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Energy Deliberations


Oil's well with you?


We have said it before and we say it again: this year (and likely beyond) the stock market will be greatly influenced by oil price gyrations.

There appear to be two camps that contemplate the fundamental future of the oil industry. One camp believes that the current cycle is a bubble, and that, as in many times in the past, the bubble will ultimately burst as supply/demand factors react to historically high prices. The other camp believes things are different this time, and that the supply/demand picture is permanently locked in a configuration supporting uptrending oil prices.

It is worth investigating why the oil markets have experienced such a historic shift, and also examining the future supply/demand factors. After all, there may be areas of investment opportunity uncovered by such an examination. Moreover, we want to assess the worthiness of the major oil companies, which are now enjoying both the profits of oil's recent price spurts and lots of love on the part of Wall Street analysts. The impression we get from watching the popular business TV programs is that investors may have overly gorged themselves on oil industry stocks.

The history of the oil industry is fraught with cycles of boom and bust. Demand has risen as the technological use of oil expanded over time. Typically prices rise along with demand until new technologies in exploration and extraction (drill bits in the early days, geological and engineering technology more recently) boosted supply. Innovative technologies helped boost supply, thereby inevitably "busting" prices.

Today, however, things are more complex.

On the demand side of the picture, there is no lack of thirst for gasoline. Even as the price of oil exceeded $50 in 2004, global demand grew at its fastest rate in over 25 years. Clearly this was due in part to China and India becoming meaningful consumers. In the current issue of The Economist, one senior European oil executive made a claim we have often heard lately, namely that, in contrast with the embargoes and supply-driven price rises in the past, "This is the first demand-led oil shock."

Baloney! The oil embargo of the 1970's was the exception - not the rule. Most oil shocks in the past were due to demand, not artificial supply restrictions. Wars caused many a jump in demand. In World War I Winston Churchill was head of the Admiralty, and made a risky decision to convert from Welsh coal to imported oil. This gave British ships a speed advantage over the Germans. Thus began a geopolitical thirst for energy that continues today.

The demand for oil has been exacerbated by the use of the financial markets. In addition to industrial users (airlines etc.) bidding up the price of oil to protect themselves from even higher prices, big equity funds have done the same to protect themselves from the collateral damage (stock price declines) feared from oil possibly surging to $80, even $100 levels.

There is also a "fear premium" on the price of oil due to geopolitical concerns. September 11, terrorism in Iraq and Saudi Arabia, the Yukos takeover in Russia, and civil unrest in Venezuela and Nigeria are estimated by some to have added anywhere from $7 to $15 to the price of oil.

A close examination of the current oil industry supply uncovers some interesting data:

If crude inventories are so high, why is the price of oil so high?

For one thing, while U.S. crude inventories are near a high for this decade, the current levels are moderate at best, looking further back:

Compared to levels in the mid-1990s and earlier, current levels of inventories are the low end of the historical range (purple lines in chart above.) This illustrates just how much inventories have been depleted over the last 10 years.

The heart of the matter lies not in inventories, however, but in spare production capacity:

The above chart shows just how thin spare production capacity has become. It is perhaps the best argument the oil bulls have to offer. OPEC production is at peak levels, and spare reserves are almost non-existent. Saudi Arabia dwarfs all other OPEC and non-OPEC oil producing countries in terms of reserves. In the past, the Saudis have acted as a kind of "Fed" by controlling oil prices during past unexpected supply disruptions by tapping into idle fields. Now, because capacity is so tight, minor changes in supply/demand cause volatile price swings in the price of crude.

The spare capacity issue spills over into the oil industry system. Because of the boom/bust nature of the oil business, infrastructure capital expense has grown at a snail's pace. Oil rigs, tankers, engineering, and refining are in tight supply.

Spare capacity issues are unlikely to be resolved short-term, because of the memory of $10 oil as recently as 1999, and because of the surprising ease with which the economy has handled $50 plus oil (not withstanding the airline and automobile industries.)

So what are the prospects for the oil industry?

On the demand side, the energy users are already beginning to re-awaken the search for alternative energy. Two term Presidents have a penchant for supporting legacy policies so they can forge a memorable chapter in history. George W. is offering all kinds of issues in his lust for infamy - social security reform and increased oil production. Dick Cheney even went so far as to declare America's need for "energy independence" by boosting U.S. production of oil. This attempt would appear to be great for Halliburton (Cheney was running that company before taking on the Vice Presidency), but not very helpful to a country that consumes a quarter of the world's oil but has less than 3% of its proven reserves.

One of the ideas that President Bush is offering is nuclear energy. Interestingly, Britain's Tony Blair wanted a public debate on the nuclear issue after his general election was out of the way. In the past, nuclear energy has been expensive, but new technologies promise to make things cheaper. The latest technology in reactors are touted by the industry as vastly more efficient, cheaper to build and run, and safer. Fossil fuels and even wind power are more expensive energy sources, according to industrial sources. However, nuclear as an alternative has some systemic problems.

In a November 2002 position paper entitled "Human Capital in Nuclear Science and Technology," the American Nuclear Society stated: "Developments in the U.S. over more than a decade have contributed to shortages in all of the essential components of national nuclear science and technology capability. Student enrollments in higher educational programs have declined steadily; academic research support and facilities such as on-campus nuclear reactors have steadily evaporated; experienced faculty have retired without being replaced; whole nuclear engineering departments have been shut down; the number of skilled highly trained nuclear professionals entering the civilian nuclear workforce from the U.S. nuclear navy has steadily diminished; experienced nuclear professionals in the non-academic workforce have begun to retire in large numbers without being replaced because of the diminishing sources of their replacements. Serious personnel shortages in nuclear power, nuclear medical and health applications, and research related to applications of nuclear science and technology to defense and space applications appear to be likely unless new circumstances intervene to change these trends."

At the very least, nuclear and alternative energy efforts will take time. In the very long run the world will have no choice but to find alternative energy sources. How fast we get there will be determined by how severe future oil shocks are, making this issue a poster child for crisis management.

Perhaps the most important spin on greed pertaining to the oil picture is Saudi Arabia. The Saudis differ from other OPEC countries in that they are an outlier in terms of oil reserves. They sit on over 260 billion barrels of proven reserves, more than twice the amount in Iran (126), and vastly more than in Iraq (115), Kuwait (99), Venezuela (78), UAE (55), Libya (22), Nigeria (21) etc.

The Saudis, in Fed-like fashion, are interested in maximizing return without disrupting volume. If oil prices spike too high and cause a global economic crisis, future demand could plummet. Moreover, alternative investment in non-OPEC resources would add competition, albeit slowly.

The bottom line is that the energy picture remains tenuous. The Saudis need to increase their "buffer" of reserve capacity (there are signs that that is underway.) Demand must soften a bit - there are signs from China of some demand reduction partly due to an economy that is less hot than last year, and due to the fact that past oil demands were one time factors (temporary shortage in coal, needs to fill pipelines and storage tanks etc.) not expected to be repeated.

From an investment standpoint, we believe the easy money has been made. Already oil company stock prices fade amid glowing earnings reports:

While energy minerals have spent much of the past few years as our leading sector, its current sector rank is 17 (out of 18 sectors.) We can only find four Type 1, short squeezes. There are 31 Type 4, long squeezes. There are only 22 energy mineral issues above their 50-day averages (there were 122 in early March.) Short intensity is light.

From a seasonal point of view, energy stocks did well in the late January to mid-May positive cycle. From mid-May to late July, seasonality is weak. There are strong r-stats to this seasonal cycle, which gives them credibility. Perhaps the weakness in energy could spark some action in other sectors of the market. That's our expectation.

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