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Quoted Pearls on Energy

Jim Willie CB
Jim Willie CB is the editor of the "HAT TRICK LETTER"

May 19, 2005

My greatest fear is that the USGovt and US Fed will actively pursue and promote a recession in order to prevent ongoing energy demand from creating a series of oil price spikes. Recession uses less oil than war!!! Somewhere wisdom might be purported that war is useful at the supply source, but recession or economic stall within the civilian zones might be more than tolerated. On the other side, if crude oil settles below $50 per barrel for even a few weeks, expect to hear some drill projects to be put on hold and delayed. An energy train wreck lies ahead. Don't be lulled into a false sense of security by the move below $50 per barrel. This is but a calm of man-made style. The Federal Reserve has caused severe damage by keeping interest rates so low for so long. Now the damage has begun to come to light, with slower retail sales among low-income households, with bond market hidden crises, with flattened money supply growth.

Within the energy sector, my personal analysis points to natural gas outperforming crude oil, but uranium besting the bunch. Natural gas production is in decline in key fields across North America. But uranium demand exceeds supply by 40%, and is heading for depletion, fast.

The twin crude oil price peaks correspond loosely to the lows registered for the USDollar in November and in March. Notice the uptrend system of parallel lines. The mid-rail offered a bounce from 52. The lower (thicker) trendline base has joined the 50-week moving average at 48 to offer additional support. If that fails, the entire uptrend would be challenged, with a struggle to ensue to find flat support at 46 and 41. The lowest (thinner) trendline support might be aligned with the flat 46 support by then.

Large energy companies reluctantly commit new funds to budget exploration projects. They tend to commit when very large deposits are in view, which is rare nowadays. They are more content in granting dividends and completing stock buybacks than in discovering new oil deposits. That is the first round, as they evaluate their alternative plans. Such a passive approach has its value. Next comes a merger & acquisition spree, not limited to just the leader, but also to the merged Seven Sisters. The Duke Energy wedding plans for Cinergy is an early warmup. The mergers are sure to continue in an attempt to exploit some synergy. The acquisition phase will soon begin to replace reserves already exhausted to output and production. In January and February of 2004, $202 billion in M&A was either agreed upon or completed among US corporations. We are sure to see large acquisitions of small and mid-sized energy firms. Note the report that Chevron Texaco is on track to acquire Unocal. Could it be that USGovt officials tugged the shirts of energy giants to use their cash to stymie Chinese efforts to grab US energy properties??? Methinks yes, and recall that Secy of State Condy Rice hails from Chevron. Danger might be sensed from Chinese encroachment. If it is not, it should be. Perhaps some concessions were given to Chevron by the USGovt, on taxes, on properties, on information.

Contract prices for crude oil have risen for the "out" years, the distant future months. A tectonic shift has occurred since last autumn 2004. Those who mistakenly (very shallow analysis) point to the recent pricing of crude oil above $45 per barrel as a temporary aberration, might want to check the forward pricing of crude oil futures contracts. A $10-12 rise across the distant year spectrum versus last Oct2004 is evident in futures contracts. This should be interpreted as "crude market recognizes post-peak supply declines" integrated into pricing structures. Couple the reality of finite limited oil supply with steady relentless demand increases, especially in emerging markets. Supply will struggle to meet 84 to 86 million barrels per day demand. Population growth and economic growth foster demand, a reflection of reality. Unless we experience an enduring world recession, even gradually rising demand by 2010 will not come without much higher oil prices. Wasteful energy usage must be halted by price deterrents. That means most usage patterns in the USA must be changed (big cars, big houses). Without a change in usage patterns, or a prolonged economic stall, we will have to adjust to much higher oil prices.

It is amazing that economists and analysts rely on backward looking methods, and overlook future supply & demand trends!!! The brokerage houses must be liars, lords or lunatics. My bet is "liars" without doubt, due to clear vested interest. Perhaps they expect a big worldwide economic recession to reduce crude oil demand, but sustain corporate profits generally??? Analyses based upon data from past decades and past dynamics are irrelevant and useless in today's world. Depletion is much farther along. Demand is much higher from the new kids on the block, and more wasteful US lifestyles.

