Outlook for Oil: 2008 Thus Far and a Preview of Coming Attractions

My concern has been that at some point, shortages of oil will cause a falling-stocks, rising-oil phenomenon that will crush my oil related stocks along with the whole market. 2008 has started like that. Oil was up 6.34% as of 2/29 (per Barclays Bank Zero Cpn ETN (OIL)) but stocks were down 8.5% (in terms of the S&P 500 ETF (SPY)). For oil-related stocks, the falling stock market trumped the rising oil market, as I have expected. IYE, a broad-based oil-stock ETF, was down 3.8% for the two months while Oil Service HOLDRs ETF (OIH), an oil service stock index, was down 6.7%.

The current situation is not exactly like the one I fear will come to pass because stocks are now declining due to credit and recession fears, not the higher oil prices. But the markets we’ve been seeing lately give us a preview of coming attractions and remind me why I added an oil options component to the mix of strategies in the EIS portfolio.

The EIS portfolio, happily, was up 5.1% for the two months (up 10.4% in February) partly because of the options component. Early in February I doubled its 3% allocation, adding another 3%, and at the end of February, it made up 9.8% of the portfolio, given appreciation.

A number of readers have written to ask about implementing this strategy, so let me review it now. The strategy is a simple matter of buying calls on long dated crude oil. To do this, one must have an account with a firm that trades futures contracts. Please do not write to ask for a recommendation of such a firm; you can find one by asking your financial advisor or by googling “commodities brokers.” If you have an account with a “private bank”, they should be able to help you.

My calls are exercisable in the years 2010 through 2015 with strike prices of $100 to $120. The option contract will gain if before the expiration date the price of oil rises above the sum of the strike price and the price I pay for the option contract. The benefit of buying an option rather than a futures contract itself is that the potential losses are limited to the amounts paid for the options while the upside potential if oil prices rise is unlimited. Futures contracts, on the other hand, obligate the purchaser to buy the oil at the price (s)he pays for the contract. If at the closing date (or whenever the contract is sold) the oil price is lower than it was when one bought the contract, one would lose the difference in price times 1000 per contract. Potential losses on futures contracts can be substantial.

Since the total cost of all my options is only 6% of the portfolio, that is the most I can lose. Such a loss would result from future oil prices being lower or fairly stable. Such a condition would likely benefit the stock market and therefore the balance of the EIS portfolio. On the other hand, if the price of oil rises to $500 a barrel by late 2015, stocks will be in bad shape but each option with a $120 strike price will show a profit of $370,000 compared with an original cost of about $10,000 today.

Outlook for Long Dated Oil

$500 oil in 2015? Am I crazy? Well, I’m not predicting an exact price of oil in 2015, but there is evidence that makes $500 per barrel a possibility. It includes

• The mega-projects work of analyst Chris Skrebowski and others that suggest a drought of new oil fields coming on stream after 2010 and a dramatic fall off in 2014. (Yes I know about Brazil’s Tupi field and it will be wonderful…by 2020.)
• Charlie Maxwell’s prediction that crude oil production will peak around 2012.
• The increasing cost of recovery of new oil projects that are coming on stream, such as oil sands or fields that are miles deep and many miles offshore or the Caspian Sea with its killer winter conditions that have helped to put that project far behind schedule
• The hundreds of millions of poor young people in China, India, the Far and Middle East, Russia, and Mexico who are striving for the economic benefits so common in OECD countries where per capita oil use is many multiples of the global average.

What would $500 oil do to stock prices? It would presage extreme stagflation, the economic scourge of the 1970s. In such a world, stock prices could crash on a 1929 scale. We would probably see rationing in the U.S., economic weakness that would rival or exceed the 30s, possibly military adventurism, and, needless to say, an awful lot of human suffering. The thing to remember is that $500 oil means less oil available to the world and that means less economic activity, a world without growth. We live with the assumption of perpetual growth. So what $500 oil means is a different world.

Baby boomers and their offspring have never experienced conditions anything like these (as opposed to boomers’ parents who lived through the Depression and WWII) so there is a tendency for boomers and their kids to think such a thing cannot happen. I certainly hope they are right, but I don’t know why they would be.

