Global oil demand is not going to “plummet.”  And for the FT to say so is just plain silly, if not irresponsible.  OK, I know.  There’s an old saying that they teach in journalism schools.  “You have to sell newspapers.”  But this declaration by the FT highlights the perils of letting a headline-writer do your thinking for you.  It’s what I call “arguing a screaming conclusion.”  And a wrong conclusion at that.

Oil Demand – Down, Then Up

But let’s move past the headlines.  The Financial Times article explains that the World Bank has just issued a new study.  The World Bank believes that the world is entering into the toughest economic times “since the Great Depression.”  Thus overall world oil demand may fall by about half a million barrels per day in 2009.  That’s what the World Bank states in its report.

Only half a million barrels?  Heck, the total world demand for oil in the past year was about 87 million barrels per day (a fact that the FT article fails to note).  By comparison, the Saudi oil tanker that was hijacked off the coast of Somalia held two million barrels of crude oil.  And despite this act of piracy oil prices still fell over the next couple of weeks, even without that tanker plying its route across the deep blue seas.

So if the world experiences the next “Great Depression” (Release 2.0, I guess), a reduction in overall oil demand of half a million barrels per day is down in the statistical noise.  And what the World Bank is saying about the grim future of the world economy is not the equivalent of “plummeting” demand.  At least, not half a million barrels of lower usage.

How Bad Is It?

How bad is it out there?  Well, according to this week’s MasterCard Spending-Pulse data, U.S. retail gasoline demand is back to about the same levels it showed earlier in 2008.  That is, high gas prices hurt demand over the summer and into the fall.  (I drove less.  Didn’t you?)  But the current low fuel prices have evidently allowed demand to recover.  People are driving more.  It’s basic Economics 101.

I was talking with an economist for the American Petroleum Institute about two weeks ago.  He told me that overall gasoline demand in October was down 3%, year-to-year.  But diesel fuel usage was up by the same amount.  Overall U.S. oil demand is down about 8%, but that reflects the slowing use of oil in industry.  Out on the road, people are still driving and trucks are still hauling.

For all the sound and fury about the run-up in oil and fuel prices through July, and then the fall in prices after that, the aggregate demand for oil is only changing at the margins.

Built-In Oil Demand

In both the developed and developing worlds, there’s a lot of oil demand built into the economic and social energy system.   That’s what modern development is all about.  That’s how the system was built over the past 100 years or so.  Yes, you can wish that the system were different.  You can even try to change the system – and risk collapsing it in the process.

Whatever you do, you can’t change the system very fast.  To paraphrase a former Secretary of Defense, “You live in the world with the energy system you have.  Not the energy system you might wish you had.”

So at best, if you want to change things you are looking at a generational shift.  If you have a generation.  Do we have a generation?

What Will OPEC Do?

Let’s try looking at some different numbers.  How about 7 million barrels of oil per day?  That’s the amount of output that OPEC might have to shut-in if it wants to get prices headed back upwards in to the range of $75 per barrel or so.  At least, that’s according to Philip Verleger, a long-time industry player as quoted recently in Platt’s industry newsletter The Barrel .

Current daily oil output from OPEC is about 32 million barrels per day.  Verleger thinks that OPEC’s output ought to be more like 25 million barrels per day.  There’s the 7 million barrel shift.  Easy, right?  It would be as if Iran, Iraq and Qatar simply stopped exporting oil.  How likely is that to happen?  Umm… yes.  Clearly, Verleger has a radical take on things.

One way or another, can OPEC cut production significantly?  Does OPEC have the discipline to manage its own affairs to cut 2 million barrels, or 4 million, let alone 7 million barrels per day?   The issue is that numerous OPEC nations cheat on their production quotas.  Hey, they need the money.  Thus they lift the oil and sell it.  Really, cheating on OPEC quotas is not a problem.  It’s a tradition.

What of the Future?

Looking ahead by more than about two years, world oil demand is certainly going to grow.  It almost does not matter what we do in the U.S. or Europe.  When you look at the numbers of young people who are already born and living and growing up in the developing world, the demand will be there.  Many of these young people already have a cell phone and a laptop computer.  When they finish school, they will want an apartment and a car.

And at the rate things are going, the energy industry is still under-investing in the necessary systems of the future.  Depletion is still ongoing.  It gets back to the very basic point that every barrel you lift from the ground leaves one less barrel down there.  And the overall global depletion rate is 6% at best.  Maybe it’s 8%.  It might be 10%.  To replace that depletion, the general trend is for the energy industry to go further away, to deeper waters or more remote sites, to drill deeper wells, with hotter temperatures and higher pressures.  Those little hydrocarbon molecules are just plain tough to catch.

