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Friday, September 29, 2006

Energy Beat - Debunking the Bear Case

By William Trent, CFA of Stock Market Beat

Barry Ritholtz recently expressed his dissatisfaction with the explanations being bandied about in the media as to why oil prices have fallen:

Here is a short list of the most common current explanations circulating in MSM:

1. More Supply coming online;
2. Reduction of global terror threat;
3. Cooling of hostilities between Israel and Lebanon
4. Seasonally weak demand, as Hurricaine season ends;
5. Iran cooling inflammatory rhetoric

I find these some of the mainstream explanations unsatisfying. At the risk of creating a strawman (only to knock it down), let me put forth my top 5 list:

1. Fast money rotating out of commodities and into tech;
2. Cooling economy consuming less energy;
3. No major supply disruption from weather or Middle East;
4. Psychology peaked earlier in year; (see Business Week Cover Story)
5. Stretched consumer shifts behavior;
6. And lastly, the Weak Strong US Dollar (Crude is priced in greenbacks)

We agree with Barry that each of these can pretty easily be explained away, as we do here:

Supply coming on line takes years. What new supply could have come on line that was not anticipated three months ago?
Just because they will let you take some of the liquids back on the plane now doesn’t mean the terror threat is any lower.
Israel and Lebanon don’t exactly have much oil - no oil supply was disrupted during their skirmish and it did not create any particularly unusual demand, so why would it have any effect on price (which was rising for years before the skirmish started?)
Seasonality is a valid point but certainly a very temporary one. It is long-term supply/demand balances that sent oil to $78, and those haven’t changed.
Iran? Isn’t this sort of the terror/Israel arguments tied together? Iran either wants to sell oil or it doesn’t. We’re betting on the former and think they are selling as much (or nearly so) as they can produce and that this won’t change any time soon.
Amaranth certainly suggests there was some speculation on the way up, but also suggests that (post their pop) there may be limited downside remaining.
The economy would have to cool to zero percent growth for the next five years for technology and substitution to offset the normal demand increase attributable to growth. If that is your forecast, fine (although I hope you are wrong.) Otherwise, your outlook for oil should be consistent with your economic outlook.
Psychology? Perhaps it had an impact on price, but it sure doesn’t affect supply or demand much. Unless you can quantify the impact on price, how do you know the current price is any more correct than last month’s?
Stretched consumer: See #6 above.
Dollar: Ditto.
So with the easy explanations as easily tossed aside, how about something with more meat? John Mauldin recently reposted a Charles Gave article on his site. Its basic tenet that oil prices will be brought back down due to substitution and new technology is beyond reproach. As far as the timing, however, we found it to be long on optimism and short on consistency. Consider:

1- The return of king coal: In WWII, the Germans (who were long coal and short oil) refined processes to make gasoline out of coal. This old process has been perfected and is now a source of energy in South Africa. Why is this important? Because there is more coal in North America or Australia than there is oil in the Middle East. The problems in using coal have historically been a) ecological issues (which can be solved with some money) and b) costs (using/moving coal is not as economic as low oil prices).

2- The exploitation of tar sands or bituminous coals in Canada, the US, and yes, Venezuela. Here, once again, the technology exists and the extraction costs are roughly US$30/bl. The production build-time is roughly around three to four years. The big hang-up is the shortage of technicians. Such shortage problems can however be solved after a few years (time of schooling/training) or, by enticing retired technicians to come back.

The company that converts South Africa’s coal into fuel is Sasol (SSL) and is on our Watch List. During the last few months they have not opened vast new capacity, nor even announced plans to start building vast new capacity. In fact, the recent decline in oil prices has hit Sasol and the tar sands producers harder than it hit traditional suppliers because these processes are only profitable when oil prices are as high as they have been recently. Given the long lead times for building the plants and extracting these resources, companies naturally want some degree of comfort that the price will not fall significantly below current levels for some time. The recent price decline reminded them why they did not start building these plants five years ago, and is unlikely to encourage them to start building them now.

The article continues:

3- The emergence of new technologies to recover more oil out of old and decaying oil fields. With the price of oil where it is, it makes a lot of sense to invest substantially to try and optimize the output from any individual well. In the past 25 years, we have seen the average extraction at existing wells climb, thanks to technology, from 25% of known reserves to 40% of reserves. Norway has set a target of 65% to 70% recovery for a good part of its reserves and is already achieving that in some fields. Where do the improvements come from? Technological progress!

Once again, technological progress that has not occurred overnight. If it took 25 years to increase extraction to 40% it is likely to take as long for it to reach 65%.