Regardless of the reality of speculative influence of crude oil price movement, the underlying fundamentals are outrageously bullish. Marshall Auerback in his "Higher Energy Prices are Here to Stay" at the Prudent Bear website provides an excellent survey on the topic.

The crude oil real price is only half the 1979 price on an inflation adjusted basis. If actual price inflation statistics are used, not the silly low CPI, then oil sells for less than half the 1979 peak price. (One author calls the CPI the Constant Price Index, funny but true.) The global trend has usage of oil at more than four barrels consumed per new barrel discovered. Three of the top 20 non-OPEC producing nations failed to replace production in the last 5 to 10 years. Leaders Russia and Mexico replaced only 11% and 10% respectively in the last 10 years. Compared to the 1970 decade, 20% more discoveries have occurred on existing oil fields (not new fields) on a cumulative historical basis. Of the 18 leading oil producing nations, who account for 29% of world oil on the market, output per barrel dropped by 1.14 million barrels per day in 2003. The rate of decline increased last year in 2004. Exploration expenditures have not resulted in successful return on investment. Of the $8 billion spent in 2004, discoveries were worth under $4 billion. It is no wonder Exxon Mobil spends more on stock buyback than "blowing half of it" on exploration. Ironically, technology only accelerates the depletion, rather than expand the supply. New methods enhance production to be sure, but the oil supply is finite. Iran now produces 4 million barrels of oil per day. They are believed to own an extra 3 mb/day output capacity, the biggest spare derrick in the world. Iran owns 940 trillion cuft of natural gas, 16% of world reserves, surpassed only by 1680 trillion cuft in Russia.

A word of information about Iran, which should be put against the backdrop of warnings in the press & media about their nuclear intentions. Be suspicious, and examine potential ulterior motives to paint Iran as the next trouble spot. Iranian current gas production is meager relative to reserves. Combined, Iraq and Iran oil and gas could be under many watchful eyes, in pure lust. Unlike Iraq however, Iran has built strong ties with both China and India. This is the stuff which motivates war when industrial nations crave the resources in short supply. In the 1920 decade, it was coal mines in Poland and oil fields in Romania which were coveted, then seized by Weimar Germany. Nowadays, military machinery and corporate contract pens are being mobilized.

In coming months, a disconnection is anticipated in my analysis between gold and crude oil. The wild card to keep a tight link (historically linked) is trade war with China. That would essentially close the US borders. Although the US political and banking leaders have begun to anger and alienate Chinese leaders, their reaction has remarkably avoided any steps to hasten any trade sanctions or dock worker strikes or protectionist measures within the USA. A bill passed the US Senate last month, calls for imposition of a 17.5% trade tariff against Chinese imports after six months time, only if China fails to end its fixed currency peg regime. Instead, China has taken firm steps to solidify supply agreements with Iran, with Russia, with India, with former Soviet Republics, and elsewhere. They are doing the spade groundwork to form the foundation of the Shanghai Coop Group. They are executing an "end run" around the US sphere of influence centered in OPEC, isolating the USA. They are setting the stage for a wider war, not over simple access to markets for to fill retail shelves, but rather a war over ownership and contracts for hard asset properties (materials, minerals, and energy resources).

Energy is different. It does derive its demand from robust economies, but also from survival requirements like heat and light. Activity within an economy requires transportation, shipping, and movement of finished goods, raw materials, and people. Even if the US Economy (and world economy) slows to some extent, the price of crude oil might remain stable at trend. Despite nonsensical drivel about a surplus of oil on the market, the fact remains that supply is relatively flat, while demand is relentlessly rising. If economies slow, then look for oil demand to rise, but rise at a slower pace. A dangerous new development in managed markets is the convenient official published forecast to trigger price declines. Examples are numerous in recent months. The disconnect between oil and gold is coming, as sure as night follows day. Higher energy costs act just the same as higher Congressional tax measures, just the same as higher material costs and health benefit costs, just the same as higher short-term interest rates. Only if the Asian obstacle to "cost push" is removed during a nasty trade war, will the US Economy be highly susceptible to substantial price inflation. Why? Because we will on a more limited basis export monetary inflation to Asia, which is later imported in the form of cheap Asian finished products. The USA imports a giant assist to secular deflation!!!

