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The Big Picture

John J. Riley
Cornerstone Investment Services, LLC

April 25, 2005

This past month the performance of the stock and bond market was….

I’m sorry, I’m not going to talk about this past month or even this year. This report is going to give you a perspective that you might not have seen before. It is going to be about the next 10, 20 even 30 years. It is going to be about the Big Picture.

We invest into the future. Having a clear vision of the future makes investing easier and helps to eliminate some of the worries about short-term bumps in the road. The focus is going to be on oil and how it will effect virtually everything.

In doing the research for this report I found out that a number of popular beliefs were false and the facts are much more interesting and more importantly, predictable.

First, I want to make it clear, we are not likely to ever run out of oil. But that doesn’t mean production won’t decline in the future and it doesn’t mean that all of the oil in the ground is useable oil.

Secondly, the problems listed in this article are also opportunities for the investor wise enough to benefit from them. By knowing the economic landscape ahead of time gives us the advantage we need to be able to prepare and plan. Problems are only problems for those that don’t plan ahead.

Information sources
Popular opinion is that the oil industry is a secretive, closed society that is hiding huge reserves of oil. This view is false. Much of the information for this report comes from sources like the Energy Information Administration (EIA); OPEC, the Department of Energy, British Petroleum and Simmons & Co, among others. Simmons is an especially important source because they are investment bankers to the oil industry which gives them a uniquely critical perspective and a view from the inside.

Its All About Consumption
From everything we now know, it is apparent to us that consumption has been the driving force behind the rising oil prices. As the charts show, production increases have not been keeping up with consumption. Africa, Asia and especially China have been consuming oil at rates that have baffled many of the “experts.”

I say “experts” because the conventional wisdom from Wall Street has been that the consumption rates of these regions would top out years ago. It hasn’t and it is not likely to for many years, even decades to come.

Urbanization/Development Drive Consumption
To give you an idea of the size of the future consumption needs, according to Simmons & Co., currently 1 billion people (Prosperity) use 85% of the world’s oil. There are 5 billion other people in the world. 3 billion (Poverty) use the remaining 15% of the world’s oil. As these 3 billion develop, moving from poverty to prosperity, their consumption (of everything, including oil) will sky-rocket. Even if their consumption grows to only 1/3 of the consumption of the prosperous, per capita, oil production would have to double. And that doesn’t include the remaining 2 billion people not using any energy yet.

The UN estimates that over the next 45 years, the population of Africa is expected to double. Asia is likely to see an increase of about 34%, Latin America and the Caribbean about 39%. The developing regions have a shift going on internally from rural to urban. City life requires the consumption of more energy.

These shifts and consumption increases are going on right now.

Production Can’t Keep Up
Simmons has constructed a model with information from various industry sources that shows by 2010 global demand for oil is expected to be about 93 Mmb/day (Million Barrels/Day). Non-OPEC sources of oil are expected to be about 49Mmb/day. This leaves 44Mmb/day for OPEC. They are currently pumping about 30Mmb/Day. Best estimates are that OPEC could increase their production by about 4 Mmb/Day. This leaves a 10Mmb/Day shortfall.

Can’t They Just Pump More Oil?
No. Contrary to popular belief, OPEC and the other oil producing countries are not a bunch of evil, money-grubbing rich guys that are purposely holding the world hostage to high oil prices while they swim in pools of petroleum.

Pumping oil out of the ground is not as simple as turning on a faucet. After a certain point, an oil field hits its peak production and then the amount of oil production steadily declines. There are ways to increase the production, but most cause the decline to sharpen. Slow, steady extraction is the best way to get most of the oil.

Hubbert’s Peak and Peak Production
Since the 1970’s we have all gotten used to ignoring the latest crackpot that says we are running out of oil. We are never going to run out of oil. But that does not mean production won’t decline.

From 1949 through the 1960’s, an oil industry geophysicist named M. King Hubbert wrote important research papers that detailed the coming oil production peak and decline. His research has been accepted by major oil companies, oil industry associations and the auto industry as realistic.

His research showed that the US peak would happen in the early 1970’s (it did) and global oil production would peak sometime early in the 21st century. The exact date of his prediction of the global oil peak is irrelevant. What is more important is to understand it may be already happening. There is evidence all around us.

Peak production does not mean the oil field has run dry. For various reasons, it gets harder and harder to pump oil out of the ground as an oil field ages.

Technology Actually Making Things Worse
Technology was supposed to save the day, squeezing more oil out of the rocks. Instead all technology has done is allow the oil fields to be drained faster, but less efficiently. Various methods including water injection and horizontal drilling can increase the production, but they also hasten the decline in production.

Think of it like the reverse of concrete being poured into a foundation. The concrete is very soupy, but still they pour it slowly and have workers all around the foundation poking deep into the cement to insure that there are no air pockets and that the cement fills the space completely.

