep-water drilling, and interrupted the shallow-water work, as well. One shallow-water deep driller in particular took a hard hit, and its share price tumbled. But now the market has begun to recognize that this driller won’t see a material impact from the deep-water moratorium on drilling. It will keep on drilling, but in shallow waters. The development momentum and industrial fundamentals still favor what it’s doing.

Thing is, in shallow water, less expensive jackup rigs can be used, instead of the much more costly deep-water units. Also, in the shallow waters, it’s cheaper to stage logistics and exchange personnel from shore. Plus, it’s much easier to access and maintain the safety equipment. For example, in many shallow water projects, it’s possible to place the blowout preventer ABOVE the water line.

Also, drilling in shallow water closer to shore allows for the leverage of existing production infrastructure, such as pipelines, power cables and communication systems. This allows for rapid development after a discovery, with the added bonus that the reserves are much bigger — because in the ultra-deep play, the structures are so much larger.

So while deepwater drilling faces some obvious obstacles for the foreseeable future, things are looking good for shallow water drillers who are ready to pick up the ball. And things are looking really good for investors who know where to wade in even when there’s blood in the streets…or oil in the water.

Until we meet again,
Byron King
Whiskey & Gunpowder

June 28, 2010

How to Make 50% with an Energy Play Rebound was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“I’ve read Internet threads where people want to use a nuclear weapon to close the oil well blowout in the Gulf of Mexico. Even Matt Simmons, who’s a hero to me because of his Peak Oil work, says we might need to use a nuclear weapon to close the well. Can you discuss that?” 

I sure can… 

Underwater Nuclear Bursts 

Here’s my background even to comment on the subject. It’s based on my Navy experience, from many years ago. I should say right here that these are my personal views. Nothing I say is an “official” statement on behalf of the U.S. Navy, Department of Defense or U.S. government.
 
A long time ago, in a galaxy far, far away, I flew a Navy aircraft built by Lockheed called the S-3. It was a graceful twin-engine, carrier-capable jet, and is now retired from Navy service (alas!). 

If man was meant to fly, he’d have wings. Or the Navy/Lockheed S-3. 

But when the S-3 was flying, one of its key missions was anti-submarine warfare (ASW). It was designed during the depths of the Cold War, when the world’s oceans were crawling with Soviet submarines. The S-3 was among the aircraft carrier’s ASW defenses.
 
To find Soviet submarines, the S-3 had a superb surface-search radar, and awesome electronic capabilities. The S-3 also carried a large load of sonobuoys that we’d drop in the water and use to listen for submarines.
 
The S-3 could carry air-delivered, conventionally armed torpedoes, if necessary. But the most powerful weapon capability for the S-3 was its ability to deliver a “special weapon,” namely a nuclear depth bomb called the B57. (This is all unclassified information, by the way. These days, you can look it up on the Internet.) 

B57 Nuclear Depth Bomb, on carrying dolly.
Red nose is a plastic cover — please remove before flight. 

Point is, back when I was flying S-3s, I became pretty smart about the ASW mission, and also about this particular special weapon. Thus do I know a few things about both nuclear weapons and underwater nuclear bursts.

What Could a Nuclear Weapon Accomplish? 

Why are some people — the eminent Matt Simmons among them — discussing the use of nuclear weapons in the Gulf of Mexico? Does Matt know something that other people don’t? Well, I think Matt is off-base on this point. Don’t take it the “wrong” way, but Matt knows more about Peak Oil than he knows about underwater nuclear bursts.
 
As we used to say in the Navy, from a small splash, you get a big flash. Among people who have no or limited experience with nuclear weapons, this gives rise to many nuclear myths, if not fixations. That is, many people think that you can really DO SOMETHING with a nuclear weapon. Sorry to disappoint, but the last thing you want to do with a nuclear weapon is trigger it, particularly in a misplaced effort to seal a blownout oil well. 

There’s GOT to be a better way to seal an oil well than this… 

Let’s just consider the explosion. Yes, you can put a lot of energy into the earth — and the water and atmosphere — with a nuclear blast. But is that really what you want? There’s such a thing as putting “too much” energy on your target. And you still might not accomplish the mission.
 
Nuclear effects — especially subsurface nuclear effects — are not predictable. So even with the best efforts you will doubtless have many unintended consequences. It might seem like a good idea to place a nuclear bomb next to the leaking oil well, cook it off, move an immense level of energy toward that awful oil well and seal it up with fused glass. Except it doesn’t work that way. 

Start at the Beginning 

Let’s start at the beginning. You need to drill a hole first, into which to place your device. Hey, BP (BP: NYSE) is already drilling two holes next to the blownout well. The two holes are for relief wells. So now you want to drill a third hole for the nuclear device?
 
