[I don't know how many of you get this free via email, but it's always thoughtful and informative. Today it coincides mostly with this thread's thrust.]
The $100 Solution
Venezuelan Madman and Other Problems
It's a Very Demanding World
The Demand for Infrastructure
London, Majorca and Regulatory Exams
By John Mauldin
April 1, 2005
How can we go from oil priced in the low teens only a few years ago to oil now
holding steady in the mid-50s? This week we have seen a projected price spike of
$105 from Goldman Sachs. Can you say $4 a gallon gasoline, boys and girls? $100
to fill up the tank of your SUV? This week we look at the price of oil and why
$100 oil is the solution and not the problem.
Since I'm writing this on April 1, I was tempted to start out the letter as an
April Fools joke. My topic would have been why the Dow is going to 36,000, but
then I realized that James Glassman and Kevin Hassett wrote about that over five
years ago in their book "Dow 36,000." So I guess we'll stick with $100 oil.
But first a quick housekeeping note. I've always sent this letter to you in text
format. It used to be that more people could receive an e-mail in text format
than HTML. I'm not certain that is the case today. I would like to be able to
include charts and graphs, and to do so would mean that I would need to be able
to send the letter in HTML format.
Next week the subject matter almost requires me to be able to include graphs, so
I'm going to send the letter in HTML format. If for some reason you do not get
it by Saturday morning, you can go to my web site at www.2000wave.com and get it
there. I would like to know if this is a problem for you, or if using an HTML
format means that the letter gets caught in your spam filters. Thanks.
The $100 Solution
Oil prices may temporarily spike to $80 a barrel during the next two years if
there is a major supply disruption, said OPEC's Acting Secretary-General, Adnan
Shihab-Eldin, last month. "I can stress that the probability that the price of a
barrel of crude rises to $80 in the near future is a low probability," Shihab-
Eldin told leading Kuwaiti daily al-Qabas in an interview in Vienna.
"However, I can't rule out the rise of a barrel of oil to $80 in the coming two
years," he said. "But, if the price rises to this level for one reason or
another (for example a shortage of supplies from a producer nation by one or two
million barrels per day), it's not expected that this spike will last long."
Prices around $50 or $60 a barrel, if they continued for two years or more,
would increase investment to expand supplies and curtail demand, pushing down
prices in the end, he added. "This is an essential law of economics," Shihab-
Eldin noted. (Source: Reuters).
OPEC is becoming increasingly comfortable with $50 oil. Only a few years ago,
the consensus was that $50 oil would reduce demand and create the potential for
a worldwide recession. Since a global world recession would not be good for
world demand, and thus oil prices, OPEC leaders targeted $22-$28 oil. They were
not being nice. They simply wanted to make sure their customers would be
financially sound enough to keep paying. This is somewhat like cocaine dealers
being concerned about their customers in order to keep up their business.
Since $50 oil has not created a recession, there is no constraint upon OPEC to
work to reduce prices from here. However, the fact is that OPEC can do little
about bringing down oil prices even if they wanted to.
Here's how it used to work. In the 50s and 60s America produced all the oil it
could use and essentially controlled the price of oil. Much of US oil was then
produced in Texas. The Texas Railroad Commission had (and still maintains)
regulatory authority over the production of oil in Texas. They limited the
production of oil so as to maintain a price that would allow oil companies to
make a profit and thus continue to be able to pump oil.
In 1971, the Texas Road Commission allowed oil producers to go to full
production, as demand had outstripped supply. That gave control of oil prices to
OPEC and they moved to increase prices dramatically in 1973-74. Up until then,
the TRC could raise or lower the price of by simply increasing or decreasing
their production.
World oil demand is around 80 million barrels of oil a day. If you increased oil
production by, say, 2 million barrels a day over world demand, within three to
four months there would simply be too much oil sloshing around and no place to
put it. Prices would drop, and if production did not also drop the price of oil
could go down dramatically.
The consensus view is that OPEC has maybe-possibly-potentially the ability to
produce an extra 1 million barrels of oil a day. Given that much of the world's
oil producing capacity is in politically unstable countries, it is quite easy to
imagine a disruption will affect far more oil production than this estimated 1
million barrels of oil a day.
Venezuelan Madman and Other Problems
The various tribes and factions in Nigeria are constantly threatening war with
each other. Iran, Iraq and Saudi Arabia are not paragons of political stability.