WHAT FOLLOWS ARE INTERESTING ASSEMBLED QUOTES FROM FAR CORNERS ON CRUDE OIL. They serve as a catalogue, a series of gathered interviews put to paper, a story on billboards, with a final gem in Robin Williams graffiti. The dates from the many quotes vary over March and April.

Michael Economides, professor of petroleum engineering at Univ of Houston: "Hugo Chavez is twenty times more dangerous for the US Economy than Saddam Hussein ever was. If Venezuela follows through with their sale of the Citgo chain of gasoline stations, they might allow the refineries in its supply chain to simply rust, and divert that crude oil to China. There is a tanker shortage, where any delivery of new tankers would take place no sooner than 2009. Saudi Arabia has no spare capacity. They can continue to pump oil, but they cannot increase output to any great extent. In Russia the disruption makes for a Greek tragedy comedy. The Yukos story is the theft of the century. They are making up the rules as they go, all the makings for a disaster. Together with Venezuela, you have a perfect storm coming, and much higher oil prices. Get used to $55-60 as the likely price band. Last year's forecast of $25 crude oil was preposterous."

Economides is probably the foremost energy expert in academia, who routinely dismisses any weather factors in the crude oil price. His track record is superb. Then a couple weeks later, after the Goldman Sachs spike report, but before the oil price came down 15%, he made more comments. "There is no excess capacity in the oil market. Two weeks ago, OPEC announced increased oil output quotas, but the oil price went up. The market does not believe any extra output potential exists. Because of tight supplies, spikes over $100 are not unthinkable. Gasoline is a separate problem; it is an insult to injury. China has gone berserk. We are heading toward the perfect storm. This is NOT an oil shock. I do not see it that way since people like me have been warning about this for five years. We have a situation where the chickens are coming home to roost. The $55 price of last autumn was absolutely predictable. A $105 per barrel oil price is difficult for me to evaluate. It is outrageous but not unthinkable."

Venezuela's president Hugo Chavez on relations with the USA: "We are just waiting for the United States to announce next that Venezuela has weapons of mass destruction," at a speech in Bangalore, India. "The United States government would very much like to keep all our oil for itself But our oil reserve does not belong to Mr. Bush. The oil belongs to the Venezuelan people They went to Iraq thinking they will control Iraq's oil reserves... but I doubt very much they will ever control that country." Chavez said oil supplies would be cut off to the United States if Washington tries to "hurt" his country. "We want to supply oil to the United States... (But) if there is any aggression, there will be no oil," he warned. This is not simple. It is a massive chess game, the early stages of a worldwide war for natural resources.

Matt Simmons, foremost world energy expert: "We are at the end of a battle between optimists and realists on what constitutes a fair price for oil. At $30 it was called a war premium, at $40 it was a fear premium, then at $50 it was hedge funds. Demand is outstripping supply. I can tell you that hedge funds were net short all through 2004. By the end of 2005, we could have a 3 million barrel per day demand excess. Watch physical demand versus physical supply. We very well could pull away in price from growing demand alone... Saudi Arabia is at or near peak production. That does not mean their output is in decline. It does mean their output does not grow. The world needs to adjust to that reality." Only the discovery and development of elephant fields can succeed to bring down the oil price, to which he quipped "When it comes to oil exploration, you don't leave the easiest for the last." On state secrets regarding oil production output, "The Saudis have protected their information so secretly, that it has become like the dark side of the moon."