What are the arguments against oil continuing to become scarce and its price continuing the rapid uptrend of the past four years? There can only be two arguments: either higher prices will dampen demand or they bring on new supply, either or both of which would tend to stabilize or reduce the oil price.

On the demand side, there are two options. One is that the profligate use of oil in the U.S. automobile sector is reduced by the substitution of more efficient cars. The other is that the developing countries of the world will slow their growth rate (as predicted by a recent Deutsche Bank report).

The U.S. car fleet takes 17 years to be completely refreshed according to the Hirsch Report. Higher efficiency cars have begun to sell but the available “high mpg” cars get only about 50 mpg at the most so far. Most hybrids today get 30 mpg or less. In a few years we may be able to buy cars that get 100 mpg.

So – to grossly simplify this exercise - by 2015, we will be about 8 years into a 17-year process, a bit less than half way. Making two key assumptions, let’s say that by 2015 we have converted 40% of the fleet to cars that average twice the current 20 mpg efficiency. That would save us 40% (of the cars) times 50% (of the efficiency) or 20% of the oil used by cars. Then we have to add in the roughly 1%/year growth in the size of the U.S. car fleet. Given that U.S. cars use about 11 mb/d of the 21 mg/d of oil consumed in the U.S. (trucks and industry use the rest), the savings by 2015 would be about 4.2 mb/d, less fleet growth costing about 2.2 mb/d, or a net savings of approximately 2 mb/d.

So the potential savings of oil from greater U.S. car efficiency by 2015 is not nothing but clearly this 2 mb/d savings will offset just a little more than one year’s growth in the global demand for oil from developing countries that has been running about 1.5 mb/d per year. If that demand growth were to continue to 2015, global usage would be increased by 12 mb/d over the 87 mb/d currently used, resulting in a need for 99 mb/d.

What about supply? The recent Deutsche Bank report notes the perverse fact that since 2003 higher oil prices have caused lower growth in oil production, a phenomenon that is related to the hoarding issue that I have long discussed. Based is on the work of Skrebowski and the opinions of Maxwell and other experts on future oil supplies I suspect the world may scrape out the capacity to meet normal demand growth of developing countries for perhaps two more years, bringing oil use by the end of 2009 to perhaps 90 mb/d. But after that, oil supply growth will stop and then start declining. It could decline slowly by, say, 1 mb/d or it could decline more rapidly by perhaps 3 mb/d. If it declines by 1 mb/d between 2010 and 2015, it will be back to 85 mb/d in 2015. Implied demand, we saw, will be about 97 mb/d after the savings in U.S. car usage.

What about biofuels? I do not think ethanol will add much more to supply unless and until cellulosic ethanol becomes feasible, as discussed in more detail below. Biodiesel based on waste materiel will be ramping up, but the numbers are not near to being game-changing.

In sum, the price of oil in 2015 will have to be sufficiently high to destroy about 12 mb/d of demand. Before looking at what price will be required to destroy that much demand, let’s think about where the demand destruction will occur. The moderately affluent and wealthy will not be priced out of the market because oil costs are a small part of their total expenditures. Also, it will not happen in the countries that export oil, although they are responsible for about 35% of the global growth in oil demand. Those countries, many of which already subsidize their domestic oil prices, will make sure their local populations have all the oil they need. So the demand destruction will first occur among the poorer people around the world in both rich and poor countries. Let’s say they account for about 5 mb/d of demand. The other 7 mb/d will have to come out of the upwardly mobile part of the population of developing countries like China, India and other non-oil-exporting developing countries – in other words, it will come out of the global economic growth rate.

I do not know – and nobody else knows either – what price of crude oil will be needed to destroy 7 mb/d of demand in the dynamic parts of the developing countries of the world. Clearly $100 has had little impact. $200 would have more. $300 would seem to possibly have a lot of impact. Is $500 too high or not high enough? That is not at all clear. It sounds like a lot of money now, but remember that it occurs in seven years, which is a lot of time for the world to become used to much higher oil prices. After all, $100 per barrel is a lot less scary to us now than it would have been five years ago when oil was $25 per barrel.