And then there is the madman that runs Venezuela. I offer you this quote from a
recent Dennis Gartman newsletter:
"Turning away from the Middle East to the Americas we cannot help but report the
following statements by Venezuelan President Hugo Chavez... the Americas'
closest thing to N. Korea's Kim Jung-Il. Speaking on television recently, Chavez
said
"Capitalism makes democracy impossible. Capitalism makes social justice
impossible. If we don't change this system, the world is going to end. The
eternal existence of our planet is not guaranteed. Look at other planets. In
Mars there was water. It's possible they will soon find remains of living
beings. Who knows how many years ago there was life on Mars? Mars is very
similar to Earth. It rotates around the sun almost the same as Earth. It's very
likely that there was life on Mars. It's possible that the Martians couldn't
keep life going on their planet.
"Old Karl Marx was right. Capitalism, monopolies, the exploitation of man by
man, Karl Marx's theory was correct. We have to break this model of domination.
"His comments stand on their own; they need no other amplification: This man is
a kook of the first order, but we must take him seriously for Venezuela remains
one of the United States five most important suppliers of crude. Politics and
energy needs make for very strange bedfellows.
And now let's look at the report by Goldman Sachs analyst Arjun Marti. In this
40 page report, he predicts a "super spike" period in which oil can range from
$50 to $105 a barrel. He thinks this will have the same type of psychological
impact that high oil prices in the 1970s had, ultimately changing consumer
spending patterns and leading to a new drive for energy efficiency. Quoting from
a story about the report in the Calgary Globe and Mail:
"First, its analysis suggests that hedge funds have had nothing to do with
rising oil prices, only contributing 'day-to-day trading noise.' Oil is up, and
will stay up, Goldman said, because of often-cited geopolitical turmoil. Another
factor is that 'light' crude, which is what costs $55 a barrel and is the
primary source of gasoline and jet fuel, is becoming a premium product compared
with "heavy" oil, which is what Canada produces.
"Finally, and not noted by many others, the rising costs at energy companies to
produce oil is directly correlated with the rising pricing of the commodity. As
part of increasing its price forecast, Goldman mulled the idea that the world
'may have entered the early stages of what we have referred to as a 'super
spike' period.' In the absence of a gusher of new crude hitting the market, such
a price surge is essentially what is needed to restore balance to the oil
universe, Goldman said."
Notice Goldman is calling this a "Super Spike." They define a Super Spike as a
multiyear trading band of oil prices which are high enough to meaningfully
reduce energy consumption and thereby create a cushion of new supply for the
market. The key factor that will create a sufficient destruction of demand would
be higher gasoline costs. Goldman says "we've entered the early stages of a
super spike without any threat of supply disruption. The spike is likely to
continue even without a supply shock, but any disruption would accelerate it."
They think that $105 oil will dramatically decrease demand, not only from the
recession that it would cause, but because consumers would start to change the
way they act. Among other things, the demand for SUVs would slow down,
consumption patterns would change, and the price of oil would then drop.
Following such a super spike and the follow-on demand destruction, Goldman
believes a "normalized" market will emerge, with oil in the $35 (U.S.) range,
the average of the past 35 years.
(As a comparison, if gas returned to the same level it was in the 1970s as a
percentage of consumer spending, oil would be $135 a barrel.)
It's a Very Demanding World
World oil demand is currently surging far higher than normal rates. In the
period 1991 to 1999, annual world oil demand growth was about one million
barrels a day. In 2004 that spiked to an additional 2.5 million barrels per day.
The Energy Information Administration (EIA) in Washington, DC estimates that
world oil demand growth will be more than 2 million barrels per day for the next
two years.
A third of that oil demand growth comes from China, which is no surprise, of
course. The need for oil comes from two primary sources. First, China now has 20
million cars. That demand is only going to increase as estimates are that China
will have between 120 million and 145 million cars a mere 15 years from now.
(China's air pollution is already among the worst in the world. It is going to
get worse.)
Secondly, all the new industry in China creates a huge demand for electric
power. Electricity is primarily produced by coal in China. The problem, however,
is that there is simply not enough electric power production capacity, and thus
much of Chinese industry has resorted to buying their own generators, most of
which are powered by diesel fuel. Optimistically that means that as China brings
on more power plants, it is possible that the diesel generators will be
replaced. This will more than be offset, though, by increased demand for oil
brought about by new cars and an emerging middle-class lifestyle.
For those interested, you can go to the web site of The Center for Strategic and
International Studies (CSIS) (http://www.csis.org/) and read some fascinating
presentations, under "China's Energy Craving." It is clear the demand for oil is
only going to rise. And this is just China. When you factor in India and the
rest of Asia, there is a real potential for global demand to out-produce near
term potential supply.
Any increase in demand over supply by 2 million barrels a day will ultimately
mean much higher oil prices. And that does in fact bring us to the super spike
scenario that Goldman predicts.
