John Mauldin and Don Coxe
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Volume 1 - Issue 2
September 20, 2004
Basic Points:
The Bear and The Dragon
By Donald Coxe
Last week a reader sent me a very interesting essay by Donald Coxe, the Global Portfolio Strategist, BMO Financial Group. He is also the Chairman and Chief Strategist of Harris Investment Management in Chicago, and Chairman of Jones Heward Investments in Toronto.
He looks at the global oil situation from a different view, one truly "Outside the Box." There is more to oil prices than Saudi production. "We'll miss the days," he writes, "when the G-7 and OPEC managed matters so that we had free time and money to blow on Nasdaq stocks, in the solipsistic confidence that we knew it all and had it all."
Today's letter is excerpted from the August 27, 2004: "Basic Points: The Bear and The Dragon" by Donald Coxe, Global Portfolio Strategist, BMO Financial Group.
Text excerpted from: "Basic Points: The Bear and The Dragon"
By Donald Coxe
Requiem for the Elites
Forecasting was so much easier when the global economy was ruled by the Democratic White Men's Club of the G-7 and the Swiss, plus the generally complaisant Japanese. Yes, there was OPEC, but after the unpleasantnesses of the 1980s, OPEC seemed, under Saudi leadership, to be willing to keep the Club fueled with cheap oil, so the global VIPs didn't have to spend much of their discussion time (or much of their nation's money) on OPEC and its quota problems. The Saudis might, from time to time, have to intervene to prevent oil prices from collapsing, but that was their worry. Those global recessions caused by OPEC-spawned oil price leaps were simply distasteful contretemps of history.
Besides, as the new millennium dawned, few, if any of the Widely Respected among the intellectual, political and financial elites were seriously interested in oil or in commodities generally. Agriculture was an ongoing concern, but only because the European Union devoted more than half its budget to cosseting its farmers and France made sure that nothing on the WTO agenda was going to interfere with that arrangement.
Then came a series of shocks to the Club's complacency:
1. George Bush, who had owned a baseball team, was elected President, although he had, from the Club's perspective, three strikes against him: he was openly religious, he had a quasi-cowboy background in the Texas oil industry, and he ran against the sophisticated self proclaimed inventor of the Internet.
2. Nasdaq's fall turned out to be something much worse than the "correction" the elites were so unanimously eager to call it.
3. The US and the world slipped into a recession, the consequence of the Triple Waterfall collapse of technology stocks and technology companies.
4. Al Qaeda suddenly became the most influential global multinational company of the new millennium. It showed its ability to use free TV slots as its key marketing tool. It displayed sophistication in financing and recruiting internationally, building its brand into a global force, franchising that brand successfully, and disrupting established trading channels--even to the extent of shutting down the NYSE.
5. Bush's response to Al Qaeda's most audacious venture was to declare a "War on Terror." Not only did this mean driving the US defense budget back up to levels that were somewhat reminiscent of the Reagan era, but it meant open war in Afghanistan and Iraq--two countries that European elites had long been handling in what they called "constructive engagement."
6. The Club's favorite currency was the dollar. Its 45% appreciation against European currencies during the late 1990s had caused some embarrassment to the Euroelites, but they understood that it kept the US consumer available for high-cost European producers. That comfortable relationship was put at risk when the dollar began to look like the currency equivalent of a technology stock.
7. China had concerned the industrial world mostly because of its ability to set global prices at levels Club members couldn't match for a continuously-increasing range of manufactured goods. By 2002 it was becoming a new kind of problem: by its fearsome purchasing power, it was becoming the price-setter for an increasing range of raw materials, initially metals, but then--ominously--oil.
8. OPEC responded to the novelty of a global shortage of oil by raising its quotas, then producing flat out--yet global oil inventories failed to rise. "Don't worry," said the elites, "There's lots of oil in the world! Look at those huge production increases in Russia, and the big inflow of capital to develop the enormous reserves there. The Saudis can turn on the taps any time. Oil is headed back into the low twenties--maybe even the teens."
9. Meanwhile, back in the Kremlin, the reconstituted KGB elites looked at the runaway profits and rising power of the oil oligarchs and decided to show who was boss. Yukos's flamboyant Mikhail Khodorkovsky got slapped into a jail cell, along with two ordinary criminals, where showers are provided weekly; he was charged with almost everything except supporting the Chechnyan terrorists. Capital inflows collapsed, along with prices of Russian oil companies' bonds and stocks. Forecasters had been relying on Yukos to continue boosting its production. Instead, its daily oil output fell by 4.5% to 1.72 million barrels a day.
