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There are those who believe the price for oil will necessarily drop due to the slowdown in the U.S. and Europe infecting the rest of the world economy. And while the existence of the slowdown is absolutely inarguable at this point the demand for energy seems to be stable. World production deficits of conventional crude oil stand at 16% over the past five years and only production from unconventional sources have been able to take up the slack. That supply costs a lot more to produce. The North American pipeline system keeps the Brent/WTI spread between $18 and $22 per barrel, which also supports higher prices abroad and for the most of the U.S. in the form of high gasoline prices.

Demand is going to come from the expansion in SE Asia. The major oil companies are all positioning themselves to source future needs now. The buyout of Nexen by CNOOC (CEO), Malaysia's Petronas buying up Progress Energy Resources as well Japan's Inpex having a joint venture with Nexen in 3 Alberta basins are all examples of Southeast Asia's thirst for crude oil and liquefied natural gas. ASEAN now represents 5.34% of global crude oil demand and is growing at a CAGR of 2.65% annually since 2000. The region accounted for 11% of the global increase in demand from 2000-2010.

It does not help matters that oil production for the 10 ASEAN nations (the lion's share of which is produced by Indonesia and Malaysia) peaked in 2000. Indonesia's production in 2010 was more than 40% below its peak production year while Malaysia has fallen back 27% from its highs. Vietnam no longer looks capable of producing 400,000 barrels per day like it could earlier in the century. Of the top five producers in the region only Thailand is increasing production year over year. It supplies, however, only 241,000 barrels per day.

The wildcard going forward in the next few years will be Myanmar, whose newly normalized relations with the West has it looking to auction off development rights all over the Bay of Bengal. Myanmar's natural gas reserves are enormous, the 10th largest known reserves in the world. One could make the argument that the 2400 km pipeline from Kunming to the Bay of Bengal, due to be completed in 2013, was the impetus for the abrupt change in foreign policy of the U.S. and its satellites.

While ASEAN does not represent a large portion of the global demand for oil, its growing economies will ensure that the price of oil will not drop significantly. These are economies that have been growing up in the shadow of relatively expensive oil versus the older economies of the U.S. and Europe whose infrastructures and political entanglements (i.e. social programs and infrastructures) were built on the back of extremely cheap petrol and represent more than 600 million people.

The New Cold War

The U.S. has been waging a cold war against China's expansion west for more than two decades now. It has been the goal of U.S. foreign policy to curtail the expansion of China west of the Himalayas. This is why a pipeline in the Bay of Bengal is a threat to the U.S. and why the State Dept. spent a lot of time in ASEAN this year, attempting to drive a wedge between it and China. China's bellicosity in the South China Sea has been a response to deals made by the Philippines and, to a lesser extent, Vietnam, to allow the U.S. Navy greater access to the region. A re-opening of a major Philippine naval base did not sit well with Beijing.

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China accounted for 10.8% of global demand in 2010 with a CAGR of 6.3% since 2000 and accounted for 94% of the total demand growth for oil since 2000. China's demand for oil was so strong that while the rest of the world was cutting back its usage during the 2008-09 financial crisis and recession, China's demand for oil continued apace. ASEAN saw similarly inelastic demand (see chart above).

This Cold War between the U.S. and China has manifested itself all over the Middle East this summer, between the sanctions against Iran to the proxy war in Syria. Since India is still dithering over the IPI pipeline and Singapore handed the port at Gwadar in Balochistan, Pakistan over to China the possibility exists now for that pipeline to traverse Pakistan and wend its way to China. The TAPI pipeline is again being touted to investors all around the world as the U.S. continues to attempt to isolate Iran financially but the age-old risks remain.

The latest headlines, however, suggest that while the Iranian Rial has imploded the U.S./E.U. sanctions against Iran are not enough to shut the country down completely and the Iranians will weather this storm. Whether this is rhetorical cover for an attack or even more severe sanctions is unclear but the timing is suspicious in light of the presidential election.

India still buys 12% of its oil from Iran, much of it in Rupees now, and the port project at Chalabar would give it greater access to Iran without having to deal with Pakistan while tacitly keeping its promise to the U.S. in not backing IPI. All of this wrangling and positioning is extremely important for how this region of the world transforms itself over the next 20 years, especially after the U.S. pulls out of Afghanistan.

The Rush for Unconventional Supply

The recent deal between Royal Dutch Shell (RDS.A) and PetroChina (PTR) to develop China's shale gas reserves underscores just how acute China's future energy needs are. The deal was driven by the Chinese oil companies lacking the expertise to implement processes like fracking to unlock shale gas reserves. Allowing Shell to come in and trade expertise for a stake in the project was a landmark event.

