The Reasoning Behind Oil's Irrationality

"The market can remain irrational longer than you can remain solvent." (John Maynard Keynes)

I'm reminded of this quote when I look at today's oil prices.

A barrel of oil at $90.00 seems irrational even with potential mid-east disruption. Oppenheimer charged that illegal manipulation is under foot in the oil markets and that the SEC needs to investigate the futures markets in oil. I can remember when oil was $60.00 a barrel and all the major American oil companies said underlying fundamentals only pointed to $42.00 a barrel Now they say demand should have oil at $50.00 a barrel. Someone needs to point out to major American oil companies that in 2 years their own pricing models, no matter how lower than spot or futures prices, still jumped 20 percent. Still this seems far too high no matter Turkey or Iran.

In my research , I notice several rising and pertinent factors:

1. Rising percentage of take by National Oil companies causing reduction of investment by the Majors.
2. Take point 1 and you will find smaller oil companies replacing the majors to a certain degree, but not enough to offset a declining oil production base.
3. Increasing take by governments that are free and open societies, the state of Alaska, the Province of Alberta, the Canadian Federal Government and Great Britain, decreasing spending by oil companies on exploration and some development. Free Republics and Democracies don't live in a vacuum, their constituencies want more money from the oil complex and they are out to get it.
4. The rising specter of a new U.S. Administration doing the same after the 2008 elections.
5. Increasing restriction and slowing by governments on amount of available land to be licensed for exploration Here the prime culprits are the U.S. and Venezuela. The U.S. is burdened with a cheap filing fee for Federal lawsuits initiated by environmental groups, Indigenous Tribes and Federal Law restricting the majority of the Continental Shelf and National Public Lands from oil and gas exploration. In Venezuela's case the government wants the heavy oil from the Orinoco to be exploited fully before they open up new land for conventional oil exploration, but then refer back to point 1 and you get nothing.What's at stake here: a combined 170 billion barrels of conventional oil between the two countries now off limits.
6. Lack of skilled labor and equipment causing very serious delays in projects. A Canadian oil analyst opined that these skills and equipment shortages are far more serious to the Albertan oil patch then the new Alberta Royalty Schedules.
7. Natural gas not achieving pricing parity with oil. This would allay higher oil prices to a medium sized degree. Gas projects are in trouble due to taxation, lawsuits and low gas prices. Read gas from the proposed Alaskan gas pipeline, gas from the proposed McKenzie Valley pipeline, read gas from the Troll field, where the Norwegian government recently said no to proposed gas shipments. Also, refer back to point 5.
8. Russia in effect barely able to produce enough energy for herself and contract customers due to the chaos in policy over energy projects. I know longer hold the view that everything in Russia is Machiavellian in its planning. These guys have chaos .No Rasputin like thinking here. Russia is stumbling when it comes to rapid and sustained oil and gas production. Expect no more than a 2.6 percent annual increase in Russian production for the next several years.
9. Alternative energy projects are not a viable alternative yet. Only nuclear power is physically able to shoulder the burden. But nukes are politically unacceptable, apparently in the U.S. and Britain where it is rumored that Britain's aging nuke power plants will not be refurbished. 10. OPEC unable and maybe unwilling to increase production. See Carlin Lee's excellent article in Seeking Alpha, dated October 31, 2007.The upshot: the Saudi's expect oil to rise $12.00 a barrel as a baseline per year out to 2010 to 2012.No one should be surprised. A British company that monitors tanker traffic in the Arabian Gulf reports that traffic has fallen in the last 4 to 6 weeks even with the Saudi-Kuwati initiative to increases OPEC production by 500,000 barrels a day. OPEC's own website has only two large projects scheduled after 2010 and they are in Iran.