10. In January 2004, Club members were fretting that soaring oil and commodity prices, and a strong global economy could re-ignite inflation. Some central bankers were already tightening. Global bond markets were sliding. Then China announced it was going to rein in its spectacular growth.Within weeks, the Middle Kingdom's economy had turned on a yuan. Next, as if some miasma had mystically spread across the world, economic numbers almost everywhere turned from strong to moderate to weak. Leading Economic Indicators worldwide turned down, with the US indicator falling in both June and July, a trend shift of possibly momentous proportions.
11. By July, global stock markets had shed the last soupçon of bullishness and had begun emitting ursine odors. The Fed finally started raising rates in June, but, despite its strongly bullish economic predictions, most of the data published in the days and weeks thereafter made it look as if Greenspan were taking away the punch bowl after most of the partygoers had already left. Besides, some conventional monetarists griped, by raising the announced price of its money, all the Fed was doing was ratifying what had already happened: year-over-year growth of M-2 has been among the lowest in years. The Fed was not suddenly shifting from a heavy foot on the accelerator to a heavy foot on the brakes.
12. The front-page story worldwide became the threat to the world from $50 oil.
What was going on--and who, if anyone, was in charge?
The Rivalry for Asia
Mao and Moscow inked a friendship and alliance treaty in 1950. "The Internationale" proclaimed the world-wide workers' revolution, in which all men were brothers and national distinctions would be wiped away within minutes of the conquest of capitalism and colonialism.
By 1962, the Sino-Soviet Partnership for Peace and Progress had become the Sino-Soviet Rift. When China invaded India, the USSR publicly supported India (but did not involve itself militarily). Moscow and Beijing began to flood Party newspapers abroad with competing claims for Marxist purity. Result: splits within the avowed Communist movements.
Of late, Beijing has chosen to present its foreign policy principles to scholars and diplomats under an old-but-newrubric, "The Five Principles of Peaceful Coexistence." This propaganda line says that nations can live peacefully together only if they respect each others' sovereignty and territorial integrity and refrain from interfering in each others' internal affairs. Then the Chechnyan rebellion brought Vladimir Putin to power. The rivalry of the 1960s between Russia and China was about to be revived under new management.
Putin's attack on Yukos is part of his reinstatement of Kremlin control over the energy sector. For example, recently, it was announced that Vladislav Surkov, a Kremlin insider, was named to the board of oil giant Transnefteprodukt, and one of Putin's closest aides replaced a bureaucrat as head of Rosneft, the state-owned oil company. By staffing his administration with former KGB colleagues, he has built a staff of the kind of dedicated, ruthless apparatchiki that made the USSR the nation that was, for a time, #1 in ICBMs and #1 in space technology. The world was overawed by a society that could achieve those technological triumphs. That high-tech edifice was built on the base of a primitive commodity-oriented economy--agriculture, steel, mining, forest products, oil and gas. Back in the 1950s, a commodity based economy was wonderful.
One major economic group remained beyond Kremlin control, and was threatening to become an alternative power center as a result of the China-driven change in world energy markets.
Putin doubtless understood long before any of those highly paid prophets of Wall Street that oil prices were heading much higher. That meant that he not only had a splendid opportunity to move the economy forward on a rising tide of oil revenues, but also that he dared not let the oligarchs gain the kind of political power that would flow from being immensely rich sheikhs in a society where average incomes were $8,000 (on a purchasing power parity basis).
The Yukos drama is about (1) wresting profits from the world's biggest publicly-traded oil production company, and (2) publicly humiliating an oligarch (who happens to have Jewish ancestry) who crossed the line in the sand Putin had drawn against oligarchic participation in politics, and (3) demonstrating to the world that, whatever may have been past law and contract, no significant oil, gas or pipeline development will occur in Russia without Kremlin approval. It will involve direct government ownership and control-- even when the company is publicly traded. This is already being called "The Renationalization of Russian Oil." Although Exxon Mobil has pulled back from plans to make big investments in Russia, Chevron-Texaco, Shell and Conoco Phillips appear willing to take minority positions in state owned firms in order to be able to gain access to Russian oil and gas reserves. Big Oil is also digesting the knowledge that one of Khodorkovsky's sins was to enter into an agreement to supply natural gas to China. Putin has overruled that deal, and is seeking to send the gas by a much longer and costlier route--to Japan.
Why?
Maybe this is the opening salvo in the next phase of that long Asian rivalry. Yes, the Russians and the Japanese had a war nearly a century ago, but Japan is no threat to Russia today. Japan has money, technology--and a near-desperate need for oil and gas.
The Bear & the Dragon in an Oil-Short World
Putin's Petroputsch has helped to roil global oil markets and stall the global economy. He couldn't have this influence were it not for the ravenous demand from The Dragon.
