As long as there are abundant local supplies of rice, countries are happy, eager in fact, to export excess production in order to generate foreign exchange. But as soon as local consumption exceeds locally available production, then all hell breaks loose and the next thing you know countries are banning exports, a move that has already been undertaken by Vietnam and a number of other countries.

In that scenario, price eventually no longer becomes a factor in the availability of the commodity. Vietnam, for example, is not going to let its people starve just because higher global prices would allow it to earn an extra $10 a bag of rice.

And so in the face of the prospect of any serious shortage of an important resource — energy being maybe the most important — export markets freeze up and the price begins to be set at the margin, literally based on a global competition for the dwindling supplies that manage to leak out around the edges.

“People are crazy not to be focusing on the oil export situation,” Dr. Brown told me.

Of course, the question of energy alternatives is a big topic and one which needs a far more extensive discussion than space allows for here.

Will viable alternatives be developed to help mitigate a domino collapse of oil exports? Absolutely. Of those alternatives, nuclear, solar and heavy oil seem to hold the greatest promise.

But the sheer scope of the problem — with the world now consuming the energy equivalent of one billion barrels of oil every five days — assures that we are probably decades away from a real solution.

In the words of Jeffrey Brown…

“If you look at the situation in terms of presidential terms, looking at fossil fuels plus nuclear the world burned through the equivalent of 10 percent of all oil ever consumed in Bush’s first four-year term. And, in our model, we’re going to burn 10 percent of all remaining conventional crude in the second four years of Bush’s term.

“That is the equivalent of around 25 billion barrels a year. So that’s 100 billion barrels every four years, and we’ve burned 1,000 billion barrels. It gets interesting when you consider that current estimates are that we’ve only got 1,000 billion barrels of conventional crude remaining. I think with natural gas liquids, we’ve got a little bit more. But of the conventional crude oil, we’ve got 1,000 billion remaining. Which then begs the question, how fast can we bring on the tar sands and everything else?”

Grasping for straws, I asked Jeff about an article I had read recently about the Bakken oil shale reserves around North Dakota.

“They’re talking about somewhere between 200 billion and 500 billion barrels in situ, but the USGS recently came out with a mean estimate of between 2.5 and 4.4 billion barrels recoverable, as an outer limit,” he replied, before continuing.

“In 1966, they said, if Lower 48 ultimately recoverable is 150 billion barrels, then the U.S. would peak in 1966. If the recoverable oil from the Lower 48 ultimately came in at 200 billion barrels, then the U.S. peak would come in 1971. The higher-end estimate probably turned out to more accurate, and the U.S. peaked in 1970. But the point is this; a one-third increase of estimated ultimate recoverable — a total increase of 50 billion barrels — postponed the peak by all of five years.”

The trend for sustained higher energy prices appears solidly in motion.  If Brown and the ELM are correct, energy prices will double then double again.

Even if he is wrong and prices don’t rise geometrically, the global dogfight to replace declining supplies — decidedly exacerbated by the loss of Mexican and maybe Russian exports in the near future — is going to get ugly and expensive.

So, what’s the investment angle? Paradoxically, the larger energy companies are probably a bad bet, because they are forced to replace their depleting reserves, which is getting harder and more expensive to do with each passing day.

It is our contention that, because the solutions to the world’s energy problems are going to involve a variety of energy sources and technologies, you have to build a portfolio that is equally varied.

That assures you are well positioned to profit from the broader trend, while avoiding the risks of being overly exposed to a single sector. (As an example, solar has had a great run, but most solar plays are now overvalued).

The good news is that there are no shortage of high quality energy-related investments available…in coal, heavy oil, LNG, photovoltaics, natural gas consolidators, “run of river” hydroelectric, uranium and small to mid-cap oil companies with the potential for significant near-term gains in reserves or production.

In the final analysis, it comes down to two choices; you can either suffer the consequences of persistent higher energy prices, or use the work Jeffrey Brown has done with the Export Land Model as an early warning and get positioned to profit.

The decision is yours, but don’t wait long to make it.

Regards,
David Galland, Casey Research
June 24, 2008

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

Oil has finally reached $100 per barrel, yet few people on the distant end of oil supply lines are aware of how fast the status quo can change. The status quo tells us to expect more oil when we want it. That market forces always bring ample oil supplies to market. That oil producers will always accept a fixed amount of paper money in exchange for concentrated liquid energy.

But the status quo view of the oil market has been wrong for years. Many still use speculation and geopolitics, rather than supply and demand, to explain rising prices. These pundits never question whether the exchange of paper money for black gold is sustainable. In the old days, when oil prices rose, big exporters like the Saudis recycled most of their oil money into the U.S. bond market, giving rise to the term “petrodollars.” But those days are long gone. Middle East oil producers now pump lots of money into local economies and oil price subsidies. These policies have led to much higher oil consumption in OPEC countries and will keep lots of oil from ever reaching the export market.

The oil trade has radically changed, and investors need to understand these changes. So it helps to look at a model of a hypothetical oil exporting country.

Jeffrey Brown’s Export Land Model accomplishes this. It shows how dramatically exports can decline when two things occur at the same time: Domestic consumption increases while production declines. Brown, an independent petroleum geologist who writes for The Oil Drum, presented his Export Land Model at the ASPO-USA conference in October. When you really think about this model, the debate over how much oil is in the ground becomes trivial. Rather, we should think about how much oil could be available for export in the coming decade.

Brown’s model is easy to understand. It makes sense. Several historical examples validate it. Yet this line of thinking is totally outside the mainstream. As Brown explains, his model represents:

“A hypothetical country with ultimate recoverable reserves of about 38 billion barrels… The model showed the effect on net exports of a country that hit peak production and started declining at 5% per year. The exporting country consumes 50% of its production, and that consumption is increasing by 2.5% per year. The 5% decline rate is loosely based on the post-peak Texas decline rate of about 4% per year.”

