7 reasons to doubt the oil optimists

Recently I wrote about "Trough Oil": the idea gaining  ground that Peak Oil pessimists were wrong and that oil going to become abundant and cheap in the coming decades.

I laid out the causes for such optimism in the original article but in this follow up piece I am focusing on the counter-arguments: why increasingly hard to satisfy oil demand will continue to keep oil prices high for decades.

1.  The current oil price

If new sources of supply are coming and demand is set to fall, why is the oil price so high?  Even with a hard landing in China, crisis in the Eurozone and world trade volumes crashing the oil price is stuck well over $100 a barrel for Brent crude.  Most oil traders expect it to remain so for the next couple of years at least - forecast.  By comparison weak demand conditions have ushered in $20 or even $10 oil in the past. These market insiders are telling us that the oil market fundamentals are still tight.

2.  Maybe production did peak in 2005

Oil production has actually risen in recent years but look behind the numbers and there have been changes since the middle of the last decade.  Production growth has slowed despite trillions of dollars of investment and Saudi Arabia, long seen as the world's "swing" producer, pumping at record levels.  See chart here:  world oil supply is not growing very much.

Secondly the proportion of oil output that isn't actually oil has increased.  Natural gas liquids are the main alternative to crude but have about 70% of the energy value which is why they sell for less.  Others include ethanol which is only viable thanks to what I would argue are crazy and damaging government mandates which are becoming increasingly controversial as food prices rise.

3. Production costs put a floor under the price

All the new sources of supply people are talking about come at a price and it is not much lower than $100 in many cases.  For example the Canadian tar sands oil extraction process uses a lot of water and energy to make something usable and this can cost $60-80 a barrel.  Approximately 2 million bpd now comes from this source so it's not small beer.

Other new sources such as US shale production, including 0.5 million bpd from the Bakken fields on the US/Canadian border, are cheaper but they still use a lot of water and energy and exact an environmental price critics say.

It is the marginal cost of the last couple of a million bpd that matters when it comes to setting a minimum oil price and that cost is rising.

Peak oil was never about oil "running out" - it's more that the big (easy) fields are declining faster than new sources can be economically developed.  That assumption still looks to hold and preludes the possibility of the oil price ever returning to much below 80$ whatever the economic conditions.

4.  Technical challenges are growing

This is a similar point to 3. but is about the difficulty and danger of extracting new reserves rather than the cost, particularly when it comes to deep sea drilling.  The Horizon disaster vividly illustrated what can go wrong with deep sea drilling but perhaps even more pertinent is to look at the reserves Brazil intends to exploit off its Atlantic coast.

These are so large (50-100 billion barrels or even more) that they alone count as one of the major reasons for Trough Oil optimism.  To put that number in context that is perhaps 1/3 of another Saudi Arabia.  But the catch is there are thousands of feet of salt rock between the ocean floor and the oil trapped beneath it.  Much of the oil is beyond a depth that even "ultra-deep" rigs are currently able to go (7,500m to about 10,000m) and the deeper you go, the more pressure and the more risk.  The Horizon disaster happened at just 1,500m.  New techniques and perhaps a $1 trillion may be required.

None of this suggests the fight to keep the world's thirst for oil satisfied is going to be either cheap or easy.

5. Declining consumption in the West will be more than offset

One of the main focuses of optimism on the demand side is that  oil consumption in the West is on a declining trend even allowing for the effects of the economic crisis.  It is true that high prices, recession and more efficient cars have combined to reduce oil consumption slightly in the US and other developed markets (but by less than 1% between 2000 and 2010 according to one chart I saw).  But this has been more than offset by rising demand from China and other fast-growing countries and I expect this to continue.

In the short term I am a China bear and I think the troubles that afflict that country will have big knock-on impacts through places like Brazil and Indonesia.  However long term there is nothing that will prevent the economic rise of the developing world and the consequent increase in competition for scarce resources.

It might be a bumpy ride but the big picture is still one of hundreds of millions of people emerging from relative poverty to something approximating a middle class lifestyle with its attendant consumption patterns: a richer diet, more travel and especially buying a car.

6. Oil producers keep more of their own oil

One of the key warnings of Peak Oil pessimists is that the problem of declining output by traditional producers is that they will increasingly consume more of their oil domestically leaving less for export. This was one of the main arguments convincing me that from now on oil prices would stay high and it would get tougher and tougher to supply demand.

And it's playing out just the way the doomsayers predicted.  Middle Eastern consumption of oil rose by 55% during the first decade of the millennium more than cancelling out the small declines in the West.  Saudi Arabia, which burns oil to generate electricity to power air-conditioning units and water desalination plants, now consumes 3 million of it's 11 million b/d total output.

7. Carry on guzzling

Transport, including aviation, accounts for about 75% of oil demand.  Despite gently declining car use in the West and more efficient vehicles being mandated by governments, demands for oil to fuel transport globally is almost certainly going to rise in the coming decades as it has done for decades past.

We have already discussed the essential reason for this - the growing size and power of the middle classes in the developing world.   The only thing that could prevent a remorseless rise in underlying oil demand - apart from the BRICs and other fast-growing countries going into rapid economic decline which seems unlikely - is a switch from petrol/diesel to something else.

Oil optimists point to clear signs that governments and  leading major manufacturers are getting behind electric cars.  Other alternatives to oil are natural gas, hydrogen and even liquid air.

