Welcome to My Nightmare
Each morning I get up hoping what I read the night before was just a bad dream or an illusion. Unfortunately reality always sets in. Last Thursday evening I had just finished reading Colin J. Campbell’s “Oil Crisis,” the companion to the author’s previous book “The Coming Oil Crisis” written back in 1997. One of the final chapters dealt with attacks on Saudi Arabia’s Abqaiq oil facilities. Abqaiq is important for many reasons. Abqaiq contains one of the largest oil fields in the world and its facilities are the main oil processing centers for Arabian extra light crude oil. Abqaiq processes up to 7.0 million barrels a day. Its facilities include pumping stations, gas-oil separator plants, and pipelines. This makes Abqaiq pivotal to Saudi and global energy production and export capacity.
Imagine my surprise the next morning to find what I read the night before become a reality as I turned on the morning news. There isn’t a week that goes by that I don’t discover more evidence that peak oil production is coming sooner than most of us think. There is a high probability we will reach global peak production before the end of this decade. Certainly an energy inflexion point could be reached within the next 12 to 24 months. As I pointed out last week, production will fall by almost 500k barrels a day as a result of Kuwait’s and Mexico’s largest oil fields peaking last year. Nigerian production has fallen by 450k as a result of the shutdown due to guerilla attacks. Finally, production in Iraq has fallen by 500k per day as a result of terrorist attacks.
Intelligence reports confirm that last Friday’s attack at Abqaiq is likely to prove the forerunner of other attacks aimed at crippling the Saudi oil industry. Saudi oil production has always been a priority target for al-Qaida. Terrorists have been emboldened by the success of attacks on Iraq’s oil facilities. Production is down 500k as a result of over 300 recorded attacks since June 2003. According to intelligence experts, these attacks are set to increase rather than diminish. Terrorists are convinced that the way to cripple western economies is through oil. Indeed whether you look at attempts by Russia to shut off gas production or Hugo Chavez’s threats to cut off oil shipments to the U.S., oil is increasingly being used as a political weapon. It appears that another cold war has begun based on energy politics rather than military might. What all of this shows is just how dependent and vulnerable western developed economies are to the vagaries of the oil markets.
Peak Oil is REAL
It was through Colin J. Campbell’s work back in the 1990s that I first became acquainted with the concept of peak oil. His work and those of other geologists were influential in my thinking and subsequently our move into oil stocks in 2000-2001. I became convinced of their thesis and wrote a major article on the subject “Hubbert’s Peak and the Economics of Oil,” back in March of 2002. Since that time I’ve been a voracious reader on peak oil, consuming more than 60 books on the topic from technical and geological to geopolitical pieces on the subject. I’ve read just about everything from just about every perspective. I’ve read the optimists as well as the pessimists. I’ve looked at the environmental view and the view of the geologists. Geopolitical aspects have also been consumed as well as those of investment bankers and energy analysts. As a result of my research I now belong firmly in the camp of the geologists. I believe peak oil occurs within this decade and may be as soon as 2008. However, this is my opinion. You may draw a different conclusion. I’ve included a reading list for those who would like to become more familiar of the subject. Many of the authors have been guests on my radio program over the years. Please see 2004 and 2005 archives at FSN for a list of interviews. I believe that as you explore this subject as I have, you can come to no other conclusion. Peak oil is real and it soon will be upon us. Diligent investors should prepare their own ark. In the words of Warren Buffett, predicting the rain isn’t as important as building the ark
Oil Discoveries in Decline
Oil discoveries worldwide are getting fewer and smaller in size. In 2005 there was no oil discovery greater than 1 billion boe in size. The world’s oil operators replaced production by bringing previously discovered fields into production and revising reserves upward in existing fields as a result of higher oil price Average discovery size has been dropping each decade. According to IHS, average discovery size was 800-900 MMboe in 1925-50, 240-300 MMboe in 1950-80, and 47-80 MMboe in 1980-2004.
According to IHS Energy, new field discovery size declined again in 2005. Oil discoveries in 2004-2005 were the lowest since World War II. There were 2,700 oil and gas discoveries between 2000 and 2005 contributing 120 billion of boe to reserves. During that same six-year period, the world consumed more than 300 billion barrels of oil. The world continues to consume more oil each year than what is discovered -- a trend that has been going on for more than two decades. Last year there were 320 discoveries, totaling 4.5 billion bbl of oil and 32 tcf of gas, or 9.8 billion boe. Most of the discoveries were made in Kazakhstan, China, and Brazil.
For 2006 prospects could be fewer in number and size. There are 300 elephant-size prospects (an elephant field now described at 250 MMboe) with the potential of 107 billion boe. Industry success rates averaged 6% in 2005 or 10 successful hits out of 140 prospects’ identified. This is just one more piece of evidence pointing to peak oil and a coming inflexion point in world energy.