Let’s also remember that the developing countries export a lot of products and services to the OECD countries. Higher oil prices paid by exporting countries will be built into the prices of their exports and therefore will be paid by their customers in OECD countries. So the entire burden of higher oil prices paid by developing countries will not be borne by them; some will be passed on to the wealthy OECD countries via import prices. For all these reasons, it does not seem beyond reason that a $500 per barrel price may be required in 2015 to cause the destruction of 12 mb/d of demand.

That’s enough about the reasons to own options on long dated oil.

Other EIS Portfolio Changes

While my longer term view of the oil price is bullish, short term I suspect that there is not much further to go. A large number of new oil projects are scheduled to come on stream in 2008 and global demand growth will be somewhat stunted by economic conditions. Therefore, in February, some EIS portfolio funds were shifted out of oil sands and oily stocks and into alternative energy and mining stocks and natural gas stocks. Included in the former two categories are some participants in electrical conservation, generation and distribution, and several companies involved in the production of lithium or lithium-ion batteries. It has become clear that virtually the entire automobile industry has decided to stress new models of hybrid cars that use lithium-ion batteries. Such batteries are lighter, more powerful, and can take more recharges. One estimate is that a Prius with a lithium-ion battery can get 80 miles per gallon of gasoline. Sales of lithium-ion powered hybrid cars are scheduled to start in 2009 and may ramp up fairly quickly.

At Piper Jaffrey’s excellent Alternative Energy Conference I heard about a dozen presentations, of which I thought the most impressive was by Cree, Inc. (CREE). The company is the largest dedicated LED lighting maker in the world. The stock has always seemed expensive, but “expensive” stocks often trade that way for a good reason and I think that’s the case here. It sells for 45 times average estimated F ’09 (June) earnings. The reason I own it: long term LEDs are a better solution than compact fluorescents (CFLs) in terms of flexibility, quality of light, and lack of pollution issues related to CFL’s mercury content. Short term: rapid sales and margin improvements are expected.

Cree highlighted the compelling commercial lighting arguments for LEDs. In public spaces (e.g. garages), retail, restaurant, and hotel environments, which new Cree products are targeting, LEDs' payback is rapid. Not only do LEDs use as little as 5% of the rapidly increasing electricity costs compared with incandescents. But more important, their 20-year lives mean huge personnel cost savings in lighting systems maintenance. And the advantage of LEDs over CFLs in public safety, given the mercury contamination problem in the event a CFL bulb falls and breaks, is important. Based on products designed for these markets, Cree aims to double its operating margins on rapid revenue gains in the next couple of years. In short, when LEDs become the standard, which I think will become the case within a few years, CREE will be a must-own stock for virtually all big funds.

I suspect the price of natural gas can go higher, particularly in the 2009 and longer dated contracts. Some fundamentals of natural gas have improved including the shelving for ecological reasons of many planned coal-fired electrical generating plants. Few if any new coal plants are likely to be built in the U.S. until a carbon dioxide sequestration technology is proven to be cost-effective, which could be some time down the road. In the meantime, given the enormous lead times required for nuclear power plants, the electrical industry has little alternative than to rely on natural gas. It’s a proven technology, relatively clean, and relatively quick to construct.

Other potential sources of increased natural gas demand include fertilizers and oil sands production. Moreover it seems that substantial stresses in European, Asian, and even Middle Eastern natural gas supplies have recently been coming to light. Countries like Ukraine, Turkey, Germany, India, and even Iran are starting to indicate unsatisfied demand for natural gas, or, at least, concerns about the reliability of supplies. If such impressions represent reality, the U.S. may be outbid for LNG deliveries by such countries. If North American LNG imports fall, natural gas prices will be boosted.

