Whither the price of oil?

Peak Oil may be in the future but Peak Oil Awareness has arrived.  I expect Time and Newsweek cover articles on Peak Oil any week now marking the official top in oil awareness.  It has already made the covers of The Economist and Business Week, the leading indicators of magazine covers.

When (WTI) hit an intraday high over $135 a barrel everyone on the planet not personally involved in an earthquake, cyclone or primary election paid full attention.   Apparently, this price level is high enough for a significant number of consumers to say, “I’ve had enough - it’s time for action.”  The decline in U.S. gasoline sales of about 4% y/y and the sharp shift to fuel efficient car sales tell us that many Americans have been saying just that since oil crossed the $100 threshold (although unseasonably cold weather in the Mid-west could be part of the reason for the decline in gasoline sales).  

Perhaps more significantly, some poorer countries that have been sheltering their populations from high oil prices through price controls and/or subsidies are deciding to let prices move more freely.  Taiwan has done so.  Malaysia and India are likely to do so.  Pressure on other Asian and South American countries to do so will build both from budgetary concerns and pressure on them from OECD countries who believe the entire world must take their cue from the price of oil to change behaviors.  China will probably be a holdout longer than others.

For energy investors the nearly vertical price chart of oil in May has focused attention on the question: will the beat go on?   Or is $135 at least a temporary top?  That question and the outlook for longer dated oil are addressed below, but first a report on how the portfolio fared in May.

A Pretty, Pretty, Pretty Good Month

The price of oil and the direction of the stock market are the two primary determinants of the Energy Investment Strategies portfolio.  So it is not surprising that in May the portfolio enjoyed its largest monthly gain ever, 16.6%.   The year to date gain is 26.6%.  (Was this a 65th birthday present to me from the Universe?)  This performance was substantially assisted by the portfolio’s options-on-futures strategy which gained by 48% for the month and is up 189% YTD.  The stock portion gained by 10.2%, outperforming its benchmark (OIH) (oil service) portfolio’s 7.6% gain and the more diversified IYE’s 3.7%.  The Standard and Poor’s 500 was up 1.5% in May but still is down 4% YTD.

The futures strategy, as you may know, was put in place to reduce one of the risks of having a stock portfolio highly concentrated in energy stocks - the risk that the oil price could go so high that it would spook the economy and the general stock market so forcefully as to cause all stocks, including energy stocks, to fall sharply.  At times during the ascent of the oil price from below $50 in January, 2007, to over $135 last month we have seen evidence of a negative reaction by the stock market.   But in May, while the oil price became almost vertical for a while, stocks managed to hold their own and even gain a bit. 

Thus, the net result for the EIS portfolio in May was that its futures position became an an effective offensive weapon as opposed to simply a defensive tool.   Because the options-on-futures strategy has become a far larger part of the total EIS portfolio, I am starting to break out reporting on it separately, at least to the extent of noting above how the the futures and the stocks have each performed.

Readers may remember that last month I opined that the price of oil may have reached a short term peak.  During May I tried to hedge the portfolio in accord with this belief, but as the forward price momentum spanked me every time I did it, such hedging actions became limited.  Ultimately my hedges did not prevent the portfolio from benefiting from most of the rise in the oil price. 

My conviction that the oil price has temporarily peaked in the short term has now become stronger, though, and the EIS futures are now fully hedged in accordance with the following analysis.

What Happens Next?

At the start of 2008, I predicted that crude would trade in a range of $80 - $115 this year, later amended to $120. That was a boldly bullish expectation at the time, so the fact that my price target has been surpassed by so much so soon is an indication of oil’s outperform so far this year.   I’ve always said that in the short term, the price of oil can do anything and while that’s still true, my sense is that oil has reached a price that is more likely than not to stand as a high water mark for a while.  “A while” is a technical term meaning 6 - 18 months. 

I say this for a number of reasons.  One rule of thumb is that commodities that rise sharply tend to reverse when put in the media spotlight.  I do not remember a commodity spotlight any brighter than it is today with regard to oil. 