4- The possibility to produce oil/ethanol out of agricultural products. On this very topic, the best summary we have read of the issues at hand was produced recently by our friend Mark Anderson, the editor of the SNS newsletter. We lift his work below shamelessly: “Ethanol is a liquid fuel, currently produced from corn… Now here’s the rub: there is a debate about whether it actually takes more energy to create a gallon of ethanol than the energy contained in a gallon of ethanol. According to Report No. 814 from the Office of the Chief Economist of the U.S. Department of Agriculture, corn ethanol contains 1.34 times the energy required to manufacture it….

There are longer-term solutions. In a period of about five years, we could be producing ethanol in quantity from cellulose. Cellulose is found in a variety of plant material, including the stalks of the corn plant. The process for production of ethanol from cellulose does not require large amounts of hydrocarbons and is, therefore, much less expensive. If the federal government continues to provide large subsidies for corn-derived ethanol, however, we are in effect providing a disincentive to make capital investment in cellulose technology. The corn lobby will fight tooth and nail, but in the end, democracy, just like the free market, has a way of doing what is right and sensible (usually, after trying out all other options). In this case, that would see cellulose derived ethanol become widely available in the marketplace.

Well, call us in five years when the cellulose plants are up and running. In the meantime, with a 1.34 energy output/input ratio the best ethanol can do is cut fuel consumption 34% - and that is assuming there is that much excess corn produced, that the plants can be built, that the increased demand for corn doesn’t make it even less profitable, and so on.

6- Prices & Substitution

High energy costs are not impacting just oil. We have witnessed a stupendous rise in the price of all forms of energy through the substitution effect. And here technology is also making huge leaps. Let us, again, go through a few examples:

* Nuclear power. There are two main problems with nuclear plants. The first is that building a plant takes a long time (though the Chinese are definitely not wasting any time on that issue). The second issue is the disposal of the nuclear waste. But this is where the exciting news lies: we have recently read reports highlighting that the volume of the waste in the new French reactors is a tenth of what it was in the old reactors. This implies that the amount of space needed to store the waste is much smaller, and the arguments of the anti-nuclear green lobby further reduced.

* Production of energy at the individual and local levels: everywhere we go, especially in Europe (where the price of energy, on top of being very high, is also heavily taxed), we find new and interesting forms of energy production: in Scandinavia geothermal energy (one drills in the rocks, and gets the heat coming from below); in France, a massive movement towards heating pumps (exchanging heat between a source of water and the atmosphere - in fact, after a brutally hot summer in Provence, I am biting the bullet and having such a system installed in my Avignon house); in Denmark, there are quite a lot of wind turbines; in Spain, you can see solar panels on a growing number of roofs. All these systems enjoy huge tax breaks, and, once they are put in, they are here to stay; markets lost for oil, for ever.

By themselves, none of the above factors is sufficient. And the rate of substitution from oil to these new sources of energy is excruciatingly slow. For example, if one had the bad luck of installing an oil boiler in one’s house three years ago, one is not going to change now. The capital costs are simply too high. But taken together they are significant and will change for ever the demand for oil or natural gas used to heat or cool houses, factories, or office buildings.

This is indeed the meat of the article, but there is nothing to say that this can happen any time soon. With a ten-year lead time to build nuclear plants, we just don’t see it making a sizable dent any time soon. Then, apart from the environmental issues, Gave offers the reason why it may not help even then:

Our 19th century world was dominated by coal. Our 20th century was dominated by oil. It is our firm belief that the 21st century will not be dominated by oil. It will be dominated by electricity; and oil will become a marginal energy. This simple truth might help explain why, since 2001, uranium has not had a single down month, and since 2003, uranium has never traded down for even a single day, regardless of what was happening to oil prices.

With uranium prices rising so much, why even bother? It sounds like it won’t do much to make energy cheaper, which is after all the point. In fact, there may not even be enough uranium out there to support much additional demand. As far as substitution consider that the median age of vehicles in the US is 9 years. If you assume that hybrids improve fuel efficiency by 50% over their gas-only counterparts, even if 100% of new car sales were hybrids it would take 18 years to fully replace the vehicle fleet and reduce fuel consumption by 50% overall (assuming demand doesn’t continue to rise.) Based on a more realistic (but still wildly agressive relative to today’s sales levels) assumption that 10% of new vehicle sales will be hybrids, the annual demand reduction is less than 0.3%. Color us unimpressed.

With that off our chest, some stories affecting individual companies recently:
Statoil STO) strikes gas at Barents Sea Well

Pension and endowment funds aren’t giving up on commodities yet.

ConocoPhillips Confirms North Sea Discovery - Oil and Gas Online

Helix names new CEO
Disclosure: Author owns shares of United States Oil Fund (USO). The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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