Some (including Jim Cramer) think much more gas-intensive ethanol production will take place based on the new mandates in the 2007 Energy Bill. Maybe. I doubt it because corn based ethanol has well known problems of food cost inflation and low energy returns and because a new ethanol fire hazard has been discovered recently and is getting more press coverage. I suspect Congress will turn against corn based ethanol fairly soon and will revise the current mandates. If and when cellulosic ethanol becomes feasible, there may be a sustained surge in ethanol production that could benefit natural gas demand, but we will have to assess that situation when it is clarified.

While it is true that a number of new gas fields are showing exciting production potential based on new horizontal drilling techniques, it is also true that the decline rates of natural gas wells are very high. Moreover, some Canadian production and exports are still under pressure due in part to new tax schemes and in part to greater oil sands requirements for natural gas. Thus, it seems possible that with more gas being used to produce electricity and the possibility of higher LNG prices, we may see natural gas supply outrunning demand in the North American natural gas markets over the next few years. Of course, the weather will still be important if not determinative.

Why The Street Can’t Accurately Project the Value of Oil Stocks

An important and fascinating disconnect between Wall Street analysts and the real world is the assumptions analysts make regarding the oil price in out years. It seems that people who are paid to focus on the next quarter of earnings have little ability to forecast the longer term oil price. Or more likely it reflects the principle of conservatism. If an analyst underestimates a bullish factor in a company’s earnings forecast and the company she recommends outperforms, that’s fine. If the price of oil is higher than projected, the company will do better. Not a problem. So it seems that the safe path for an energy analyst is to assume a lower oil price going forward, which is the norm on Wall Street. What this means is that the earnings of virtually all E & P stocks are underestimated by the Street.

So, for example, a substantial Street firm (name withheld to protect the innocent) recently put out a major study on the oil and gas E&P and service and drilling companies. The underlying assumption on the price of oil: $82.54 for 2008, and $79.56 for 2009. Period. No discussion. Just: “we think the price of oil is too high and it will come down. The 30% compounded growth rate of growth in the price of oil over the past four years is a fluke. There will be a reversion to the mean.” As I posted recently, another firm stepped boldly into the future and projected that the price in 2015 would be $137. Really. A potential supply crisis is likely to be in existence by 2015 and the price will rise all the way to $137? Amazing.

Investors in energy related stocks should benefit substantially from this pattern of behavior among Street analysts. If oil prices rise over the next 3 – 5 years, the earnings of E & P companies, particularly the independents, will be boosted and the value of companies with substantial oil reserves such as oil sands will be even more benefited. Thus a company like Canadian Oil Sands Trust that has reserves of 50 years of oil at somewhat increasing production rates will be worth multiples of what analysts are currently willing to project. That adds immeasurable upside potential to the stock’s currently attractive 7% dividend yield. Marathon Oil (MRO), with its new ownership of oil sands assets, is in a similar position.

“Demand to exceed supply in a few years”

I read that quote in a newspaper editorial. You can read similar ideas every day. What are people thinking? How do they suppose the price of oil came to quadruple over the last five years? Was that by demand not exceeding supply?

In oil, demand and supply are always about equal in the sense that the world will produce a certain quantity of oil of which virtually all will be used. If there is not enough demand to provide a sufficiently profitable price, producers leave the oil in the ground. If there is not enough oil produced to meet the desires of all users, the price will go up and those users who cannot afford to pay it will go without. So the only way to determine whether the demand or the supply is strongest is the price.

So let’s get real. Rapid growth in the oil price since 2003 means that demand has been exceeding supply. Will it continue to do so or will the current trend suddenly stop? That is the question, not whether “demand will exceed supply” implying that so far that has not happened.

Comments

[Ernie Montague]

Good luck with that. I see oil and gas stocks to hold value, though a declining economy driven by energy prices will certainly put a self regulating cap on prices. There is only so much money in a consumer budget and thus only so much to spend. The SUVs, soccer trips, vacations, and toys will all go.

[mixter]

I used to think stock market investors were the most sophisticated and intelligent investors out there. Now, I think a good many of them are fools, who are too smart by 3/4. Trying to second guess geopolitics, the global warming "geenie weenie" crowd, improved technology for alternate fuels, significant new oil and gas discoveries, and so on, is a fool's game.