Now let's be clear that nobody really knows how high oil prices will go in the
rest of this decade. Personally I think that a rise to $70 oil would start to
negatively impact the American economy, and increase the likelihood of a
recession. The US recession will affect the rest of the world negatively, and
thus we should see a drop in the price of oil.
But as noted above, there are numerous unpleasant political possibilities. In
some of the less stable oil-producing parts of the world that could seriously,
even if temporarily, spike the price of oil to $100. Anything is possible, but
not everything is likely. While I do think we will see $100 oil in the coming
decades, I would be surprised if we see it that high in this decade.
Ironically, in my opinion, $100 a barrel oil is the solution for high oil
prices. Has anybody noticed that ethanol is selling for less than unleaded gas
on the futures market? Today unleaded gas on the futures market is $1.66.
Ethanol June futures are "only" $1.21. In the future, it may be cheaper to run
you car on environmentally friendly emission free ethanol. And yes, I know the
government subsidizes ethanol. But a $.45 differential is huge. Who would have
thought that would be the case five years ago?
Dennis Gartman tells me the Athabasca Sand Tars in Canada is roughly three Saudi
Arabias. They can now get oil out of the sand at a cost of roughly $11 a barrel.
In the future instead of buying oil from OPEC we will grow it in Kansas and mine
it in Canada. $100 oil will force market solutions for other energy sources and
whole new industries and technologies.
The Casandras who predict that the world will run out of energy simply don't get
it. Yes, we will eventually see oil production peak and then begin to fall. But
it will not be a calamitous over the waterfalls type of event. It will simply be
a gradual lessening of production.
That need for energy will be replaced by other energy sources. Such a change
will be disruptive, but then most change usually is. That change will of course
increase the number of potential opportunities for investors. This is a sector
that I want to keep a close eye on.
The Demand for Infrastructure
My good friend Jim Williams at the Williams Inference Center sent me the
following note on the increasing demand for infrastructure throughout the world.
By that they mean roads, bridges, railroads, airports, ports, canals and so
forth. It is a brief piece that I think you will find interesting.
"China is using 55 percent of the word's cement. Chinese businesses and the
Chinese government are on a construction boom. In 1989, China had only 170 miles
of highways. By the end of 2003, the country had 18,500 miles of expressways. To
build all these roads, the Chinese government spent $42 billion. The Chinese
Ministry of Communications states their plan is to reach 51,000 miles of highway
by 2008. The Chinese government is committed to putting down roads, just like
the United States started doing back in 1956.
"The list of infrastructure China needs is more than roads. For example, the
country has about one third as many railways as we have in the United States and
about one fifteenth as many airports. But, China has four times as many people.
China needs more railroads, airports, bridges, roads, parking lots, phone lines,
electrical lines and power plants. The demand for this infrastructure is now.
"Growing demand from China promises a lucrative future for South Africa's iron
ore and manganese companies - if they can find a way to move the metals more
than 500 miles to the coastal ports. The problem is that South Africa's
government-run company does not have enough capacity. More trains and tracks are
needed.
"Brazil has a similar train problem. The Brazilian government is trying to help
the country's most important railways overcome a transportation bottleneck that
threatens export growth. The current overhaul aims to help sustain the break-
neck growth of Brazil's soybean and iron ore exports to China.
"India's shabby infrastructure, seen as a key roadblock to wooing foreign
investment, stands to get a major makeover under ambitious plans by the
government in the country's annual budget unveiled in March 2005. Improving
India's potholed highways, congested ports and erratic telecommunications and
blackout-plagued service, is vital to keep India's economy powering ahead.
"The demand for infrastructure is not restricted to China and India. According
to the American Society of Civil Engineers, U.S. roads, bridges, sewers and dams
are crumbling and need a $1 trillion overhaul. As of 2003, 27 percent of the
nation's bridges were structurally deficient or obsolete. Since 1998, the number
of unsafe dams in the country has risen by 33 percent to more than 3,500.
"The U.S. government is aware of the infrastructure demand. The usually
fractious members of the House of Representatives, this March, found something
they nearly all shared: an appetite for millions of dollars for home-state road,
bridge and transit projects. On a vote of 417 to 9, House members approved a
$284 billion six-year infrastructure bill.
"Natural gas will become the preeminent fuel of the 21st century. Moving natural
gas requires liquefied natural gas (LNG) terminals, special ships,
regasification terminals, and lots of pipelines for distribution. As one energy
executive put it, 'Supply is not the issue; it is the delivery of gas to the
market.' Before this transition occurs, a world-wide infrastructure for natural
gas, such as that now enjoyed by oil, must emerge."
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