Debunking the Bear Case for Energy

Barry Ritholtz recently expressed his dissatisfaction with the explanations being bandied about in the media as to why oil prices have fallen.

Here is a short list of the most common current explanations circulating in the mainstream media:

1. More Supply coming online;
2. Reduction of global terror threat;
3. Cooling of hostilities between Israel and Lebanon
4. Seasonally weak demand, as Hurricaine season ends;
5. Iran cooling inflammatory rhetoric

I find these some of the mainstream explanations unsatisfying. At the risk of creating a strawman (only to knock it down), let me put forth my top 5 (6 actually) list:

1. Fast money rotating out of commodities and into tech;
2. Cooling economy consuming less energy;
3. No major supply disruption from weather or Middle East;
4. Psychology peaked earlier in year; (see Business Week Cover Story)
5. Stretched consumer shifts behavior;
6. And lastly, the Weak Strong US Dollar (Crude is priced in greenbacks)

We agree with Barry that each of these can pretty easily be explained away, as we do here:

1. Supply coming on line takes years. What new supply could have come on line that was not anticipated three months ago?

2. Just because they will let you take some of the liquids back on the plane now doesn’t mean the terror threat is any lower.

3. Israel and Lebanon don’t exactly have much oil - no oil supply was disrupted during their skirmish and it did not create any particularly unusual demand, so why would it have any effect on price (which was rising for years before the skirmish started?)

4. Seasonality is a valid point but certainly a very temporary one. It is long-term supply/demand balances that sent oil to $78, and those haven’t changed.

5. Iran? Isn’t this sort of the terror/Israel arguments tied together? Iran either wants to sell oil or it doesn’t. We’re betting on the former and think they are selling as much (or nearly so) as they can produce and that this won’t change any time soon.

6. Amaranth certainly suggests there was some speculation on the way up, but also suggests that (post their pop) there may be limited downside remaining.

7. The economy would have to cool to zero percent growth for the next five years for technology and substitution to offset the normal demand increase attributable to growth. If that is your forecast, fine (although I hope you are wrong.) Otherwise, your outlook for oil should be consistent with your economic outlook.

8. Psychology? Perhaps it had an impact on price, but it sure doesn’t affect supply or demand much. Unless you can quantify the impact on price, how do you know the current price is any more correct than last month’s?

9. Stretched consumer: See #6 above.

10. Dollar: Ditto.

So with the easy explanations as easily tossed aside, how about something with more meat? John Mauldin recently reposted a Charles Gave article on his site. Its basic tenet that oil prices will be brought back down due to substitution and new technology is beyond reproach. As far as the timing, however, we found it to be long on optimism and short on consistency. Consider:

1- The return of king coal. In WWII, the Germans (who were long coal and short oil) refined processes to make gasoline out of coal. This old process has been perfected and is now a source of energy in South Africa. Why is this important? Because there is more coal in North America or Australia than there is oil in the Middle East. The problems in using coal have historically been a) ecological issues (which can be solved with some money) and b) costs (using/moving coal is not as economic as low oil prices).

2- The exploitation of tar sands or bituminous coals in Canada, the US, and yes, Venezuela. Here, once again, the technology exists and the extraction costs are roughly US$30/bl. The production build-time is roughly around three to four years. The big hang-up is the shortage of technicians. Such shortage problems can however be solved after a few years (time of schooling/training) or, by enticing retired technicians to come back.

The company that converts South Africa’s coal into fuel is Sasol (SSL) and is on our Watch List. During the last few months they have not opened vast new capacity, nor even announced plans to start building vast new capacity. In fact, the recent decline in oil prices has hit Sasol and the tar sands producers harder than it hit traditional suppliers because these processes are only profitable when oil prices are as high as they have been recently. Given the long lead times for building the plants and extracting these resources, companies naturally want some degree of comfort that the price will not fall significantly below current levels for some time. The recent price decline reminded them why they did not start building these plants five years ago, and is unlikely to encourage them to start building them now.

