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Calm Before The Storm?

Puru Saxena

28 February 2007

CURRENT SITUATION - Everything seems to be going well in the financial world and the investing public is busy doing what it does best – bidding up stock prices after a big rally. Today, there is no regard for risk with the investors’ greed being stoked by the mainstream financial media which claims that the US economy is in a sweet spot due to reasonable growth and low inflation (as measured by the bogus official statistics). In all fairness, the bulls have plenty to cheer about. After all, the long-term bond-yield in the US is still relatively low, the price of oil has taken a tumble and global stock markets are flirting with their record-highs. So, I ask myself whether we should join the herd or is it time for caution?

My observation is that dark clouds are gathering over the horizon and this is the time to be on guard. In fact, we may be experiencing the proverbial calm before the storm. Bearing in mind the recent developments in the Middle-East, I suspect that a geo-political disaster is around the corner. I hope I am wrong but it increasingly looks as though either Israel or the US will attack Iran over its “nuclear program”. I had first forecast this in August 2005 and believe my fears will be validated in the near future. Over the past few weeks, Washington has increased its rhetoric over Iran’s “nuclear program” and dispatched the USS John C. Stennis and USS Eisenhower aircraft carrier groups to Iran. This is an ominous development and suggests that we may be at the brink of another war.

History has shown that all major bull-markets in commodities have coincided with rising political tensions and war (Figure 1). In other words, whenever shortages in natural resources caused prices to rise, nations did everything in their power to secure their share.

Figure 1: Commodity bull-markets coincide with war

Source: Barry Bannister, Stifel Nicolaus

The commencement of the current commodities bull-market coincided with the invention of the “War on Terror” and we have already witnessed attacks on Afghanistan and Iraq. In my opinion, we are currently in the early stages of a new war-cycle as the US desperately tries to secure its future energy supplies. Previously, Iraq was accused of developing weapons of mass destruction and now Iran is being targeted along the same lines. So, if you are in the camp which believes that the US is genuinely worried about Iran’s “nuclear program”, you have to wonder why then does the US not attack North Korea? The answer to this question lies deep within the earth’s crust!

There is no doubt in my mind that the US is extremely interested in Iran’s oil and the ongoing “War on Terror” is really about dominating the resources in the Middle-East. You must understand that the US is highly dependent on foreign oil (it imports 13.8 million barrels of oil daily) and with China and India now using up more oil than ever before, the US is using its military prowess to secure its future energy supplies. It is interesting to note that Iran is the 6th biggest oil exporter and ships out 2.39 million barrels of oil per day (Figure 2). Furthermore, Iraq exports 1.82 million barrels of oil per day. So, you can see why the US is so interested in bringing about a regime change!

Figure 2: Oil exporters and importers (2005)

Source: BP, ING

At present, the financial markets have not factored in a military conflict in the Middle-East, making them especially vulnerable to turmoil. Therefore, if there is an attack on Iran, we may get sharp knee-jerk reactions in the capital markets. Under such a scenario, emerging-market assets would be the most affected. In fact, stock markets will probably suffer across the board and the price of oil will appreciate sharply. If Iran’s response is muted, the spike in the oil-price may be temporary. However, if Iran decides to stop its exports and disrupt the flow of oil through the Straits of Hormuz, the price of oil could easily reach $100 per barrel. This outcome would be a catastrophe for the energy-dependent global economy.

In addition to this, safe haven assets such as government bonds, gold and oil will thrive. If my assessment is correct, gold and energy stocks may end up appreciating significantly whilst the general stock markets decline. Accordingly, we have reduced our exposure to the emerging-markets and our managed-accounts are now heavily invested in oil and precious metals.

PEAK OIL – Our planet is rapidly approaching its oil-production peak. In fact, some leading geologists argue that we are already past that point.

It is important to understand that oil-production follows a bell-curve (Figure 3). This is true whether we are talking about a particular oil-field, a nation or the planet as a whole. Once more than 50% of the reserves are depleted, the rate of oil production enters a rapid and irreversible decline.

Figure 3: World oil-production peaking?

Source: Dr. C.J. Campbell

Today, several oil-provinces around the world are producing significantly less oil when compared to their record-production levels. Despite phenomenal breakthroughs in technology, these regions have failed to sustain their record-high output levels and this is proof of the concept of peak-oil. If we look around today, the US is past its peak, the North Sea is in decline, Indonesia is struggling and even Mexico has announced that its largest oil-field is past its peak-output. Although these regions still have massive reserves, the rate at which they pump oil out of the ground on a daily basis has entered a serious and permanent decline. In the recent past, non-OPEC nations increased their production and managed to compensate for the declining output levels elsewhere in the world. However, when you take into account the fact that these countries are also faced with geological limitations, it becomes clear that unless we discover gigantic oil-fields very quickly, our world will find it extremely hard to keep up with rising demand.

When discussing “peak oil”, it is also important to mention that over the past 35 years, we have discovered just one gigantic oil-field anywhere in the world! For sure, there have been some discoveries in different parts of the world but only a single world-class oil-field has been discovered in over 3 decades; Kazakhstan’s Kashagan Oil Field in the Caspian Sea. This is despite all the technological achievements over the same period. In other words, unless we have been incredibly unlucky and there is indeed a jackpot waiting to be found, this is not a healthy sign.

To complicate matters further, demand for oil continues to grow rapidly. At present, our world consumes roughly 84 million barrels of oil per day. If current growth rates continue, Asia’s demand alone will increase from 22 million barrels per day to approximately 40 million barrels by 2020. According to the US Energy Information Agency, global consumption is projected to increase to 103 million barrels per day in 2015 and 119 million barrels by 2025. In order to meet this explosive demand, global production must increase by 45% - about five times the maximum annual output available from Canada’s oil sands.

So, you can see that our world faces an imminent energy crisis which may cause an escalation of resource wars over the coming years. Normally, I do not like to make bold forecasts but I can say with confidence that the era of cheap oil is over. Moreover, I also suspect that things will get a lot worse on the geo-political front before we return to a period of world-peace.

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Puru Saxena

Email – puru@purusaxena.com

Website– www.purusaxena.com

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

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