And keep in mind that nobody can produce oil that has not been discovered.  Or developed.  Or for which there are no handling facilities.  That takes investment, and lots of it.  Which requires money and finance, which is in rather short supply just now.  So there are just a few years in which the world can reorder the way it does oil, let alone the big picture on energy.  And there are a lot of moving parts in all of this.

The Moving Parts of Oil Production

One of our fellow (sister, actually) readers is deeply involved in monitoring the world oil situation.  The other day she sent me a thoughtful list of “ifs” that have to happen just to begin to get future oil production on firm ground.  Here it is:

• IF oil price rises above the marginal cost of new non-OPEC supply in time to get new production back on track;
• IF oil-producing countries and China stop subsidizing prices to their own populations;
• IF OPEC gives international oil companies (IOCs) like Exxon, Shell, Chevron, etc. access to explore and develop their reserves;
• IF the trillions in exploration and infrastructure capital are invested;
• IF OPEC invests seriously in increasing their own capacity;
• IF enhanced oil recovery (EOR) processes can really increase the recovery rate as much as hoped;
• IF the reported reserves are really there;
• IF the U.S. Geological Survey predictions of “yet-to-find” oil in the Arctic, offshore and elsewhere are correct;
• IF the Saudis can are capable of reaching and sustaining 15 million barrels per day of output;

IF, IF, IF …

“And,” adds my correspondent, “virtually all of these are outside the control of any policies that might be set by the oil-importing nations of the West.”

So unless a lot of things happen – pretty soon and in the right sequence, and competently — we’re going to be faced with the prospect that there’s not going to be enough oil to go around.  So oil prices are going to head back up.  People and governments are going to get desperate over supplies.  And much of the usual and predictable bad stuff that you’ve heard before is going to happen.  Which gets back to that Financial Times headline.  “Plummeting” demand?  Really.

A Few More Dots to Connect

President-Elect Barack Obama made a major announcement last weekend.  It was along the lines that his administration would work to invest in infrastructure.  Congress loved it because it means that the politicians can appropriate money to spend on concrete and steel.  That’s what I’ve been saying would happen.  But it’s nice to hear it.

The announcement was good in the short term for a couple of the OI stocks, like Alcoa (AA: NYSE ) , Cemex (CX:  NYSE ) and General Electric (GE:  NYSE ) .   They all have things to sell into an infrastructure buildout, as do more recent additions like Koppers Holdings (KOP:  NYSE ) and Allegheny Technologies (ATI:  NYSE ) .

Where will the U.S. government get the money to pay for the infrastructure buildout?  Same place it gets all the money to bail out the banks and Wall Street, I guess.  It’ll borrow it.  And in the process the U.S. borrowing will soak up most of the nation’s “spare” capital, such as it is.  U.S. government borrowing will crowd private borrowing.

The U.S. government can borrow money for the time being.  For some strange reason, people still want to buy U.S. Treasury bills, bonds and notes.  Don’t ask me why.  The interest rates are just about zero (safety sells, I suppose).  And the dollar is strong.

Actually, the dollar is much stronger than it ought to be.  I expect a major dollar-correction in the first quarter of 2009, which will be good for foreign-denominated stocks that trade on the Toronto Exchange.  (Although Canada is having some surprising political issues right now.  I’d appreciate hearing from Canadian readers about their take on what’s going on with Prime Minister Harper.)

In the longer run, the U.S. expenditures will come back as inflation.  That means that you want to look at owning gold and shares in the best-run gold miners.  If I had to pick just one gold miner with the best prospects, it would be Kinross Gold (KGC:  NYSE ) .   It’s well managed.  Kinross just completed a series of mine expansions.  And it’s ramping up production to sell increasing levels of output into a generally rising gold market.

Until we meet again,
Byron W. King

December 29, 2008

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

After the Vancouver event ended, my family and I headed north for another visit to the great state of Alaska on behalf of my Outstanding Investments subscribers. Among other things, I looked at some old gold mines and new mining prospects and had some serious fun hiking in the forests of the southeast coastline along the Pacific Ocean. I even had a chance to explore my “inner Army Ranger” by zip-lining across the treetops at the edge of the Tongass National Forest, traversing deep gorges on rickety rope bridges and rappelling down steep cliff faces. In all honesty, I did that for me.

Now I am back at home in hot, muggy Pittsburgh, PA. But as compensation for the present and rather uncomfortable weather, the local sweet corn, fruits and other vegetables are coming in, and it has been just a great (and delicious) growing season. The Steelers have a new coach and a lot of exciting prospects ahead of them. And by the end of this month, we will enjoy the glorious fall weather and colorful foliage of Western Pennsylvania that make this part of the world such a delight. So let’s try to look forward with a positive attitude, despite the many heartbreaking issues that form the daily news headlines.