I remember the market took a big dive when President Eisenhower had a mild heart attack. What the hell did that have with the price of beans?

Warren Buffett is the smartest investor of all. Just buy good sound stocks and hold them as long at they are well managed and there is good reason that they will grow and prosper in due time

[jt]

Have to agree with you mixter...when one reads investment message boards and sees who the retail investors are, one realizes that the majority are a bunch of lemmings who do neither DD nor have any kind of a plan other than to "get rich"..."to da moon!!"

Another part of the problem is American's unsinkable ignorant belief that we are participating in open and "free" markets. The fact is that they are now being manipulated..."managed" for those who object to words they find politically incorrect...beyond all belief of the common investor as well as most of the investment "analysts" (there's another topic).

Those who think they are being scientific by following TA are just as easily abused. They fail to give sufficient weight to the fact that TA is ALWAYS backward looking, ie, whatever happens is what is determining what is supposed to happen. BUT...in a manipulated market, those with the power and money to manipulate prices also have the power to manipulate the TA. They now where the support lines and trend lines and wave lines are...and they they have the power to push prices above or (infinitely more commonly now with commodities) below those lines and watch the dominoes fall as the "smart" money sells as instructed by the TA.

Just look at the gold and silver markets. Those who have made an absolutely ungodly fortune from selling fiat currency to our Treasury and to the world (currency that cost them absolutely nothing and now doesn't even require paper!!...just electrons) have been manipulating those paper and even physical markets for years, even decades. One of their major coups was to "train" the market that the "shares confirm the metal"...so that if metals were up one day, but shares dropped, that meant that the metals were going to fall the next day. Sure enough, it became a consistent enough pattern that they could get enough coattail following from other "commercials" and specs, that it would happen. So then they would simply go into the equity market, as they have been doing for many months now, and short the crap out of them.

Anyway...it would appear that the Gold Cartel is now facing the Commercial Signal Failure where those who followed their manipulations and previously profited from them are so far underwater shortwise, that they can no longer bear the pain and are covering. THAT is when you start to see the TRUE fundamentals FINALLY starting to come to public notice.

Same with oil and NG.

[miner]

A thoughtful article. I have a heavy exposure to oil and gas stocks in my portfolio, so I consider myself bullish on these commodities.
However what I believe is often missing from articles like this one:
There will come a point where the developed countries will say enough is enough with ever increasing oil prices. Particularly the US is good at reacting when the chips are down. We will go to nuclear and/or clean coal energy in a big way, a 10 to 20 year process. We will go for gas efficient, electric or hybrid cars, a 10 year process. We will come up with other fuel saving/enhancing/ reducing technologies, a 20(?) year process. $500 oil is unsustainable in our present societies. React we will.

[blah-blah]

mixter: you must be the smartest commentor on Seeking Alpha. For every one of you, there's a 1000, 'AAPL deserves to be at $300 because I like their products so much' guys.

jt: exactly!

[reph]

Oil may hit $500/b in 2012 simply due to the hyperinflationary bias of the federal reserve. They clearly intend to print their way out of bank/homeowner/govt insolvency.

But I do agree oil is likely to rise even priced in euros, gold, agg commodities, etc.

[OrgonDude]

Right on, jt! I, too, have seen that same "bunch of lemmings who do neither DD nor have any kind of a plan other than to "get rich"..."to da moon!!"

Repeating success in the market, during both good times and bad, takes lots of dedicated DD and thinking outside the box. We'll talk.

[genomik]

Disruptive technologies r important. Perhaps a bit invested here as well could be good. This guys credentials are mind boggling.

March 3, 2008

It's a Bird, It's a Plane, It's Craig Venter (Here to Save the World)
Read Comments (0)
At the Technology, Entertainment, and Design conference, Craig Venter announced his "fourth-generation fuel" project. He plans to create an organism that takes in carbon dioxide and produces fuel, using synthetic chromosomes and already extant organisms to ramp up their octane-producing capabilities. "We have modest goals of replacing the whole petrochemical industry and becoming a major source of energy," said Venter, according to Agence France-Presse.