T. Boone Pickens, longstanding oilpatch pro: "The oil price is going up. In April 2003 [at the onset of the Iraqi War] we were told oil would go back to $30. In May of that year, we said it would go to $50 before $30 [and it did]. In September 2004, we expected $60 before $40. Well, when we were at $40.40 we said 'we just passed the fifth floor after falling off a 10-story building, but we are not dead yet!' We are heading to $60. This is the weakest season of the year, when inventories are built up. From the second quarter and third quarter, we will be coming into demand. The current oil price is legitimately based upon supply & demand. In the short term there is plenty of oil around right now. We will make it to $60 by the third quarter for sure. The typical backwardization [in futures contracts] has changed dramatically. Back months have come up in price for oil contracts. The oil supply you add will not overcome the decline from over-production [in existing fields]... I don't think we will get over 84 million barrels in output. By the end of 2005, with growth as it is, we can expect oil demand to be about 87 million barrels. The shortfall will be reflected in price. I don't think we will see $40 oil ever again. In fact, I will give even odds that we don't see $45 oil again."

Saudi Al Naimi, OPEC chief minister: "Look for a different mix in the band makeup, with more cheaper oil and more sour crude figuring in the formula. Also look for a different price band, between $40 and $50." In other words, they pave the way to lie about the average contamination and shove low quality oil onto the market. Al Naimi has begun to act like an OPEC central banker, complete with Fedspeak controlled language on increases to production output, then cutbacks. Now he offers the equivalent of false economic statistics for crude oil data. However, in defiance, he lent credence to an eventual $80 crude oil price.

A friend in the energy investment business relayed an unsolicited email he received from a man last winter who has worked for Aramco. The joint Saudi-US conglomerate operates the vast oil production, construction, research, and petrochemical industry inside Saudi Arabia. The man wanted to share some valuable information. No quotes can be offered, but the jist of the message is etched firmly in memory. He reports that Saudi oil production is in trouble, as its large elephant oil fields may not be in decline, but extraordinary measures are being used to sustain that production. He cited specific data which supports that the Saudis have turned to their lesser older and lower quality fields in order to keep up with output. In doing so, they are compromising greatly the oil quality. He cited API rated data, to make the case that Saudis are mixing in low grade oil loaded with contaminants such as sulfur with their light sweet crude. The result is a slight degradation in oil "mixed" API rating on diluted output. They are dumping the lowest grade oil in desperation. The rub for the Saudis is that clear limits exist for mixing lower quality sour crude oil with their sweet crude in order to stay below the requirements for input into existing refinery plants. Without question, the Saudis are using methods known to be in late stages to stretch their output, with little to spare. To call them tertiary level production techniques is being kind. It is sixth and seventh level.

Algerian oil minister Chakib Khelil: "OPEC does not have the production capacity necessary to increase its quotas." Iran, Qatar, Venezuela, and Algeria have come out in favor of keeping production steady.

Kuwaiti oil minister Sheikh Ahmad al-Fahd al-Sabah (also OPEC President): "I think now we are dealing with the production without the quotas. The oil market is oversupplied by 1.2 million barrels per day. OPEC does not need to cut back production in June. Saudi Arabia has raised production to almost 10 million bpd this month."

Chinese FOREX official: "We want our own strategic petroleum reserve, larger than the United States, and we can pay cash to purchase the oil."

John Kingston (Platts Global Director of Oil): "Supply will almost surely be less than demand... God help us if we have a disruption in oil supply."

Rick Santelli from the Chicago pits is one of few sharpies on CNBC. He has much worthwhile to say on both bonds and currencys. At times he is somewhat a mainstream apologist and agent of rationalization. He noted when crude oil first eclipsed $57 in price that a significant change had occurred with respect to other markets. He first attempted to frame the change as a "more sophisticated bond market." Not so fast, as he first offered spin, then the reality. He went on to explain that the bond market long-term interest rates continue to regard higher energy costs as a drain on the economy. Higher costs are very difficult to pass along as higher prices, given the presence of China and India. They will persist in flattening the Treasury yield curve, UNLIKE IN THE 1970 DECADE.