The Grand Old Duke of York

Looking at the stock markets and the headlines they’re making of late, I am reminded of the Grand Old Duke of York. He had 10,000 men. He marched them up to the top of the hill. And he marched them down again.

Except in the case of another York, this one being the New York Stock Exchange and its bellwether Dow Jones average, for example, the march went up to 14,000 points or so, courtesy of a long-term credit expansion that flooded the markets of the world with excess, if not seemingly endless, liquidity in an environment of apparent disregard of risk. Then in mid-July, the New York Dow started its retreat when a piece of the subprime mortgage market went critical. Liquidity contracted like a hangman’s noose.

Risk was rapidly revalued, if not repriced, downward at the rate of the acceleration of a man falling through the trapdoor of the gallows. And in mid-August, in what may be the early phase of a long march down the proverbial hill, the soldiers of the Grand Old New York Dow marketplace pitched camp near the 13,000 level. What next?

Are we watching the Dow Jones marketplace dig in and make a stand? Or is this just one more daily stop along the line of retreat, if not a slow-motion rout? Things change, of course, and in the stock markets of the planet, sometimes they change very fundamentally. By way of analogy, recall that what started as the road to Stalingrad for the Germans eventually became the road to Berlin for the Russians. It was the same line on the map, but a different outcome, depending on who was marching where.

When You’re Up, You’re Up

Getting back to that Grand Old Duke of York, he once said, “When you’re up, you’re up.” Are our stocks up? That certainly makes for a good day, except you also have to remember to sell at the top if you want to book the gain. What? How does one know that it is the top of the market? Just listen for the bell. Doesn’t somebody always ring a bell at the top, as the cable car drivers do when they reach the crests of the hills of San Francisco?

And When You’re Down, You’re Down

And as the Grand Old Duke of York also said, “When you’re down, you’re down.” So are any of my favorite stocks down? That makes for a bad day, except that maybe it is also a buying opportunity in the context of the long perspective. Again, how does one know that it is the bottom of the market? Just read tomorrow’s newspaper, of course. I’d be glad to loan you my copy, but I must have mislaid it somewhere.

And When You’re Only Halfway Up…

Finally, as the Grand Old Duke of York said, “And when you’re only halfway up, you’re neither up nor down.” Well, it depends upon when you joined the ranks of Outstanding Investments subscribers. If you have been with us for a while, you are probably up despite any recent market retreats. If you enlisted recently in the subscribing ranks, you may be down a bit, but not down as much as the poor wretches who failed to pad their portfolios with energy and natural resource shares. Long term, the material-energy world is the world of reality. It is the place to be. I’ll take you there if you’ll click here to subscribe to Outstanding Investments.

What Is Going On?

So you ask, “What is going on?” I hesitate to offer any categorical answer about the state of the stock markets. I have no universal field theory for why the stock markets of the world are doing what they are doing, and hence do not want to say anything that is outside my bailiwick. But I see that, for example, the price of oil has pulled back and I know a few things about the price of oil.

The Price of Oil

Back during mid-summer, oil was pushing $78 per barrel, and there were many forecasts for higher oil prices going forward. At one time or another in the not-too-distant past, players as diverse as the president of oil superpower Venezuela, Hugo Chavez, and the oil analysts at money-managing superpower Goldman Sachs were predicting oil at $100 or more per barrel. And really, would the reviving military superpower Russia have bothered to send an expedition to claim the resources of the North Pole if its leadership thought that long-term energy prices were going to decline? Can superpowers ever be wrong?

Still, within a couple of weeks, oil dipped back into the $72 range per barrel. If you listen to some commentators, the economy is unwinding and we will soon be back to $2 gasoline. But not to worry, dear readers. The Peak Oil paradigm is still with us, and we will surely see $100 per barrel of oil, sooner or later. Be patient. We will get to that $4 gasoline, and probably much more, in due course. Really, when you think about it, the collective American addiction to driving and traffic congestion seems to subliminally demand higher prices.

From the standpoint of supply, there have been no major oil discoveries anywhere in the world of late. And at the other end of the economic equation, there has been no major breakthrough in the arena of demand destruction when it comes to oil usage trends going forward. Supply is tight. Demand trends are rising, as I will discuss below. So why the pullback in the price of oil?