La Nina is Here Again
The U.S. Climate Prediction Center (CPC) announced recently that another La Nina (cold pattern) has arrived in the Pacific. La Nina has the weather experts concerned. The Western US and Canada are particularly vulnerable. You typically get cooler waters off the West coast. This means less moisture evaporates into the air. The result is there is less rainfall inland. More rain and snow falls on the coast and less rainfall is carried inland to the southern and central states. Arizona is experiencing “Dust Bowl” conditions, while the Pacific Northwest is experiencing record rainfall.
La Nina conditions usually last 4-6 months peaking in late fall early winter. It impacts precipitation during the growing season and hurricane development during the tropical storm season. According to Evelyn Browning Garriss, editor of the Browning Newsletter, “In the U.S. this pattern will favor continued drought in parts of the South and Southwest from Arizona to Arkansas and Louisiana and above normal precipitation in the Northwest and the Tennessee Valley area…There is also a tendency with La Nina to have more tornadoes, and more hurricanes."
Gold Mining is Not as Profitable as Base Metals Mining
Newmont’s (NEM) fourth-quarter profit plunged 67% due to declining output and higher production costs. Net income declined to $62 million, or 14 cents a share, from $190.4 million, or 42 cents, a year earlier. Revenue rose 8.9% to $1.3 billion as gold prices rose. The company’s production fell 2.3% to 1.74 million ounces led by declines at most of its mines located in Nevada, Indonesia, Australia, New Zealand and Uzbekistan. The company is having an uphill struggle to maintain production and contain costs. Since its three-way merger with Normandy and Franco-Nevada, production has been on the down slope. The company reported that production is set to decline again this year from 6.49 million ounces to 6.26 million.
Newmont illustrates the point that gold production remains to this day a very unprofitable business. Most mines lose money. Newmont’s return on equity has fallen from 4.47% in 2002 when production was at its peak to 3.95% for 2005.
In contrast to large gold producers such as Newmont, large metal producers like Rio Tinto (RTP), BHP Billiton (BHP), and Companhia Vale do Rio Doce (RIO) are experiencing record profits and higher returns on equity. BHP is buying back stock, increasing its dividend, and expanding its production in critical areas such as iron ore, oil and gas, and base metals. It is going to take much, much higher gold prices before gold mining becomes profitable. I spoke with a geologist yesterday and he told me gold mines are set up to maximize reserves, while base metal mines are set up to maximize profits. It is one reason why I favor developing juniors that are building up their reserves, while gold mining remains unprofitable. Better to load up the warehouse than produce the metal at such paltry returns.
Unloved and Under-owned with More Room to Grow
Despite record profits and persistently high oil prices, oil stocks remain incredibly cheap. The energy sector is still one of the few areas within the market that you can still find cheap stocks that sell well below their intrinsic value, below their growth rates, and where dividend yields can be found that are above the major markets. Oil analysts still haven’t accepted the fact that we have entered an era of escalating oil prices due to demand supply constraints. I still see analysts on bubble vision saying they believe oil prices are heading lower. In their minds a slowing economy will bring about less demand for oil and natural gas. We have entered into an era where there is no one institution that is able to control the price of oil. This includes OPEC. If you’re an importing nation, which probably includes the majority of countries in the world, you have very little choice in choosing where you get your oil from and are subject to the vagaries of oil dictators or the plans of terrorists. You have very little choice but to pay the prevailing price, demagogues’ notwithstanding.
Just to break even each year, the world needs to find 4.3 million barrels a day to replace global decline rates. Then there is the new oil that needs to be found to enable global economies to expand. The major economies such as the U.S. and China need oil to keep their economies running and expand economic output. Without expanding supplies of energy the global growth engine comes to a screeching halt. This critical fact is often ignored by most analysts in their oil assumptions. Because pressure on the world’s oil supply chains keeps building, the price of oil will keep heading higher. The next global recession will not cause the world to consume less oil than it already does today. It will merely slowdown the rate of economic growth.
It is more likely that will see $85-$100 oil than $40-$50 oil before the year ends. That is why oil companies still look cheap. The shares of majors still remain under-priced and many independents are simply bargains. Oil analysts like Kurt Wulff, CFA think many oil stocks are under-priced. According to Wulff, Chevron Corporation (CVX) is priced at oil prices closer to $37 a barrel than today’s closing price of $64. ExxonMobil’s (XOM) current stock price reflects $43 oil. The simple fact is: everywhere you look, oil shares remain cheap. How long that will last remains to be seen. At the moment Wall Street and Main Street still don’t get it. Opportunity?
Until the next time... fair winds and clear skies!
© 2006 James J. Puplava
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