The article continues:

3 - The emergence of new technologies to recover more oil out of old and decaying oil fields. With the price of oil where it is, it makes a lot of sense to invest substantially to try and optimize the output from any individual well. In the past 25 years, we have seen the average extraction at existing wells climb, thanks to technology, from 25% of known reserves to 40% of reserves. Norway has set a target of 65% to 70% recovery for a good part of its reserves and is already achieving that in some fields. Where do the improvements come from? Technological progress!

Once again, technological progress that has not occurred overnight. If it took 25 years to increase extraction to 40% it is likely to take as long for it to reach 65%.

4- The possibility to produce oil/ethanol out of agricultural products. On this very topic, the best summary we have read of the issues at hand was produced recently by our friend Mark Anderson, the editor of the SNS newsletter. We lift his work below shamelessly: “Ethanol is a liquid fuel, currently produced from corn… Now here’s the rub: there is a debate about whether it actually takes more energy to create a gallon of ethanol than the energy contained in a gallon of ethanol. According to Report No. 814 from the Office of the Chief Economist of the U.S. Department of Agriculture, corn ethanol contains 1.34 times the energy required to manufacture it…

There are longer-term solutions. In a period of about five years, we could be producing ethanol in quantity from cellulose. Cellulose is found in a variety of plant material, including the stalks of the corn plant. The process for production of ethanol from cellulose does not require large amounts of hydrocarbons and is, therefore, much less expensive. If the federal government continues to provide large subsidies for corn-derived ethanol, however, we are in effect providing a disincentive to make capital investment in cellulose technology. The corn lobby will fight tooth and nail, but in the end, democracy, just like the free market, has a way of doing what is right and sensible (usually, after trying out all other options). In this case, that would see cellulose derived ethanol become widely available in the marketplace.

Well, call us in five years when the cellulose plants are up and running. In the meantime, with a 1.34 energy output/input ratio the best ethanol can do is cut fuel consumption 34% - and that is assuming there is that much excess corn produced, that the plants can be built, that the increased demand for corn doesn’t make it even less profitable, and so on.

5- Prices & Substitution

High energy costs are not impacting just oil. We have witnessed a stupendous rise in the price of all forms of energy through the substitution effect. And here technology is also making huge leaps. Let us, again, go through a few examples:

* Nuclear power. There are two main problems with nuclear plants. The first is that building a plant takes a long time (though the Chinese are definitely not wasting any time on that issue). The second issue is the disposal of the nuclear waste. But this is where the exciting news lies: we have recently read reports highlighting that the volume of the waste in the new French reactors is a tenth of what it was in the old reactors. This implies that the amount of space needed to store the waste is much smaller, and the arguments of the anti-nuclear green lobby further reduced.

* Production of energy at the individual and local levels. Everywhere we go, especially in Europe (where the price of energy, on top of being very high, is also heavily taxed), we find new and interesting forms of energy production: in Scandinavia geothermal energy (one drills in the rocks, and gets the heat coming from below); in France, a massive movement towards heating pumps (exchanging heat between a source of water and the atmosphere - in fact, after a brutally hot summer in Provence, I am biting the bullet and having such a system installed in my Avignon house); in Denmark, there are quite a lot of wind turbines; in Spain, you can see solar panels on a growing number of roofs. All these systems enjoy huge tax breaks, and, once they are put in, they are here to stay; markets lost for oil, for ever.

By themselves, none of the above factors is sufficient. And the rate of substitution from oil to these new sources of energy is excruciatingly slow. For example, if one had the bad luck of installing an oil boiler in one’s house three years ago, one is not going to change now. The capital costs are simply too high. But taken together they are significant and will change for ever the demand for oil or natural gas used to heat or cool houses, factories, or office buildings.

This is indeed the meat of the article, but there is nothing to say that this can happen any time soon. With a ten-year lead time to build nuclear plants, we just don’t see it making a sizable dent any time soon. Then, apart from the environmental issues, Gave offers the reason why it may not help even then:

Our 19th century world was dominated by coal. Our 20th century was dominated by oil. It is our firm belief that the 21st century will not be dominated by oil. It will be dominated by electricity; and oil will become a marginal energy. This simple truth might help explain why, since 2001, uranium has not had a single down month, and since 2003, uranium has never traded down for even a single day, regardless of what was happening to oil prices.