Lee Raymond CEO of Exxon Mobil made several unusual comments: "The price of oil is basically a political question. The fundamentals of supply & demand balance do not support the price levels where they currently are... I am not affected in any way by the #1 market capitalization set by XOM as a company... Typically, mergers take place when the oil price is low. We would have to be very cautious to go out and make any acquisitions now... We intend to return to shareholders in the form of dividends the cash we hold which we do not think can be fully invested in the future." He did not address why XOM exploration budgets have been cut back in the last two years. He did not address how XOM would attempt, not to merge to cut costs, but to acquire in order to replace their reserves in response to ongoing production. The plain ironic truth is that exploration and refineries are not in the best interest of share holders of stock!!! The interests of consumers and economic policy makers are indeed satisfied by further exploration and refinery construction.

An interview with refinery leader Valero must be paraphrased, but the point can be preserved. Its CEO said that as much as 80% of all crude oil deposits ready for production around the world is sour crude. Light sweet crude is what the Saudis pumped for a few decades, with very low sulfur content (in the form of hydrogen sulfide). Sour crude is more of a challenge, due to the high sulfur content, which renders refining toward gasoline, diesel, and heating oil far more costly. Most of the world refinery capacity is for sweet crude. Valero is a leader for sour crude refining.

Greenspan spin to an oil refinery conference in San Antonio: "If sustained, these market technicals could encourage enough of an inventory buffer to damp the current price frenzy... The difficulties associated with inadequate domestic (natural gas) supplies will eventually be resolved as consumers and producers react to the signals provided by market prices. Indeed, the process is already underway... The recent shift in expectations, however, has been substantial enough and persistent enough to bias business investment decisions in favor of energy cost reduction Of critical importance will be the extent to which the more than 200 million light vehicles on US highways, which consume 11 percent of total world oil production, become more fuel efficient as vehicle buyers choose the lower fuel costs of lighter or hybrid vehicles Energy issues present policymakers and citizens with difficult decisions and tradeoffs to make outside the market process. But those concerns, one hopes, will be addressed in a manner that, to the greatest degree possible, does not distort or stifle the meaningful functioning of our markets." Will higher interest rates take down the US Economy, or would high energy costs have taken down the economy? Will the treatment kill the patient?

President Bush: "I am worried about trends in the energy market." That sounds quizzical, since Vice President and Secy of State each have roots in energy world. Promises of $20 oil after the fall of Baghdad were indeed granted, although not taken as reasonable by any thinking body. Instead the oil price is almost tripled since that promise. Recent speeches indicate a shift in emphasis, a wise turn perhaps toward nuclear generation and natural alternatives like biodiesel, if not innovations like hybrid cars. Despite the inefficiency of hydrogen fuel production, my personal preference is for an armada of oceanside hydrogen plants that convert seawater using solar power.

Clueless John Snow pitches in with his wisdom, as a blind man observes: "Oil prices are too high. They act like a tax. They reduce disposable income and create headwinds. Fortunately our economy is so strong and so resilient we've been able to press through those headwinds all against the backdrop of moderate inflation." He is correct on the tax, and thus the opposite correlation with gold. He is very wrong on strength and resilience, as he might believe the GDP statistics full of false lifts. He might have been asleep on the vast outsourcing, which now includes R&D functions. See the mid-March issue of Business Week. He followed with the recent comments that "no nation can devalue its way to prosperity." What? Sunlight forced in? It must be a tough job to be hired as an ensign or executive officer on a ship on a one-way trip to oblivion, a location south of Cape Hope. Lastly, the absurd, as he remarked on the diet for the obese energy users, "The USA has many successful conservation programs in place." He said this with a straight face. Given the chronic improper inadequate price inflation adjustment on economic growth, conservation would cut deeply into the US GDP growth.

Doug Sandler of Wachovia Securities: "A great secondary way to invest in energy is through defense contractors. In order to keep the peace, we will have to use military force to secure oil supplies." Let that serve as both a sign that Marshall Auerback's thesis "The Militarization of Oil" is on target. The Orwellian language is developing. Is peace shattered for oil supply, quite the opposite? Veiled within might be acceptance that the Iraqi conquest was motivated by the desire to secure oil supplies. Don't get me wrong. Installation of democracy is a wonderful thing when desired. Removal of weapons of mass destruction is a lofty goal, but most WMD seen on my periscope float on USS Treasury Bond naval vessels.