Oil production is the same in reverse. It has to be extracted slowly to insure that all of the oil from all of the little pockets is gotten. The faster the oil is pumped out, the more likely there will be oil left behind. This oil then becomes unrecoverable.

Disturbing Lesson From Oman
This lesson was learned the hard way in Oman. According to Simmons & Co, Oman had a single “Giant” oil field, called Yibel. It was discovered in 1963. Production began in 1969 and water injection started in 1972. By 1990, there were no vertical wells, they were all horizontal.

Production, thanks to technology, peaked at 250,000 bbl/day by 1997. By 2001, production was down to 90,000 bbl/day. 2004 estimates are around 40,000 bbl/day. What is worse is that Yibel is now expected to produce less than half of the original estimate of the oil in the ground.

Simmons says the event took everyone by surprise, that it “came out of the blue”. It shouldn’t have though. All of the warning signs were in place.

Are there other Yibel’s out there? The answer is an unqualified yes.

Peak Production Has Already Happened to Many Oil Fields
Below is a table of several key OPEC producers. It shows that they hit peak production years ago. How soon will their production collapse?

Other oil fields that we think of as bottomless have declined in recent years. 2002 production from some fields in the North Sea are down about 90% from their peaks about 20 years ago. Prudhoe Bay in Alaska is down about 60% from its peak in the late 80’s.

Old Oil Fields
As indicated by Simmons’ research, about 70% of our oil is from fields that are over 30 years old, 20% from 14 fields averaging 60 years since they were discovered.

Few New Finds
We are not replacing the oil we are using with new finds. New oil finds have declined almost every year since the 1960’s. There haven’t been any “Giants” found since then either. Most new finds have been small. The deep water oil, Russian oil, Caspian Sea Oil and Canadian sand oil have all proven to be either more hype than reality or extremely difficult and expensive to extract.

Increasing Consumption + Declining Production = ???
It is obvious what this adds up to - higher prices for oil. The question is what price is fair, what price is high and what is low? This is a question that is almost impossible to answer.

We know the trend, we know the factors, but how much will a developing, powerful nation like China or India be willing to pay? Because, like it or not, we believe they will be determining the future price of oil, not the developed world.

What Does This Mean to Investors?
Oil and natural resources will be a cornerstone of portfolios for years, even decades to come. Those that fight the trend will only suffer. But owning oil and oil services is not all an investor can do. The impact of high oil prices will reverberate throughout just about everything.

Inflation/Deflation
As ironic as it may seem, our deflation scenario doesn’t change. (More on that in another report.) Oil prices will continue to put pressure on inflation numbers. This will continue to force the Fed to keep interest rates high. This is bad for bonds. This will be especially bad for corporate bonds as companies will be getting squeezed by higher costs to do business, increased competition and higher interest rate costs.

We expect to see a disconnect between corporate bonds and Government bonds as corporates under-perform a market we already expect to do poorly.

Stock Market
Earnings expectations will have to be adjusted downward as the reality of higher oil prices works its way to the bottom lines of Corporate America. Higher interest rates and higher oil prices combined to give the market a devastating one-two punch in the 1970’s and we don’t’ expect anything different today.

Opportunities
Higher oil prices are probably going to help put more pressure on the US Dollar. This makes foreign bonds and stocks even more attractive. What would happen to the Dollar if oil was priced in Euros as many have been talking about? Foreign investments look better and better!

Other Resources
As the world develops, they are consuming more of everything, not just oil. Whether it is corn, copper, cement or cobalt, consumption rates are starting to take off and will likely be strong for years to come. This represents opportunities in the commodities markets.

Conclusion
Although this paints a very negative picture for conventional stock and bond investors, it is full of opportunities for those that understand the Big Picture. We at Cornerstone are more excited and focused than ever before.

The future for oil as an investment continues to be excellent. But not just oil, as the developing world continues to grow, many other natural resources and commodities will be effected in the same way. The Dollar doesn’t look so good, but that is great for foreign stocks and bonds. And even the negative for the US stock market is an opportunity for those that understand how to benefit from a market decline though hedges.

We will still be looking for short term breaks in the market, but we believe any pull-back in oil or hard assets will be short-lived and a buying opportunity.

Sources:
1 - Energy: A Global Overview - Simmons & Co. 11/17/04
2 - United Nations Population Information Network
3 - www.hubbertpeak.com/hubbert
4 - The Saudi Arabian Oil Miracle – Simmons & Co, 2/24/04
5 - The Peak Oil Debate: Crisis or Comedy? - Simmons & Co. 3/27/04
6 - Energy Bulletin 9/10/04
7 - British Petroleum Statistical Review of World Energy 2004