This week Ed Hyman's ISI, reporting on the latest International Energy Agency statistics, advises that world oil demand since 1988 is up 25%, from 64.95 million b/d to 82.15 million b/d. In those sixteen years, European consumption is up exactly 16%, US consumption up 18%, Japan's up 25%, and China's up 175%. Yes, China's Great Leap Forward in Oil Demand comes off a small base, but its absolute consumption has risen more than the US in that period--with American consumption up 3.08 million b/d and China's up 3.98 million b/d. China now consumes more oil than Japan--7.6% of the world total, compared with 7.4% for the world's second largest economy.
Economics 101: all commodity prices are set at the margin.
China's fast-growing demand for oil at a time Russian oil production is constrained by Putin Petropower Politics has had enormous impact. By moving in just four years from being an oil exporter to being the world's second largest oil importer, China turned a short-term global oil surplus into a long-term global deficit. As The Wall Street Journal reported yesterday, neither OPEC nor Big Oil are reinvesting their remarkable oil profits in exploration and development. Russia is the single best hope for being able to generate significant near term--and longer term--production increases; it has well-identified drilling targets, a theoretically capitalist system, and grew its output faster in the past five years than anywhere else in the world. OPEC is no longer the answer; too many of its members are being forced by dysfunctional economies to spend their oil receipts in handout schemes, and few have enough significant seismically-identified targets to drill and develop enough production to more than replace the inevitable production declines of this decade.
Russia has the hydrocarbon reserves, the brains, and the cash flows to keep raising its output. To the extent it liberalizes its oil industry, it will attract gargantuan cash flows from Big Oil, which has virtually run out of great places to invest its bourgeoning profits.
Here is a snapshot of the global oil situation:
1. Within OPEC, only Saudi Arabia, Iraq, and Venezuela have potential excess production capacity--and the total available increase within the next 2 years is less than 2 million b/d. All other members are operating flat out. Some members are producing modestly below their quotas (such as Indonesia), but that is because they have underinvested in production capacity and their wells are experiencing the inevitable decline rates.
2. The Saudis have publicly announced plans to invest as much as $30 billion this decade in bringing on new production. That's the good news. The bad news is (1) Most of this will be heavy, high-sulfur crude, and Western refinery capacity is already stretched. (2) Because of the decline rate on existing Saudi oil fields, less than half this new production will be a net boost from current Saudi oil output. (3) Large-scale water injection will be needed: water is, we are given to understand, somewhat rare in the Saudi desert and must be produced by desalination and then transported to the wellhead. Apparently, these new fields wouldn't be economic at real oil prices below $32 or so. (The Street has, we understand, long assumed that (1) anywhere in Saudi Arabia you punch a hole, oil comes up, and (2) existing oil fields are near-perpetual producers.)
3. Iraq is able to produce more than 2 million barrels a day except when terrorists blow up pipelines and/or loading facilities. If (when?) the Islamofascists have been crushed, Iraq could embark on a massive capital spending program that could, if reserve guesstimates are anywhere near accurate, treble its production by 2010 or thereabouts.
4. Venezuela has huge reserves of heavy oil, but they could only be developed over many years and after many, many billions of dollars have been invested. With the tainted referendum victory of Castro buddy Hugo Chavez, the priorities will be (1) to continue the huge handout schemes the referendum vote generated: the state oil company was tapped for $1.7 billion for election goodies; (2) to supply oil to Cuba cheaply and on credit, (3) to use similar petrobribes to influence politics in other Latin American nations. Although Big Oil is lining up to get Chavezian approval to develop those massive Orinoco deposits, the companies will surely be cautious about making multi-billion-dollar investments in a hurry.
5. Oil production in major existing Western production zones, such as North Slope Alaska and North Sea, is either at or past its peak. No new giant fields have been identified.
6. The oil reserves contained in the various heavy oil sands deposits of Northern Alberta are very profitable at oil prices above $30, as long as the Canadian dollar sells at a discount to its American counterpart, and as long as natural gas prices do not trade significantly above their BOE (Barrel Of Energy) equivalent--one-sixth the value of oil. (Natural gas is used to heat up the oil stuck in the sands so it can be pumped to the surface.) However, developing these immense resources takes years and billions in capex, and, in the meantime, Alberta's conventional crude production will be declining, albeit modestly, so on a net basis Canada cannot be a major factor in the global oil equation.
7. Caspian oil reserves are huge, but bringing them to global markets involves political risks--getting agreements from all requisite governments, some of whom are mere statelets, to the production facilities and pipelines--and even greater geopolitical risks--any route must pass through territories already known for large-scale Islamic terrorist activity.