Todd Salamone of Schaeffer Investment Research: "Last year Wall Street had an average oil price of around $30 by year end. We are now at the $55 level. They are consistently very wrong. Now Wall Street has a $40 oil price target for this year. As long as such bearish expectation exists, we have plenty of fuel for a much higher oil price in the future."

Bill Powers of the Canadian Energy Viewpoint shared his viewpoint at the Calgary Resource Investment Conference in April, as to the likelihood of a crude oil decline, its impact, and potential consequences. His opinion is well worth hearing, since it brings up a critically important point. He stated if the crude oil prices drops by $5 or $10, after the recent $57 high (which has occurred), or after an even higher spike, then various drill projects in progress will be put on hold. Future supply will be hindered. We have already reached that point. Each project takes time from initial permit, feasibility, finance, equipment, and staffing to reach final production. The process can easily be interrupted by a decline in the oil price. A wicked feedback mechanism thus works in favor of higher prices, as halted projects stall the new supply from higher prices themselves. Producers require a stable price above a certain threshold over a certain period of time in order to proceed with the costly and time consuming process of risking capital toward potential new production output. Price pullbacks greatly interfere with the process and present an obstruction to the "green light" signal. A movement toward "Just-In-Time" inventory is widely practiced in industry. The energy sector is no exception. Supply disruption from price swings will deliver shocks to the oil price.

Southwest Airlines properly hedged their jet fuel expenses from the rising price of crude oil. Airlines generally consume 50 billion gallons of jet fuel per year, whose price is higher than high octane gasoline. "Our rigorous focus on cost reduction and successful fuel hedging program shielded us from record high energy prices," said chief executive Gary Kelly. The company said it was 86% hedged for the first quarter, reducing fuel and oil expense by $155 million and enabling it to record a $27 million related accounting gain, in a multi-year contract. This company is a paragon of fine management in the face of airline distress. The hub system is on the way out, a practice not conformed to my SW Airlines.

Macro-economist newsletter writer Warren Pollock is unimpressed with energy property sales to China, as they are wealth engines: "Saving money is hard for individual Canadians. It's very hard to accrue a large enough pool of savings capital in order to participate in ventures that harvest leveraged profits from intrinsic natural resource wealth. Here too the Canadian government has an answer: allow the sale of untapped natural resource deposits to the Chinese in the hope that it will generate jobs. What a foolish strategy, giving your wealth away, your real physical wealth! A fire sale of wealth designed to address a transitory social concern like employment... Time will tell if Canada has the mindset of governance to prevent it from becoming another Saudi Arabia, a country rich in wealth but filled with poor people. For Canadians to become rich they need to be able to form capital, they need to develop business acumen, have confidence, and say no to social governance."

Robin Williams on a national energy program at a talk show: "We should use liposuction on all our fat kids in the USA, and run our cars off it." Could the comedian be onto something?

So what is the best investment now - gold, energy, miner stocks, energy stocks, corporate bonds, govt bonds? The answer is not so simple, but rather hangs on so many contingencies. The answer depends on factors which are not so clear, not quite finished, not yet seen, not so well known. Like whether ..

the Fed hikes rates too many more times, let alone another time at all a trade war with China blossoms, and our borders close, which would contain our routinely exported inflation the oil supply is disrupted, for whatever reason (choose among a dozen potentials) a derivative blowup occurs within any of the hundreds of mini-LTCM's from recent bond distress, big commodity price shifts, and sizeable currency movements

These uncertainties are just too darned difficult to forecast. The Hat Trick Letter provides analysis and guidance on developments with monthly issues and special reports. One needs a flow chart on contingencies for investment decisions, given all the forks in the road.

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May 18, 2005

Jim Willie CB

Jim Willie CB is the editor of the "HAT TRICK LETTER"

email: jw@goldenjackass.com
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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his website at www.GoldenJackass.com