Another is the imminent activation by Saudi Arabia of their new Khursaniyah field that should add 500 kb/d to production.  Another is the continuing growth in Iraqi crude which reached 2.5 mb/d last month, a post-invasion record.  And, while anything could happen in Nigeria, there seems to be at least as much upside potential as there is downside at this point.

A major consideration I think is the little noted impact of Queuing Theory on oil supply and demand.  There is no question but that the enormous oil price increase over such a limited time - up 2.5 times in just 16 months - should cause supply to increase and demand to decrease.  However, both demand and supply are subject to Queuing Theory which is a mathematical expression of the phenomenon we observe on a crowded highway when the front cars start to move but the rear cars must sit still for a while. 

Oil supply and demand is very much impacted by Queuing Theory, as one can easily imagine.  I discussed above some of the demand reductions happening in the U.S. and the time delay we see in that playing out.  The trend has only just started and it is occurring in other developed economies as well.  In many less developed economies the price mechanism has been aborted by subsidies and controls which are just starting to come off, as was also discussed above.  All of these delays are part of Queuing Theory at work. 

In terms of supply increasing, the high oil price is causing the reactivation of previously capped oil wells.   It will continue to cause increased attention to working over old fields.  There is a huge amount of oil left in the ground that at higher prices and with improved technology can be recovered.  In fact “oil bears” and some peak oil deniers use this old-field supply as one of their primary arguments for saying that oil supplies will increase far more than is generally understood. 

Well, this phenomenon takes time to happen.  There are severe equipment and manpower shortages in the energy world.  A lot of challenging and difficult  things have to happen before the price incentive begins to work to bring increased quantities of oil to the surface.   But happen they will, in time.   Thus it is reasonable to expect that over the next year or two, natural oil field decline rates may be reduced as more investment is made in exploiting old fields.   In fact, we may well see oil supply increasing just as the oil price becomes “soft” - at least, compared with $135 a barrel.  That is the Queuing Theory at work. 

Megaprojects

Finally, I think we must pay more attention to the people who have been assembling data on oil field megaprojects.  This is a bottom-up attempt to understand the amount of new oil supply that will come on the global market each year for the foreseeable future (about five years) from many dozens of projects.  As readers know, one of the guiding principles to my investment philosophy has been Chris Skrebowski’s work on megaprojects.   Simplifications are by definition distortions, but my very simplified understanding of his work is that a fair amount of new oil will come on line in 2008 and 2009, lesser amounts for the three next years, and very little after 2013. I mentioned this last month and suggested that oil megaprojects may increase oil supplies for a couple of years but now I would like to look more closely. 

A much larger group of people, many whom post on The Oil Drum, are working on a Wikipedia-based megaprojects analysis.  Their estimates, shown below in thousands of barrels per day of new oil flows added during a given year, are a lot larger than Skrebowski’s.  Here is what they see going forward:

For the sake of comparison, they say added flows in 2007 were 3,314, a fairly typical level for the five years prior to 2008 in their estimation.  Skrebowski in 2006 published his estimated numbers for the three years 2008 - 2010 as follows:

What to make of such enormous differences between Skrebowski and the Wikipedia people?  One interpretation is that the Wiki project people have a later and more intense effort and have simply picked up a lot more data than Skrebowski did and therefore their numbers are more accurate.   One problem with that idea is that we are now 5 months into 2008 and the price of oil is certainly not saying that new oil flow has doubled compared with last year.

A better interpretation, I think, is that the Wiki people worked off of historical corporate and other public announcements of expectations of production.  These announcements are likely to have over-estimated reality in two ways.  First, the actual flows in the initial year are likely to be far smaller than the ultimate flows that the announcements probably referenced.   Second, there have been far longer than normal delays in new capacity coming on stream because of equipment and personnel shortages.   It is entirely possible that Skrebowski, a professional oil analyst, pre-edited his estimates to account for these factors.