With uranium prices rising so much, why even bother? It sounds like it won’t do much to make energy cheaper, which is after all the point. In fact, there may not even be enough uranium out there to support much additional demand. As far as substitution, consider that the median age of vehicles in the US is 9 years. If you assume that hybrids improve fuel efficiency by 50% over their gas-only counterparts, even if 100% of new car sales were hybrids it would take 18 years to fully replace the vehicle fleet and reduce fuel consumption by 50% overall (assuming demand doesn’t continue to rise.) Based on a more realistic (but still wildly aggressive relative to today’s sales levels) assumption that 10% of new vehicle sales will be hybrids, the annual demand reduction is less than 0.3%. Color us unimpressed.

Comment on this article

Comments

[WC Whiner:]

While not exactly my view, the bear case to which I posted a link was at www.morganstanley.com/...

Their arguments, like yours, base on demand and supply. On demand, they say (and I agree), "the main piece of news is the cooling of the US housing market, inasmuch as it could foreshadow a significant slowdown in the largest oil importer in the world;" on supply, they argue (and I am agnostic, perhaps disagree), "the geopolitical risk premium associated with risks of supply disruptions that has built up since 2004 is now large enough to cope with potentially dangerous events in the Middle East."

On the demand side, even without a cooling economy, we have already seen lower demand numbers due to higher prices. The EIA devoted one of their weekly commentaries to it. "..the rise in gasoline prices since 2002 has had an impact on gasoline demand, keeping it from being even higher than it is. Economists and oil market analysts should be relieved to realize that basic assumptions, such as the notion that high prices should restrain demand (from levels that would otherwise be reached), still remain true, even if at first glance it appears that high prices are having no impact." Cf tonto.eia.doe.gov/oog/...

Like MS I believe global demand numbers are underestimated ("..demand is actually higher than currently estimated and forecasted. Needless to say, stronger demand implies upside risks to prices."). As a result, I am not out there shorting the crude curve as far as my margins will take me. However, I see the same supplies as they coming online ("supply of light sweet crude is due to increase by around 1 mb/d each year in 2007 and 2008"), and feel that GDP is at high risk of a slowdown next year, if not all the way to zero.

My outlook for energy prices is indeed consistent with my economic outlook. I think the risks lie to the downside for housing, hence consumption, hence production, and hence demand. As a result, I have had an underweight for some time and a few small short exposures betting spreads stay at the lower level they now occupy. Should the housing and economic data start to come in strongly, I will with chagrin take my losses and unwind those positions -- but so far, the data flow is full of items like the worst NAR in years, new home sales down 20% YoY, downward revisions to GDP and the fourth month of five in which real PCE grew less than 3% YoY.

The main thing that will blow my poisitions out of the water, I predict, is not growth, since I'm just not seeing 06Q3-07Q2 as anything but disappointing. It is the lunatics on all sides in the ME doing something really stupid -- which is why I have to date stayed away from any positions that take a direct hit from price spikes alone.

I continue to think any analysis beyond this simple demand/supply work is a distraction to the investor. In the short/medium term in which the markets operate, to borrow from the Fugs: ethanol, nothing, nuclear, nothing, tar sands, coal sands, a whole lot of nothing. I'm watching crude production, refinery capacity, and every economic datum I can espy.

2006 Sep 29 02:51 PM

[William Trent_:]

You seem to believe demand is more elastic than I do. You may well be right. Can you point me to a worthy source that would suggest as much?

With regard to housing, do you believe that there will be unoccupied homes (hence using no energy) due to overbuilding/speculati... or that consumers will put on sweaters, as Jimmy Carter recommended? Or that they will just cut other spending and the effect will be through the reduction in manufacturing of goods? All are plausible, though possibly only over a 1-2 year time frame.

I tend to avoid the "short/medium term in which the markets operate" because (with a few exceptions) I have little skill in digging up and interpreting the information necessary for such a strategy ahead of other investors. As a result I tend to look out a little farther than most in my search for value and I have a relatively high tolerance for short-term losses. As a result, I will admit that my most frequent mistake involves grabs at falling knives. For the sake of wealth maximization I am working on it, though.