8. Nigeria's production is intermittently interrupted due to a multi-decade dispute between the inhabitants of the Niger Delta (source of most of the nation's oil) and the government in Abuja (source of most of the nation's problems).
9. The International Energy Agency, which underestimated global oil demand for years, now includes Chinese and Indian consumption in its calculations. It forecasts a deficit of more than a million barrels a day for the Fourth Quarter.
10. According to The Wall Street Journal, the world's operating rig count today is down by more than half from the peak [which was near the top of oil's Triple Waterfall] in 1981. E&P companies that take big exploration bets are punished in the stock market, which wants dividends and stock buybacks, because the consensus still expects a plunge in oil prices. "Show us the money, don't put it back into the ground."
For the first time within living memory, oil is selling at free market prices. That also means that the willingness to look for oil is driven by the market's perception of future oil prices, not by perceptions of what a cartel will dictate.
During the years before 1972, when the US was a net oil exporter, the Texas Railroad Commission in effect set a floor for oil prices through its regulation of production in that state. OPEC took over when US exports dwindled to insignificance and the nation became a net oil importer on a grand scale. Barring a global recession, OPEC will no longer have any real price-setting function to perform. It is becoming a club for Arab glitterati abroad. In recent weeks, Saudi oil minister Al Naimi made repeated pledges to drive down oil prices through increased production. For decades, that kind of statement from a man in his position was enough to send world oil prices plunging. This time, markets treated his remarks as mere blustering--and oil prices continued to rise. The market is in charge.
Who Is "The Market?"
As oil prices kept rising farther and farther above the Street's forecasts, the Shills & Mountebanks, who told people to sell oil stocks because of a coming oil collapse, scrambled to issue explanations.
Their three most-disseminated explanations:
1. Iraq
This claim is founded in actuality: Iraqi oil production did fall by more than 1.5 million b/d in 2003 until Halliburton and the US Corps of Engineers and a group of courageous Iraqi engineers and technicians got it back up to speed--a year ago. Oil briefly spiked to $40 a barrel as war loomed, but it traded between $26 and $32 for the rest of 2003. So why continue to blame Iraq? The advantages of this excuse are (1) that the idea that Bush waged the war for oil is widely-believed, particularly among followers of Michael Moore; so this excuse plays to a demonology that is already well-established; (2) Jihadists have targeted Iraqi production and distribution facilities with frequent success this year, but total production cutbacks are in the millions of barrels range. So the S&Ms have a point: except that those cutbacks would have been meaningless if, as they insisted, there was a huge global oversupply of oil.
2. Terrorist Threats
The S&Ms suggest that a "fear premium" of as much as $7/b is built into oil prices because of terror threats toward oil facilities worldwide. Fear can be rational or irrational. There's no doubt Al Qaeda and its brethren want to cause trouble in Saudi Arabia, and they certainly have the capacity to sink an occasional oil tanker or blow up a loading facility. But we've known since 9/11 of their aim of destroying the West, so why shouldn't the "experts" have long ago decided that oil deserved some kind of fear premium, rather than, for three straight years, predicting a coming oil price collapse? In any case, if there's a $7 premium in spot oil prices, then global oil inventories should have climbed dramatically as frightened consumers hoard oil against Islamic fanatics. But global oil inventories (apart from the Strategic Petroleum Reserve) have risen imperceptibly.
3. A Speculative Mania
That S&Ms should descry a speculative mania implies that those who fostered the growth of the biggest of all manias had acquired useful experience. It is as if O. J. Simpson were to present a paper at a criminology conference about anticipating domestic murders.
There's no doubt that the oil runup has attracted speculators, but there is reasonable doubt that they created it. The asset that has outperformed almost all others this year can hardly escape the attention of hedge funds, commodity funds, and just plain punters. The Wall Street Journal notes that T. Boone Pickens' hedge funds have reaped more than $550 million in oil gains in the past two years, and Paul Tudor Jones and other well-known players have also won big.
But non-commercial investors held just 28% of the long bets on the NYMEX Crude contracts as of last week (according to the Journal). Goldman estimates that the total stake of such players would only be enough to drive oil prices up by a few dollars.
Besides, for every buyer, there's a seller, and there's no doubt that oil producers have been selling heavily forward--more than enough to overcome hedging purchases by consuming industries, such as utilities and transportation firms. Indeed, there is evidence that some E&P companies have listened to the terrible advice they were getting from Wall Street investment bankers and were selling far ahead "to lock in overvalued oil prices." I've heard tales of bankers telling firms that they could improve their credit ratings if they'd sell forward, because they could show lenders they had guaranteed profits far into the future.