Trying to square this circle, I have adjusted the Wiki numbers by taking 35% off the flows in each year and adding those quantities to the flows two years later. Then, to account for the decline of these new fields, I have taken 5% of each year’s new production and used that amount to reduce production starting three years later.   There is no adjustment for any possible optimism included in the original public relations announcements.   Here is how these numbers come out:

What about decline?  CERA says the global decline rate is 4.5%, which would be about 3.4 mb/d per year.  Others have estimated higher amounts.  Matt Simmons recently stated that he expects to see decline rates of 10% - 15%, rates that seem to be occurring in Mexico’s Cantarell field. It seems likely to me that as fields age, the global decline rate is likely to increase.  Therefore, I have projected it out starting at 4.5% and growing by .5% per year to reach 6.5% in 2015.  That translates to the following declines:

Does all this have any possible significance?  Well, first of all it does not predict new oil flows with any accuracy.   On the other hand, I think it has a lot of value as a general predictor of what sorts of changes in flows we might well expect over the next seven years, remembering that most major projects have seven years of visibility before production flows begin.   

What it says to me is that flows through 2011 may well be significantly higher  - by 1 to 1.5 mb/d - than they were during the past few years.  Then, at some point after 2012, they are likely - as Skrebowski has also forecasted - to fall off a cliff.   It suggests that new flows may exceed declines for 2008.  If decline rates do not increase at all over time, in contrast to my forecast above, new flows might exceed declines for the next five years.

On the other hand, the apparently healthy-looking net oil flows in 2010 and 2011 should be measured against the likely gains in oil demand by that time.  Let’s remember that demand in 2008 and probably 2009 should be somewhat diminished by reactions to the rapid price increases we have just seen - delayed according to Queuing Theory.  So the new oil flow increases in 2008 and perhaps 2009 would come against reduced demand increases.  Instead of demand increasing by 1.5 - 2 mb/d as in the recent past, it may increase by only 1 mb/d or less for the next year or two.  The IEA has already reduced their 2008 expected demand increase to 1.3 mb/d.

Thus, we may well see a respite in oil prices over the next year to two years.  I doubt that means oil would go much below $100 because at this point I suspect OPEC will not want to see that happen.  But we could well have a year of two of oil moving in a fairly tight range of $95 - $125.  But after a year or two, demand will pick back up.  In three years, demand may be increasing at rates closer to 2 mb/d, particularly if prices are fairly level over the next year or two.  Combine that with declines that will be increasing, perhaps to 4 mb/d in three years and it is easy to see that prices could begin escalating in 2010 or 2011. 

But what is abundantly clear from the above numbers, regardless of what happens in the next few years, I think, is that starting sometime between 2011 and  2013, the world is going to experience a true oil supply crisis.  I am not the first person to make this observation.  Skrebowski has said the same thing.  Charlie Maxwell has said the same thing.  It seems clear that Matt Simmons would agree, as certainly would Boone Pickens. 

All these people know far more than I do about what I’ve been discussing.   I think what is remarkable is that a reasonable massaging of the best publicly available data can allow an analysts like myself working along and without a long background in oil to come to the same conclusion - that a true oil crisis is within view. 

I’m not in the business of forecasting societal breakdowns or human tragedies.  If I were, however, I think the numbers we’ve been discussing here would cause me to pay a lot of attention. 

Is This Analysis Actionable?

I think it is.  I have adjusted both my equity and options-on-futures positions to de-emphasize oil for the short term.  In the futures account I have hedged the long term options with short term short positions. 

While I’ve not discussed natural gas in this letter, my sense is that gas is likely to outperform oil over the balance of the year.  Thus I have shifted assets into gas in both equities and the futures strategy. 

If oil levels out or declines from here, as I forecast, that should have positive implications for equities associated with global trade.  Thus I have maintained positions in shipping companies (TBSI) and (DRYS) and a few domestic railroads, all of which benefit from the need for countries like China to import grains and coal from long distances and from the general business of international trade. 

I have also put on a large position in (SQM), a Chilean mining company with an outstanding portfolio that includes inputs to fertilizers and drugs, and, importantly, produces lithium.  This is the best way I know to play the enormous trend toward hybrid electrics and all-electrics that will use lithium-ion batteries.  Interestingly, SQM’s iodine is also used in solar thermal electrical generation, anther energy related trend that I believe will be huge.   It is disconcerting (looking forward) that SQM’s stock has risen so far and so fast.  On the other hand, SQM is a very unusual company in that every one of its products is in huge demand now and appears headed for much greater demand in the the future.  I recommend their annual report to you.