Then you need a nuclear device to emplace in the hole. Except that the U.S. has no nuclear devices rated for 5,000-foot and deeper water depths. Sure, U.S. special weapons are built to withstand multi-G accelerations, and all sorts of launch and drop shock loads. The devices can function in the vacuum of space. They can even pass through transient re-entry heating. But there’s no weapon design out there — none that I’ve ever heard of — to deal with the high external pressure under a mile or more of water.
 
That goes for nuclear-armed torpedoes as well — which I can’t discuss except to say that long ago, the Navy developed weapons to chase down Soviet deep-diving submarines. If you ever read Tom Clancy’s book The Hunt for Red October, he has a particular Soviet submarine diving to over 2,000 feet. That’s all I’ll tell you. 

Wigwam Test 

So let’s say that we overcome the initial obstacles of drilling a hole and emplacing a weapon. Let’s say that we can put a nuclear device down there next to the well. What happens with an underwater nuclear blast?
 
From unclassified sources, I can tell you that the deepest underwater nuclear explosion on record is the Operation Wigwam test, conducted on May 15, 1955. Wigwam consisted of a subsea 30-kiloton nuclear detonation, or a bit over twice the power of the 1945 Hiroshima blast.
 
The Wigwam test blast was about 450 miles southwest of San Diego, Calif. (29 Deg N, 126 Deg W) in open ocean, with water depth of 16,000 feet. The purpose of the test was to look at the vulnerability of submarines to deep underwater nuclear explosions. (I can’t tell you much on that, but it’s not pretty.)
 
The Wigwam nuclear device — a very large B7 “Betty” specially reinforced and rigged as a depth charge — was suspended by a 2,000-foot cable from a barge. The dry weight of the bomb was 8,250 pounds, and 5,700 pounds when submerged. After it detonated, here’s what the blast wave did, just before the fireball exited through the surface. 

“Beware, beware!” Little splash, big flash. Cover your eyes and hope you’re upwind. 

Oil, Water and… Radionuclides? 

Right now we have a well spewing oil into the Gulf of Mexico. It looks like BP is getting the well under control. The relief wells are also going down, slowly but steadily. We can envision this tragedy coming to an end.
 
At this point, do we want to let loose a nuke and have radioactive particles mix with the oil and water? Do we want radioactive water vapor rising into the atmosphere just south of New Orleans?
 
And what of the shock wave? Do we want to rip the seafloor to shreds? Do we want a nuclear-level shock wave traveling through the seafloor in the vicinity of the BP oil well? What will that do? Will it break other oil pipelines installed on the bottom?
 
What of an oceanographic phenomenon called “bottom bounce”? That’s a situation in which the shock wave bounces off layers of seawater and travels back down to the ocean floor to be reflected even further out. You could, possibly, put destructive levels of energy many dozens of miles away from the burst point. You could break things faraway. So you see where I’m going with this.
 
What about the oceanic environment? This is not the early days of the Cold War. We know a lot these days about the complex biology of the ocean. Radioisotopes, like strontium and iodine, concentrate as you move up the food chain.
 
Your basic oyster is a filter feeder, moving hundreds of thousands of gallons of seawater through its system over its lifetime. This causes isotopes to concentrate to a level that can poison wildlife and people. Anybody or anything that eats these critters will surely suffer from radiation damage to every level of cellular function, and almost certainly to reproductive cells. More specifically, radioactive strontium and iodine concentrate in the bones and thyroid glands, respectively.
 
This is all straightforward, established science. If you want things to get even uglier, and last a real long time, you’ll use a nuclear weapon out in the Gulf of Mexico.
 
Bottom line is that we need to get the nuclear weapon discussion off the table. Put the nukes back in the bunkers, where they belong. 

Where to from Here? 

Marilyn, I’m glad you asked your question. But a nuke clearly isn’t the right choice.
 
With that said, another question comes to light…
 
With a small percentage of oil still flowing out of the well, a massive cleanup ensuing, more goverenment regulation and the effects of a drilling moratorium tying the hands of our energy industry – where do we go from here?
 
I’ll start by making a statement I’ve made before and I’ll make again: the cheap and easy oil is GONE. Finding new energy to fuel our nation is going to be harder, more regulated and more expensive.
 
Is a U.S. moratorium the right choice? I’ll let you decide that.
 
But there’s one matter that you won’t have a choice on: the higher price you pay for oil.
 
With oil sitting north of $70 a barrel I can’t imagine it getting any cheaper.
 
Indeed, a few years from now we may look back and deem this period the point where the U.S. lost its edge in energy.
 
That’s all for now. Thanks for reading…
 
Until we meet again,
Byron W. King
Whiskey & Gunpowder

June 11, 2010

Nukes and Expensive Oil was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.