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The Fourth Era of Oil

Investment Opportunity of the Decade

by Joseph Dancy, LSGI Advisors, Inc. | July 7, 2008

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“No less an expert than Charlie Munger, the vice chairman of Berkshire Hathaway who is Warren Buffett’s investment partner, advises that good investments are difficult to find.” Munger notes due diligence on prospective investments is time consuming and rarely leads to attractive opportunities. Good investment ideas that you can understand and evaluate are uncommon, and present themselves infrequently.

Although academics will dispute this contention, concentrated portfolios are not necessarily higher risk according to Munger, nor is volatility an accurate measure of risk. “An investor must be patient. But when a situation finally arises where the probabilities are heavily weighted in favor of an investment, he adds, the patient investor should act decisively”

“Global energy trends are creating opportunities where, to paraphrase Munger, probabilities strongly tilt in favor of the investor.” When this situation occurs he advises to invest heavily.

The Energy Boom is Just Starting” by Joseph Dancy, June 4, 2007 Barron’s

Energy Demand

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at least 27 years according to a report issued by the International Monetary Fund. Global growth slowed in 2007, but in 2008 economic growth is forecast to advance by 3.7%.
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Is Iran Facing an Energy Revolution?

"Much higher natural gas prices seem likely even though U.S. producers are thought to be sitting on sizable supplies of undeveloped resources," the bank said. "A recovery in U.S. manufacturing should sharply boost natural gas demand. Once LNG imports become the marginal source of U.S. supply, much higher international natural gas prices should prevail."

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One model we follow uses a supercomputer located in the U.K. to digest millions of pieces of observation data. They then run numerous simulations. Over time the results begin to vary – but at some point the models point to a general consensus. Using statistical measures of the variance of the results, and the consensus conclusions, the model has been quite accurate – a major improvement in mid-term weather forecasting.

Running the latest data in the U.K. supercomputer, the model is now forecasting a hot summer for Western North America (see map). If so, this has bullish implications for the natural gas market. Since extreme heat and drought conditions tend to have a high degree of correlation historically, the heat also has implications for the grain harvests in the U.S.

Energy Supply

In the first quarter of 2008 production has fallen to 1.2 million barrels per day, less than forecast, and Mexican exports have declined 12.5% from year earlier levels. The decline is expected to continue at double digit rates even with additional expenditures to stabilize production.

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Big Spring, Texas, Refinery Fire - 2.18.08

25• A long-term study of global crude oil supplies and resources prepared by the U.S. Geological Society in 2000. The study was “the most thorough and methodologically modern assessment of world crude oil and natural gas resources ever attempted. This 5-year study was undertaken ‘to provide impartial, scientifically based, societally relevant petroleum resource information essential to the economic and strategic security of the United States.’"

The U.S.G.S. study concluded that between 1996 and 2025 roughly 21 billion barrels of oil would be found in new fields every year. Actual exploration results from 1996 to 2003 indicate only 9 billion barrels per year have been found – 60% less than forecast. (Chart courtesy of the Financial Times). For such a detailed and essential strategic study we find the shortfall in exploration results to date absolutely stunning.
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• Figures released by the Russian government show that the country's crude oil production fell for a fourth straight month in April, confirming pessimistic forecasts for the year. Most analysts forecast a gain in production for 2008 to over 10 million barrels per day, one in a long series of production increases.

Output in April was 9.72 million barrels per day, more than 2 per cent lower than the post-Soviet high of 9.93 million barrels per day in October, 2007. Declining production resulted in Russia's crude oil exports declining 3.3% year-over-year in the first quarter of 2008

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Storage levels the last two years was much higher at this point in the ‘shoulder season’ than we have today, so the ability to fill the storage facilities before the next winter season was much easier last year than we will face this summer and fall.

Offshore Gulf of Mexico production rates have been declining, and are forecast to continue to decline as many of the fields are mature and also decline quickly.

Higher prices for natural gas and LNG in Asia and Europe draw cargoes to those regions. Imports by Japan, the world's biggest LNG buyer, grew 19.4 percent in March from a year earlier. The decline in LNG imports will make the challenge of filling storage all that more formidable.
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• The U.S. obtains roughly 25% of its crude oil and 18% of its natural gas production from offshore fields in the Gulf of Mexico. Roughly one-third to one-half of the nation’s refining capacity is located on the Gulf Coast.

Both production and refining can be easily interrupted by hurricane or tropical storms. Three long term forecasters we follow are predicting an above average hurricane season – which begins to ramp up in eight weeks.

30Regardless of how accurate or inaccurate these forecasts prove to be the fact is we have seen eight Category 5 Atlantic hurricanes in the past 5 years.

And last year, two Category 5 hurricanes -- the most intense on a five-tier scale -- made landfall in the Atlantic Basin for the first time in recorded history. The frequency of intense storms is off the charts statistically when compared to historical records.