Now, the investment idea: Buy any oil company or royalty trust in a society that still respects the rule of law that has increasing net production coming on-line between now and 2011. Some ideas are:

• Oilexco (OIL), producing 18,000 barrels a day and will enter 2011 at 100,000 barrels a day. This stock is hot and will get hotter. Downside: only if the Earth gets hit by a meteor.
• Bow Valley Energy [TSE:BVX) doubles production from 7, 000 barrels to 15,000 barrels by 2010. Downside: Company has 41 million in cash with two Canadian investment trusts and the money is overdue. Company says it can fund all its capital requirements and the funds were asset backed. Nexen, Yemen might be a problem. but Buzzard in the North Sea will throw off 1.6 billion in cash flow after full ramp up and two if not 3 GOM properties on stream by 2011.
• Crescent Point Energy Trust [ TSE:CPG.UN] produces light sweet crude primarily from the Bakken Formation in Saskatchewan Province. Has 3 billion barrels of oil in place and extraction of a single digit percentage of this greatly increases proved reserves. Operating most of their production in Saskatchewan leaves them in good shape on the Alberta Royalties changes. Downside: Saskatchewan does an Alberta on royalties.

Yes, they are all Canadian and produce from Canada and the North Sea. I encourage you to emulate the strategy that TAQA, the Adu Dhabi National Energy Company, has implemented. Instead of staying close to home and drilling exploratory wells in the United Arab Emirates or elsewhere in the Arab world, TAQA has purchased existing production in two of the highest cost oil producing countries in the world, Canada and Great Britain.

TAQA has spent more than 6 billion dollars in Canada alone in the last 6 months, picking up the Canadian assets of Pogo and the Canadian Trust Primewest (PWI). Recently, TAQA has announced that they will spend 20 billion by 2012 for more existing assets.

TAQA paid a 26 percent premium for Primewest as versus the recent purchases of True and Canetic Energy Trusts by Penn West (PWE) that had only a 6 and 7 percent premium respectively.

TAQA is investing in high production cost assets, mature oil bearing basins, and premium priced purchases; TAQA is irrational, right?

All leads to this fact---peak oil is here. Since 2004, the world has peaked at 85 million barrels of oil in annual production. Predictions by the IEA of incremental increases in production 0f 86, 87, 88 million barrels have come and gone.

Maybe that and some of the ten reasons listed above are the real reasons we are at $90.00 barrel oil. And maybe the futures markets have woke up to it before anyone else, other than TAQA, that is.

Disclosure: none

Comments

[SailDog]

From an investment perspective I cannot fault this article's conclusions. But his reasoning did prompt a recall of that syndrome of not seeing the wood for the trees.

The fundamentals are why oil is $90+ and will carry on trending up.

Whinging about oil locked up in ANWR, Venezuela etc misses the point that we have passed the point when oil becomes more valuable in the ground than as dollars in the bank.

It doesn't matter why production has remained flat at 85m barrels a day since 2004. The fact is that it has. Meanwhile China, India, Russia and most of the OPEC countries are using much more oil. As production is flat, that must mean more and more people in other countries are using less oil. That is why the price is trending up. It doesn't seem so difficult to me, but nobody else had said as much that I have read. Jeffrey Brown's Export Land Model is very alarming. Is suggests that net oil available for export is in an accelerating downtrend.

The final point is field decline. The North Sea is declining at around 8%, while Canterell crashed 20% in 2006. Global field decline could be anything between 4% and 10%, though nobody knows the exacty number. Platts report field declines of 8% in certain Saudi fields, but we don't know which fields, or what the overall picture is.

If we take the low end and round it down, global field decline from existing production is 3m barrels per day every year. In other words, with flat production since 2004, new production additions in the 3 years have totalled 9m barrels per day. That is more than total Saudi production. How many more Saudi Arabias are there?

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Be cautious of analysis based on what you think but on what you see. There may be something that you do not know but others know. At any moment there are both bullish forces and bearish forces at work, but we do not know which ones are prevailing and also, we do not know all the forces. Your points may well be all valid but market still going to opposite direction of what you think. Big winners of market are rarely professors or Nobel winners of Economics.