Speculative mania?
Looks to us like a difference of opinion between those battle scarred oil industry executives who managed to survive oil's Triple Waterfall and speculators who believe that the 20-years of disappointment for oil are yesterday's story.
Manias are when nearly everybody agrees, creating Shared Mistake.
Yes, when there's a 50% rally in the world's most important commodity, there's bound to be raucous speculation. But this isn't a case of the rooster's crowing that brought the sun up.
Investing When the Story Is On Page One
The Rule of Page 16 says that investors should be leery of investing heavily in either oil futures or oil stocks these days. That Rule says, "You neither make nor lose serious money by the outcome of a story on Page One. You make or lose serious money from the outcome of a story that's now on Page 16 but is headed for Page One."
Rule of Big Numbers: When any market is moving--either up or down--toward a very big number, and that number is daily discussed on Page One, the market will get close, but not touch the magic number. When every newscaster is talking of the threat of $50 oil, you could feel some confidence that oil would get close, but would then pull back.
Looking at oil's action in recent weeks, one has to wonder about a short squeeze. None of the news stories cited by the new experts on oil prices could explain the relentlessness of oil's run from $36 in late June to $49.
If so, who was getting squeezed?
We know that some of the big Wall Street investment banks trade heavily in commodities for their own accounts. Some of them have been bulking up their oil trading facilities. Another possibility is that some of the big E&P companies who had been "hedging" by selling forward, realized they were actually "speculating" big time, and that their shareholders were getting reamed by their bets against oil. If so, they might have bought in their out-month sales, thereby putting pressure on the spot price
Regardless of the internal factors in the oil market, there is no denying that the run from $36 to $49 was bad news for the global economy. Oil is now back below $45 and should head back to $40 or even lower--once the short-term speculators get squeezed out.
The best outcome for investors would be a drop in oil prices back to the mid-thirties. That would prevent a severe squeeze on heating oil users this winter. Those who've shrugged off the effects of high oil prices on car owners don't seem to have considered what happens to residents of the American Northeast if they're still paying heavily for gas to drive to work and their heating oil costs are up 40% from last year.
The Stuff of a Complicated Relationship
Much of the story of this century will be about the complex relationships that will develop between Russia and China-- and between both those nations and India.
By cutting back on Russian oil industry expansion at a time of the first true global oil shortage, Putin has not only enriched his nation and strengthened his currency reserves, but he has made himself into the world's most influential oil sheikh. He is playing his hand well.
China must manage its relationship with its powerful neighbor carefully. It needs almost everything Russia produces (with the possible exception of vodka). It also needs to keep the cost of its commodity imports--most particularly oil--to levels its still-youthful economy can afford.
We'll miss the days when the G-7 and OPEC managed matters so that we had free time and money to blow on Nasdaq stocks, in the solipsistic confidence that we knew it all and had it all.
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Basic Points is a publication prepared by Donald Coxe of Harris Investment Management Inc. ("HIM") and BMO Harris Investment Management Inc. ("BMO HIMI") for the exclusive use of clients of BMO Nesbitt Burns Inc., BMO Nesbitt Burns Corp., HIM, Harris Trust & Savings Bank, BMO HIMI and Jones Heward Investment Counsel Inc. (collectively referred to as the "Global Asset Managers").
All rights reserved.
The opinions, estimates and projections contained herein are those of Donald Coxe and do not necessarily represent the opinions of HIM and BMO HIMI as of the date hereof, and are subject to change without notice. HIM, BMO HIMI and the other Global Asset Managers believe that the contents hereof have been prepared by, compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, the Global Asset Managers make no representation or warranty, express or implied, in respect hereof, take no responsibility for any errors and omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use or reliance on this report or its contents. Information may be available to the Global Asset Managers which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global Asset Managers and their affiliates and respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. Any of the Global Asset Managers may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is a direct or indirect subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may act as lender or provide certain other services to certain of the corporations mentioned herein and may receive remuneration from the same.
® "BMO" is a registered trade-mark of Bank of Montreal, used under licence. "Nesbitt Burns" is a registered trade-mark of BMO Nesbitt Burns Corporation Limited, used under licence. TM "The M-bar roundel symbol" is a trade-mark of Bank of Montreal, used under licence.
That's all for this Monday evening. I am getting on a plane tomorrow in Hamilton, Bermuda, dodging a hurricane or two and spending the next twelve hours getting to San Francisco.
Your wondering what idiot agreed to this travel schedule analyst,
John F. Mauldin
johnmauldin@investorsinsight.com |