Ah, the humility.

[paultaut]

All electric cars are a solution of sorts. Altair Nano(ALTI) and Advanced Battery(ABAT) have been developing long lasting, short recharging ion lithium batteries.

The big problem, if they ever come into fashion, will be the power grid's ability to recharge them.

ABAT is a Chinese company which is providing 3,000 electric buses for the olympics.

Altair is in the same business but has recently developed a one Megawatt battery for AES.

Disclaimer: I own both stocks for the long haul.

[NutritionFacts]

Thanks Jim for putting the effort into this article. It makes an interesting read, regardless of one's viewpoint.

[iThinkBig]

Good article and well laid out arguments. Bottom line, the U.S. has been using a ton more oil filling up it's strategic reserve and the burning of oil in the war on Iraq. Consumers and business ARE being impacted and the numbers show domestic demand has been tapering off. Lastly, while the ME countries may indeed be hoarding either because of dwindling supply or simple supply and demand, countries like China and India that have subsidized oil are beginning to feel the backlash of skyrocketing fuel prices. China has their own big banking issues and cannot continue indefinately to subsidize growth, meaning demand will also decline there. The wild card you mention about alternatives is interesting. I see it this way: When enough pain is felt by the middle class, they will vote out the turds in Washington mismanaging this economy. I don't expect it this election cycle however, so I do expect deep recession, even possible crash and short-term depression. But, the U.S. has a massive amount of infrastructure, bright minds and freedom of choice. I suspect in 4-5 years America will begin to build the 'Manhatten' project of alternative energy and by 2015 we will have diminished oil demand by 30%. Until then, I assume you will grow much wealthier. I don't begrduge massive windfalls from assanine decisions of our policy-makers but speculation in the financial and energy market is bankrupting the majority of the population. This in the end, will have a direct impact on you're life as well as you mentioned 'military misadventures'.

[William Place]

It is a stinking shame that the 911 terrorists did not target the new york stock exchange and the new york mercantile exchange instead of the world trade center. If they had destroyed those dens of thieves there would be a Mohammad Atta street in every community in America. Our only hope is that the Iranians develop nuclear weapons quickly and use them on wall street. The real terrorists that threaten the american way of life are financial terrorists and they are right here in the US. Only with these parasitic leaches DEAD will the middle class have a chance of getting though this mess intact!

[Stephen44]

The oil bubble is about to burst. The natural supply vs. demand of the market will see to that. There is no shortage of oil on the international market. The geopolitical "crisis" that always pops up to inflate oil prices is nothing more than manipulation of the facts by those who profit in oil. In the next 30 days the USGS is going to release a revised assessment of the Bakken oil field in North Dakota. It was last assessed in 1999. At that time it was estimated that there were 400 BILLION barrels of retrievable oil reserves. To put that number in context, Saudi Arabia has 266 billion barrels of oil reserves. At the time oil was trading at $10/barrel and it was estimated that it would cost between $20-$40/barrel to retrieve. That problem has been solved with new horizontal drilling technology. It now appears that we can retrieve that oil at $16/barrel! That is enough to supply the US for 41 years and generate 18 TRILLION dollars of revenue. My only hope is that our government doesn't waste and mismanage this new oil boom.

[Mmarrkk]

Are you sure about that Bakken number? seems a bit high. confusing it with the shale oil down in Utah/Colorado? don't know but that number seems high

[Stephen44]

Mark: Those numbers are correct. I now hear that the USGS report should be released this Thursday. Do a Google search on "Bakken oil field". The size of this field covers nearly all of North Dakota and extends into Montana, South Dakota and Canada. We will know more about the numbers on Thursday. The conservative low estimates are it'll multiply the US oil reserves by at least 10X's.

[Stephen44]

Ok the USGS report out today stated that the Bakken has over 3.5 billion barrels in "recoverable" oil. It also estimated that total reserves to be 200 billion barrels. They are going to release another "in depth" report on the 28th to the total number of barrels that the Bakken may hold. I guess we'll know more on the 28th. This should start the ball rolling on infrastructure and developement of resources in that region.