Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.
As is typical for the New Year, the media today are filled with articles on how people can cut fat out of their diet (weight loss being one of the most popular and easily broken resolutions).
Ironically, we believe the global economy may soon find itself being placed on another type of restricted diet – one that will certainly reward investors in key commodities.
Copper has received a lot of attention in the past month or so after setting new all-time highs, and because many producers and analysts expect the world will experience shortages of copper in 2011. However, we'd like to draw your attention to another commodity whose supply/demand fundamentals could have an even more severe impact on the world.
You've doubtless read our opinions on the subject of Peak Oil before. It's a topic that has incurred much heated debate over the past decade.
To recap, the story begins in 1956 with M. K. Hubbert, a geophysicist, who argued that once half the oil is extracted from a given deposit, production inevitably peaks. He correctly predicted that U.S. oil production would peak around 1970. Using his work as a starting point, other oil experts in the 1990s predicted that worldwide oil production would peak in the mid-2000s. Some, such as Kenneth Deffeyes, believe those predictions have already come to pass.
The International Energy Agency takes a similar view, saying that conventional oil production peaked in 2006 and will waver around current levels of 70 million barrels a day until it starts falling in earnest after 2020. Non-conventional reserves will, however, be able to make up the difference between supply and demand.
For some the existence of non-conventional sources of oil makes Peak Oil a nearly meaningless concept. Stanford Professor Steven Gorelick, for example, holds that oil production is in no danger of peaking. Peak Oil deniers argue that rising oil prices will prompt new discoveries of oil deposits, which will provide ample supplies for the future. They point to potential sources such as the Canadian oil sands, the Bakken Shale formation, and the deep sea deposits discovered off the coast of Brazil as evidence that oil production can continue to rise. They also note that oil production in the U.S. has begun to increase slightly in recent years, thanks to deep water drilling in the Gulf of Mexico as well as some production from the Bakken shale.
We believe the issue is not how much oil exists in the world, but how economical it is to produce. For instance, there is evidence that large amounts of hydrocarbons exist on various moons within our solar system. But the cost of delivering that oil to refineries on earth would be literally astronomical. Similarly, it may always be possible to produce more oil from a field that is more than half-empty. The reason production falls is often because costs rise after the half-way mark, to the point that it becomes uneconomical to produce the remaining oil.
The world's problem is that the biggest new sources of oil being developed today come with considerably higher costs. Some of those costs result from the efforts needed to maintain production at aging fields, or from higher exploration costs. Others come in the form of environmental damage and clean-up expenses, as occurred after the catastrophic oil spill in the Gulf of Mexico last summer or the steady destruction of the environment in oil sands regions. It also costs much more in terms of energy and other resources to extract oil from oil sands or from miles below the ocean floor. Petrobras, the Brazilian oil giant, has proposed building underwater cities which would extract the oil from deep areas. Imagine factoring the cost of such projects into the price of oil.
It seems that Peak Oil is too simple a concept. A better term might be “Peak Economical Oil” or PEO, defined as the point where additional oil supplies will be considerably more expensive, so that any increase in demand leads to disproportionate increases in oil prices. As cheap oil supplies get used up, production costs rise and PEO becomes an ever greater force.
In fact, PEO likely became a defining factor in the oil market around the turn of the century. Between 1990 and 1998, oil demand rose by around 10%, yet oil prices fell 50%. Clearly, cheap oil was still plentiful then. From 1998 to 2004, demand rose another 10%, but this time the price of oil more than doubled. That was a sign that the world had begun to turn to more expensive sources. By the end of 2010, oil was selling for over $90 a barrel – 6X higher than in 1998. In fact, it was $21 higher than the average price in 2006, even though demand was roughly the same.
It makes sense to assume that PEO will become an ever more important factor in the oil market. In other words, particular increments in demand will lead to ever greater increases in oil prices. And again that is because increases in global oil demand, combined with declines in production from the remaining cheap sources, will force us to turn ever more to expensive sources. Consequently, with even small gains in oil demand oil prices will likely rise dramatically. We would not be surprised to see oil hit new highs in 2011 or 2012, especially if worldwide growth remains on track.
Investors should therefore look at non-conventional oil companies that can increase production at relatively steady costs. Companies that can improve oil conservation are also great buys.
In the latter area one company that gets very high marks is Johnson Controls (JCI), a company best known as an automotive parts maker. The company has a building efficiency division whose products and services help improve the energy efficiency of office buildings, one of the few strong growth areas in the U.S. and Europe. Demand for such solutions in the developing world is also likely to rise as urbanization and energy demand accelerate. JCI also manufactures specialized batteries used in energy-efficient applications, such as technologies for shutting off a car engine when a vehicle stops at a red light (and starting it promptly when the accelerator is pushed). We're adding this stock to our Growth Portfolio with expectations it will make strong gains over the next 18-24 months.
Another standout is BorgWarner (BWA). Once a stodgy manufacturer of train parts, the company is now a market leader in technologies that improve the fuel efficiency of internal combustion engines. As gasoline prices rise, so will consumer demand for better vehicles with better fuel mileage, and BWA's profits. We anticipate the company's profits will set a new record this year and that the shares will rise considerably within the next two years.