So was the news that China's coal-to-liquids development has borne fruit in the form of gasoline. Shenhua Energy is now selling petrol and diesel produced from coal in northern China's Inner Mongolia autonomous region. While in its infancy the project is capable of producing crude equivalent at ~$26-30 per barrel using the Bergius method versus the Fischer-Tropsch method, which has costs on par with oil from shale. With the mobilization of the vast coal reserves in both Mongolia and Pakistan under way, this technology could within 10 years supply a lot of China's marginal demand. In the end we see a number of things happening within the oil industry in Asia:

  • China's push for both supply and shortened transit routes is the major cause for a lot of the moves being made on the geopolitical stage between the Mediterranean Sea and the Straits of Malacca.
  • China's investment in Myanmar is extremely important. Both the pipeline to Kyaukpyu and the port project at Dawei (West of Bangkok), which Japan has stepped up to back, are key to improving access to Middle Eastern and African oil without having to be bottled up behind the Malaccan Straits.
  • Mongolia is a potentially large supplier of oil whose worth will be mapped in the coming years. Its coal, iron and copper reserves are plentiful and cheap and are key to opening up Northwest China.
  • Afghanistan and Pakistan are desired by all the major regional players: Iran, Russia, India and China, while the U.S. attempts to play them against each other.
  • Once China secures sufficient access outside of the Malaccan Straits it will likely back off on its claims in the S. China Sea a bit and allow Vietnam, the Philippines and Indonesia more breathing room.
  • ASEAN's demand for oil will continue to increase as a percentage of global demand even in the face of a global recession.
  • Falling production rates and rising demand growth through previous downturns confirms that the economies of ASEAN are mostly immune from the global macro picture with respect to energy consumption.
  • If oil prices do not rise from here it will only cause ASEAN demand to rise faster.
  • Indonesia, Thailand and Malaysia have all shown strong resilience so far and have resisted getting sucked into the currency wars of competitive devaluation with their central banks managing any imbalances by doing nothing.
  • The falling U.S. Petrodollar system will put upward pressure on oil prices.
  • For the U.S. to maintain its dollar flow and manage the depreciation of the dollar the price of oil will rise tit for tat with every oil deal it is cut out of.
  • A war with Iran would be bullish for the dollar in the medium term as it would soak up a lot more dollars at $200+ Brent as well as shut off a major source of Non-U.S. dollar oil trading.
  • The higher oil prices rise the more incentivized the world will be to ditch the dollar as a settlement mechanism.
  • China and Iran have both tacitly announced an alternative to the SWIFT payment system, which is the backbone of the U.S.'s threat against all of its "allies." Without the threat of being cut out of SWIFT the less leverage the U.S. has in isolating Iran financially.

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As for investments there are a number of ways to play these markets. The Gold to Brent crude ratio is closing currently 15.4:1. The long-term average over the past 3 years has been 15 +/- 2.5. When the ratio hits 17.5 it corrects sharply and the same thing below 13. In essence, oil is not priced in Dollars anymore but rather in Gold. With the U.S. elections just four weeks away we expect to see the price of oil capped below $120 per barrel. Since Brent crude is what determines gasoline prices for ~80% of Americans, Brent is what matters politically. That puts an upper limit on any movement in the price of Gold at ~$1850 per ounce by the election.

Some other ideas are as follows:

  1. We like Exxon-Mobil (XOM) due to its diversified portfolio into natural gas of which a lot was bought at distressed asset prices.
  2. The major oil services companies, Baker-Hughes (BHI), Schlumberger (SLB) and Halliburton (HAL) all look strong heading into a new bull phase for natural gas, especially as we are into the cyclically strong period for energy in general.
  3. The SE Asian state energy companies like Petronas and PTT are well positioned but have political issues dogging them in the short term
  4. Petronas should be unleashed to repay shareholders after the Malaysian elections as UNMO is leaning on the "dividends" to fund its re-election campaign.
  5. PTT is investing heavily into Myanmar, working with the government to develop a number of properties while it also develops using more coal.
  6. Coal stocks are trading at low valuations due to the recent price drops, but with oil prices likely to remain high, more coal plants will be built across the region. Malaysia, Thailand and Indonesia, are looking into using more coal to supply part of their future demand. It may be time to look at the Market Vectors Coal ETF (KOL) now that the prices have crashed.
Source: Southeast Asia's Big Oil Drive