2006 Sep 29 03:34 PM

[MarineCorpsVet:]

Mr. Trent is wise about many things however he needs to gain a little wisdom re: his espousal of the "peak uranium" idea. His use of weasel words (usually reserved for enviro-whackos) such as "...there MAY not even be enough uranium...". Uranium is one the most abundant elements on the earth. It will be many of Mr. Trent's lifetimes before we even come close to running out of uranium. Maybe before then we will have developed fusion power and won't need to go the lengths of removing it from sea water.

2006 Sep 29 07:44 PM

[William Trent_:]

Thank you for the initial compliment. We will be sure to pass it along to the missus. However, we didn't previously consider Uranium Miner (the link in question) to be enviro-whackos. The quote we based our weaseldom on was:

"A persistent deficit between world U3O8 demand and worlds U3O8 mining supply has existed for close to two decades and inventories are steadily being depleted. Low grade uranium sources are plentiful and readily accessible but uneconomical at current prices, substantially higher prices are necessary to make them viable."

The uranium price movement of late also suggests a greater scarcity than you give credit for. As to lifetimes, we won't run out of oil for many of my lifetimes either, but I still think the price is going up and it will continue to be relatively scarce for a few years.

2006 Sep 29 10:43 PM

[WC Whiner:]

Actually, I'm not sure we disagree on the elasticity of demand. That increasing gasoline prices over 2002-2006 impacted demand by only 0.2-0.4 mmb/d is a testament to that demand curve's inelasticity (click through for the EIA's estimates). However, that there was any impact indicates it is not perfectly inelastic. I have yet to see any really believable analysis indicating how demand actually varies. It has been my guesstimate to look at Europe for the demand effects of higher energy prices on developed-world demand, with an adjustment for the gasoline demands unique to the more sparsely settled US. I do not expect the US (~350mm BTU per capita) to get anywhere near German (

2006 Sep 29 07:57 PM

[WC Whiner:]

Hm, something ate the rest of that post. Seekingalpha should take their VC money and spend a lot of money on a consultant to implement a comments system that is at least as good as the free-beer-free-speech-... blogging software I use, which can handle a less-than symbol without choking. Anyhow, Germany is sub-200mm BTU/cap, which I don't see the US hitting soon given its differences, but something like Belgium's 300mm seems doable, at some price. Cf www.eia.doe.gov/kids/i... -- there is room for demand destruction. That I do not know at what price explains that my bets so far are spread bets, not energy price bets.

I tend to prefer very-long-term plays as well, but sometimes a market gets ahead of itself enough that I can quantify and react. In this case, it has been a combination of the energy market up move with the housing market down move. Something has to give, and I predict it is consumption. The moment the data contradict me, I'll be back overweight fuels.

So far, so good.

2006 Sep 29 08:01 PM

[WC Whiner:]

Apologies for the triple post, but I realize I also lost my answer to your housing question: I believe that home-equity withdrawals cease, cutting ~500b/yr right off the top of consumption. Residential investment slows (it is already), cutting a bit off production. Marginal demand for everything drops, but since energy supply/demand had been so balanced, I expected a good-size dip down (which is baked in already even if $60 was the bottom). Some people will in fact wear sweaters or buy less at Wal-Mart, but I am not all that interested in the anecdotes. As with everything, give me the data. Right now, see inventories at tonto.eia.doe.gov/oog/... and tonto.eia.doe.gov/oog/... and tonto.eia.doe.gov/oog/...

MS thinks high inventories are a rational response to global uncertainties, and perhaps they are right. However, they are certainly a testament that current spot prices are still above market-clearing ones, which to my way of thinking illuminates the demand picture, since not long ago much higher prices were market-clearing.

2006 Sep 29 08:09 PM

[William Trent_:]

Thanks not only for responding, but by overcoming the obstacles required to do so. You make a good case, though I still think days are a better measure than barrels. That supply is currently higher than demand should (in most cases) be a given. Whether it is growing as fast is the long-term story.

2006 Sep 29 10:51 PM