Sometimes You Sell What You Have to Sell

In general, the price of something falls when there are more people selling than there are buying. And recently, there have been more people selling oil contracts than buying them. Why is that? Because there have been a lot of entities around the world that have had to raise cash to cover losses in the subprime mortgage meltdown, or otherwise to book some sort of gain to impress the clients. And when you have to raise cash in a hurry, sometimes you cannot sell what you want to sell. Sometimes you just have to sell things for which you can find or make a market.

Let me explain that a bit further. Many large players in the subprime mortgage arena, such as banks, brokerages and hedge funds, are heavily invested in subprime mortgage commercial paper. In most cases, they bought the subprime paper with the clients’ money, promising a certain return or yield over time and charging hefty management fees in the meantime. Up until now, the banks and others have carried the paper on their books according to a “model” valuation and have been able to keep the clients happy by sending them quarterly statements filled with fuzzy math that indicated all was well. Also, for the past few years, there was no real reason to question the underlying accuracy of the portfolio valuation model. Interest rates were low, and liquidity was available. The subprime paper traded in a reasonably orderly fashion, or at least with few evident problems. The business model appeared to be working like a Swiss watch, and in the perception of those who were living the dream, that business model displayed the soundness and inherent durability of the Swiss currency.

But starting a few weeks ago, when a number of Bear Stearns funds imploded, it became necessary to liquidate some of this commercial paper, backed by subprime mortgages, in a real marketplace and not in some la-la land of model valuation. The lesson of the Bear Stearns implosion was that the market for such commercial paper could evaporate almost instantly. The “for sale” sign was up, but nobody wanted to buy. So all of a sudden, portfolio managers across the world realized that the model valuations were sheer fantasy. When they gazed into the mirror, they really weren’t getting better looking each day. When the time came to sell, there was no market. Time to panic, right?

As I said above, when you cannot sell what you want to sell, you might be forced to sell things for which there is a market. So many banks, brokerages and hedge funds have been raising cash by selling their oil futures, for which there is a market.

Hence, presto! The price of oil has fallen. And with the falling price of oil, we have seen declines in the share prices of oil companies, oil service companies and drilling companies.

Where Do We Go From Here?

So where do we go from here? Well, there might not be a market for subprime mortgages, but there sure as heck is a market for oil.

The daily world oil supply is in a precarious state, with the depletion of numerous major oil provinces approaching crisis proportions. From the North Slope of Alaska to the North Sea, from Mexico’s Cantarell to Kuwait’s Burgan Field, the reality of depletion is hitting home. Daily oil output from older fields and regions is declining, and many new hydrocarbon projects are coming online slowly, behind schedule and over budget. Add to this the problem that there are significant constraints in the labor force and in the availability of critical equipment and mechanical systems. There is trouble out there, with a capital “T.”

Yet total world oil demand is still rising, driven by the usual suspects China and India, where oil use is soaring (as well as by the developed world of Europe, North America and Japan, where it has already soared). Deutsche Bank, for example, estimates that Chinese demand alone for oil will increase by at least 6% in each of the next two years.

Also recently, the International Energy Agency (IEA) revised its forecasts to raise its global oil demand estimate. The IEA predicted that oil use would rise by an average of 2.2% per year (about 1.7-1.8 million barrels per year) for each of the next five years. IEA also predicts that the amount of world oil usage and consumption within developing nations will rise to 46% of worldwide demand by 2012, up from the current 42%.

According to the IEA, within five years total, world demand for oil will increase to almost 96 million barrels per day, up from about 86 million barrels per day currently. These are just estimates, just extrapolations. There is almost no way that the global oil industry will be able to extract sufficient hydrocarbon product from the rock formations of the Earth (oil, natural gas liquids, tar sands, oil shale, you name it) to meet this forecast level of demand. Something will have to give, and the sure bet is that the price of oil will be rising.

Live in the Material-Energy World

So make sure that you live in the material-energy world of real oil, and real resources, as opposed to the make-believe world of “model portfolios” backed by subprime mortgages issued to people without the ability to repay them. This latter part of the economy is a mess, and it will surely get messier. What we have seen in the past month is the bow wave of a larger phenomenon that will play out over the next two years, at least. Be prudent as the markets gyrate, and be wary that the U.S. economy may contract (or worse) in an oncoming recession. This also applies to the economy of Euroland, and, by implication, to many other regions that depend on exports to the developed world.

But do not be overly afraid of using market retreats to accumulate shares of well-managed companies with oil reserves in the ground, or great oil service companies that will be critical to the future of resource extraction. You can accumulate on pullbacks, and please accept our best wishes for your future success. And thank you for reading Whiskey & Gunpowder.

Until we meet again…
Byron W. King

September 6, 2007

Living in the Material-Energy World was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.