The red line in this chart shows that “export land” starts off exporting one million barrels per day. Because production, the black line, is declining at 5% per year and consumption, the gray line, is increasing at 2.5% per year, exports plunge to zero in less than a decade. Brown mentions two other important points about the model. First,

“Only about 1.7 billion barrels, or 10%, of remaining post-peak recoverable reserves would be exported.

“Second, the overall exponential net export decline rate, about 29% per year over the eight-year net export decline period, is much more rapid than the production decline rate of 5% per year.”

The following chart shows how Brown’s model compares with two recent case histories: Indonesia and the United Kingdom. Indonesia, depicted in black, reached peak production in the late 1990s and has almost become a net oil importer. The U.K., depicted in gray, peaked around the turn of the century and became a net oil importer in just a few short years. U.K. North Sea production declined rapidly because offshore fields tend to have very high decline rates:

The top five net oil exporters from 2000-2005 were Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates. Oil consumption in these five countries grew 3.7% per year over this period. Since 2005, consumption growth has accelerated in a few of these countries, so net exports from the top five may decline at a much faster rate than the market expects. We may have seen only the early stages of oil price increases.

Geopolitical Power Will Shift to Oil Exporters

How will the U.S., so reliant on imported oil, cope in an environment of tightening world oil exports? Most U.S. consumers have been sleepwalking on the march to $100 oil. Instead of understanding where oil comes from and altering consumption habits, the public seems more interested in taxing “greedy” oil companies. The longer this happens, the more painful the adjustment will be. Most of us don’t realize that the U.S. no longer has a monopoly on the world’s oil exports…let alone the implications.

Hugo Chavez just announced that Venezuela will export 500,000 barrels per day of crude to China in 2008, up from the current level of 350,000 barrels per day. He wants to increase shipments to one million barrels per day by 2012. Whether he achieves this goal or not, one thing is clear: Venezuela will soon be shipping lots more oil to China than it will to the U.S.

Mexican oil production is declining so fast that it will likely become a net oil importer within a few years. Kazakhstan is unilaterally renegotiating contracts with foreign oil companies to increase the government’s share of growing oil revenues. African countries like Nigeria may do the same with companies like Exxon Mobil.

For years, China has aggressively pursued contracts to secure reliable oil supplies, especially in regions like Africa. As it currently stands, the U.S. has no energy security plan other than to remain friendly with Saudi Arabia and hope that country meets its production goals. But even if OPEC can keep production high enough to meet insatiable demand, it’s unlikely that it will ship oil in the same quantities to the same customers.

Another thing to keep in mind, which we saw unfold in early November, is Ben Bernanke’s dilemma. With oil and gold at record highs, can he really afford to slash short-term interest rates to help save housing? Though he likes to bluff, he can’t afford to push rates down to 1%, as Greenspan did in the last easing cycle. If he did, another round of dollar weakness would drive international investors to gold and tangible assets even faster. It would also make oil less expensive in stronger foreign currencies, which would draw more oil supply to foreign markets.

Under a worst-case scenario, within a few years, much of the world’s tradable crude oil could be withdrawn from futures markets and locked up under long-term supply agreements with “favored” customers. And current trends point to the U.S. losing its favored customer status, even among longtime reliable suppliers from the Middle East.

Middle Eastern Wealth Looking Inward

I maintain regular contact with a private equity fund manager. He just returned from a trip to the Middle East to gauge the local interest in alternative investments. He wrote:

“The gulf is earning $1 trillion every two years, assuming $80 oil. We met with one of the ruling families in the region, and it anticipates no fall in oil prices anytime soon. One question I asked on the trip was how long we should expect the U.S. dollar/Middle East currency pegs to last. I expected a lot of strange looks and party line answers about how they’d be shooting themselves in the foot, since the U.S. is their largest customer, but almost uniformly, people thought a major move away from the dollar is 18-36 months away. But rather than a completely free-floating currency, they believe the ‘basket’ approach of Kuwait is likely to be the outcome.”

Since the dollar is about half of the Kuwaiti currency basket, the impact has been somewhat muted. My contact also noted an unmistakable trend common to all Middle Eastern sovereign wealth funds — they are moving away from U.S. Treasuries with two specific goals in mind. First, they are looking for higher returns in alternative asset classes like hedge and private equity funds. And second, they want to shift portfolio exposure from the West to their home markets — particularly in local infrastructure. This includes roads, utilities, schools and hospitals. Growing Middle Eastern wealth is leading to higher living standards, which leads naturally to higher oil consumption.

This isn’t the behavior of investors seeking to maintain their end of the status quo “oil for U.S. dollar” trade. So the writing is on the wall for the petrodollar trade.

What does this mean for the U.S. and other oil importers? It means the global drilling rig fleet will grow in importance. The rig fleet must become more productive, because target oil and gas reservoirs are becoming smaller and more scattered. The recent spike in drilling activity has strained the industry.

If spikes like these continue, the equipment will become worn out quickly and oil prices will then continue to rise.

Regards,
Dan Amoss, CFA
January 10, 2008

P.S.: The U.S. isn’t the only country in the world that desperately needs oil. What we keep hearing from our government and our media is that it is all the oil companies’ fault. What they aren’t telling us is that perhaps the world is simply running out of oil. What else aren’t they telling us?

P.P.S.: While I will continue to work diligently for all my readers of Strategic Investment, starting Friday, January 18, we will be offering my brand new service, the Strategic Short Report. Stay tuned, and look for details coming very soon.

A Truth About Oil Exporting was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.