31An anomaly perhaps, but should a Category 5 storm strike in an area populated with a high density of oil refineries, oil and gas fields, or for that matter people, the outcome could be catastrophic.

The increasing use of biofuels has created a convergence of the energy and agricultural sector – and the supply and demand relationship in both sectors is compelling.

• The price of some fertilizers has nearly tripled in price in the last year. A squeeze on fertilizer supply has been building for roughly five years. As demand has grown the fertilizer manufacturers of the world were unable to keep up. Some dealers in the Midwest ran out of fertilizer 34last fall, and they continue to restrict sales this spring because of a limited supply.

• Overall global consumption of fertilizer increased by an estimated 31 percent from 1996 to 2008, driven by a 56 percent increase in developing countries, according to the International Fertilizer Industry Association.

Manufacturers are scrambling to increase supply. At least 50 plants to make nitrogen fertilizer are under construction, many in the Middle East where natural gas is abundant. Without nitrogen fertilizer, there would be insufficient food for 40 percent of the world’s population.

35• All-time high prices for soybeans and wheat, and near-record high prices for corn, have pumped up U.S. farm incomes by 50 percent since 2006. The value of Indiana farmland has soared from an average of $3,500 an acre to more than $4,000 in the past two years.

• Record-high grain prices are fueling a rural economic boom in U.S. farm states. Farm equipment dealers have a backlog of several months in orders for new machinery. Cropland rents are rising, along with agricultural land prices.

A telling barometer of the farm economy is the rising number of orders for new farm machinery. New combine sales were up 15% nationwide in 2007, sales of 4-wheel-drive tractors rose 23%, and sales of large-scale, two-wheel-drive tractors were up 26%.

The Fourth Era of Oil: Investment Opportunity of the Decade

Last month we delivered a lecture to our Oil & Gas Law class at Southern Methodist University on the 'New Era of Oil: The Age of Scarcity'. This is not a standard law school topic, but relevant when discussing the legal history and development of market demand prorationing, allowables, unitization, the rule of capture and related conservation regulations.

Our thesis is that we are entering the fourth era of the oil age – one the world economy has never experienced before. This era will cause many disruptions, but will also create investment opportunities that arise only once every few decades.

From the 1859 discovery of crude oil in the Drake well in Pennsylvania until the 1930’s East Texas Field discovery we had a situation where supply was growing exponentially. Increases in demand did not keep pace, so the price of crude oil plummeted. Governors shut in oil fields to prevent overproduction and waste. Arising from these problems the Texas Railroad Commission and other regulators obtained the statutory authority to restrict incremental oil production to better match global demand.

The second era lasted 1930 to 1972 as state regulators like the Texas Railroad Commission restricted production to stabilize the price. When the production of crude oil peaked in the U.S. in 1972 the role of the Railroad Commission in restricting production passed to the Organization of Petroleum Exporting Countries – the third era of oil. In each of the first three oil eras we had excess productive capacity to meet the rising global demand and any short term shortages that occurred.

Going forward we find ourselves in the position where global demand for crude oil is now approaching the ability of the world’s producers to extract production – and soon demand will exceed productive capacity. For the first time ever we will have no excess global productive capacity to meet growing demand.

In such an era – never seen before in the global economy – we expect the following:

(1) wildly volatile crude oil prices - mostly to the upside,
(2) resource nationalization - the material is too valuable to export,
(3) irrational hoarding behavior by consumers,
(4) a spillover of price volatility into the markets for other energy sources (natural gas especially),
(5) a wild frenzy to acquire domestic oil and gas resources (property deals and deals on Wall Street),
(6) a melt-up of the energy and energy services sector,
(7) a focus on energy conservation,
(8) new opportunities in the solar and wind energy sectors,
(9) more focus on biofuels (emphasized by the 2007 Energy Act) - which incidentally will drive grain prices to record levels, and
(10) as a result of the extreme increases in food and fuel prices we expect to see food shortages, instability, riots, and the like in less developed and less stable countries.

One of the most significant developments we expect to see, besides much higher energy prices and volatility, will be the interconnection of the global energy and agricultural markets – tied together by biofuel initiatives.

Adequate capital has not been allocated to the energy and agricultural sectors in the face of global physical and political challenges – and that historic misallocation creates great opportunities for business in these sectors. The energy and agriculture markets are quickly converging, which points to much higher prices for both commodities.

Because of these trends we remain heavily over-weighted in the energy and agricultural sectors. If we are wrong on our assessment we sell our losers quickly, insuring our losses will be somewhat limited. But the evidence of a new era for both energy and agriculture – reflected in global production and demand data – is compelling.

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© 2008 Joseph Dancy

Contact Information

Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail

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