But the odds are that they will all remain a niche for the relatively well off or environmentally-concerned.  This is not because there won't be technical advances in, for example, batteries but because the petrol car economy is so embedded (at such a vast sunk cost) that even a superior form of automobile technology would face a massive struggle to overturn it.

Consider vehicles powered by liquified natural gas which have been around for decades.  They do not require any great leaps forward in technology, new refueling infrastructure (many filling stations already sell it) or a new fleet of cars (petrol cars can be converted quite cheaply).  And gas - in the US at least - is 1/7th the price of oil.  But only a tiny fraction of the US vehicle fleet is powered by gas.

In summary - the global petrol engine population will continue to faster than the increase in fuel efficiency; oil supply from the "easy" sources of the past will continue to dwindle and prices will stay high.  This has important investment implications but that will be for another post.

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Mining stocks and China's hard landing

A quick update on some comments I made about China's economy in June: China and the miners - place your bets.

It was a time when the argument over China's faltering economy was finely balanced: would growth rates dip and quickly recover (soft landing) or could China be on the cusp of something more serious?  I suggested that buying mining shares rather than China funds - like Glencore and Anglo Pacific - was a good way to go if you were feeling bullish.

Events since, including lower than expected industrial output, export and inward investment numbers, have pushed the debate decisively in the direction of the China bears.

So have mining stocks declined?  Not really.  Glencore and BHP are up 20% and 15% respectively since my article at the end of June.  Anglo American is down but there are special factors including a disputed copper mine in Chile. Anglo Pacific is up 8%.  Iron ore, coal, oil and copper prices are all up sharply.

So in the short term it looks like the correlation between poor Chinese economic data and mining assets doesn't hold.  However stock markets are forward looking and much of the China bad news had been factored in by the time of my article.

The latest rises represent bounces from previous setbacks not renewed optimism.  The bounce has been attributed to a belief that the Chinese government will ease policy to keep growth rates up and especially sanction another slew of infrastructure projects which are resource intensive.  Another factor is a growing belief that the ECB is prepared to act decisively to head-off the crisis in the Eurozone probably by buying Spanish and Italian sovereign debt.

Where now?  In the medium term it's hard to be wildly optimistic about the Euro situation whatever the ECB does.  As for the bigger question of how long can China keep growing at 8% plus it seems that the authorities will pull all the levers necessary even if that means maintaining the economy's hideous imbalances in particular the bias towards wasteful investment (nearly 50% of GDP) in property and infrastructure.

Meanwhile the big miners are scaling back on some of their expansion plans to reduce the threat of oversupply.  Share price meltdown averted?  For now maybe although it doesn't feel like the right time to pile into resource stocks particularly after recent gains.

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China and the miners: place your bets

“A crisis is an opportunity riding the dangerous wind” goes a Chinese proverb.

For investors who want to make money out of one of the century's biggest and most profitable themes - the commodities boom led by China - now is a time of great opportunity and risk.

There is an apparent opportunity because the mining shares that have done so well are relatively cheap after several months drifting lower.  And risk because the cause of the share price weakness, the slowdown in China, could yet end in a crash.

The China-boom-or-bubble debate has been a hardy internet staple on business/investment chat sites for several years.  Perhaps only the inflation-deflation argument has generated more heated argument.

On the one side you have the China bulls who believe the country's thirty year 10% annual growth record is good for another decade or more yet.  They call the current slowdown a blip and claim normal service will be resumed later in the year as government stimulus measures kick in. These include the first interest rate cut for three years and a car subsidy program.

The China bears fret that the incredible China boom is literally that - too good to be true - and that Chinese growth is unsustainable  Just like Ireland, Spain and Japan, a boom underpinned by cheap money and property speculation will give way to bust.

"Dubai times a thousand" was how a renowned bear (Jim Chanos) put it but he said that 2 years ago and, although property prices have come down in some top tier cities, the general crash he predicted has yet to materialise.

I lean towards the side of the bears but it is an oft-observed fact that the economic phenomena that seem unsustainable can persist for much longer than you think.  People have been calling the demise of the US (and Japanese and UK) sovereign debt markets for years.  They may be proved right eventually but you can lose a lot of money shorting something prematurely.

As for the bull case, I have a lot of time for Dr Stephen Loeb and he is in the "blip" corner.  His article "Silver, Copper, Gold and China" states the case for continuing China growth and a recovery in commodities (and miners) very well.

If you are persuaded by his argument and think the commodities boom has a lot further to run, then now would be a good time to back your judgement and buy ETFs which hold physical commodities like gold and copper which have suffered recently.  Loeb is very keen on silver which has a key industrial role in for example solar panel production.

Another option is the shares of mining companies.  Obvious choices are highly diversified giants quoted in London such as BHP and Anglo-American.  In the past I have had profitable dealings in mining royalty holder, Anglo Pacific (AFP), which has recently been marked down due to some specific problems at a coal mine which it will recover from (see here).

Finally I am intrigued by Glencore which always seems to be in the headlines, most recently because of its on-off merger with Xstrata.  It's shares have slid by almost a third in just a couple of months.  The markets have been a bit dubious of this company I think partly because it's profits derive from trading commodities as much as producing them and the trading bit is somewhat opaque.  However there is no doubt that the people who have built up Glencore, including multi-billionaire Ivan Glasenberg, are extremely smart and ambitious.

Buying Glencore would be a triple play on a China recovery, a successful conclusion to Xstrata merger and on the company's management.  Too rich for my blood but the share price, at under £3, makes it tempting.

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