Short-term Markets, Long-term Problems

by Richard R. Loomis & Susan Salter | Contributor, World Energy Source | February 14, 2008

In the midst of the Great Depression, Herbert Hoover campaigned for president with his vision of the American Dream: a car in every garage and a chicken in every pot. And, it went without saying, a comfortable house in which to store them.

Whether or not you think the United States is headed for a recession today, the American Dream has evolved into a sense of material entitlement that threatens to overcome us. 

Now it’s a Hummer in every garage, a Starbucks on every corner and a home for the asking, no matter how financially prepared – or not – the buyer is. That’s how we got into the subprime mortgage mess.

For that, we can thank not only delusional consumers, but also institutions making loans that make no financial sense. It was only two years ago that companies like New Century Financial – a mortgage lender specializing in high-risk subprime loans – dubbed itself “a new shade of blue chip,” according to James Surowiecki in a 2007 New Yorker article. “Today, with its stock price down more than ninety per cent in the past six months and the company close to bankruptcy, it looks more like a new shade of Enron.” And for some reason, that “wonder legislation,” Sarbanes-Oxley, didn’t help us avoid this one.

The lenders targeting low-income house hunters came under a spotlight that revealed varying levels of fraud and abuse. And it wasn’t just the borrowers getting burned. “Many of the lenders hid their troubles from investors, even as their executives were dumping stock,” noted Surowiecki. By lending money to people either destined to fail on their mortgage payments or mistakenly assuming they could “flip” their houses before the bank caught up with them, lenders set up the country for what is now a record number of foreclosures. In fact, the number of home foreclosures “soared in 2007, with 405,000 households losing their home,” according to a report cited by CNN.com. “That’s up 51 percent from the 268,532 homes that were repossessed in 2006.”

Even as borrowers pack their bags, homes will sell as bargains, and the mortgage industry will once again be very difficult to work with. And what have we learned? That the American Dream of home ownership is just that: a dream, not a right. It is a goal, not an entitlement that everyone can claim. For the past few years, we have forgotten this fact in the mad rush to make everyone a homeowner.

What does the mortgage mess have to do with our current energy issues? Both involve the dangers of “short-term gain, long-term loss” thinking. This country was built on low-cost energy fueling our economy, not low-cost homeownership. Because of this, we will quickly weather this real estate bubble even as we ignore the crisis looming before us. Our economy continues to grow, albeit a little more slowly thanks to our financial brethren, and we continue to set records and move forward. Unemployment is at an all-time low, and income continues to rise. While our consumption rises, we drive the economies of the developing nations around the world.

A look at the U.S. economy shows that we are very efficient users of energy: Over the last 10 years we have continued to decrease the amount of energy we need to generate a dollar of gross domestic product. Still, the sheer volume and size of our economy requires huge amounts of energy.

We are currently importing all but 30 percent of our oil needs. If the current projection holds, by 2012 we will be importing all but 12 percent. Our current production places us as the third-largest producer of oil on the planet, but our production has declined by 1.25 percent each year for the last 17 years. A National Petroleum Council study cited in the January/ February 2008 issue of World Energy Monthly Review predicted very similar issues in providing enough oil for our economy. American demand has continued to rise with two cars in every garage and no end in sight. Now two other economies – China and India – have gotten a taste of Western-style consumerism, and they like it. Whether or not you think the United States is headed for a recession today, the American Dream has evolved into a sense of material entitlement that threatens to overcome us.

Subprime Energy?

Those growing economies pose an even bigger problem for the U.S. economy than the subprime mortgage debacle. For years now, the energy industry has predicted that we can provide enough oil on the global market to supply our needs domestically and worldwide. Recently, however, the industry has begun to question this premise. Oil investor Matt Simmons predicted the peak, and he has said in retrospect that the peak production of oil occurred in 2005. This debate is often mischaracterized as “running out of oil,” which is a wrong interpretation. However, with current technology, there is a limit to the amount the industry can produce in a day. Thierry Desmarest, the former CEO of Total, predicted that the peak will come at 100 million barrels per day (bpd). Desmarest’s successor, Christophe de Margerie, had a slightly different twist on that view, saying 100 million bpd “is now in my view an optimistic case.”

“The implication of de Margerie’s remarks is that the crisis is coming a lot sooner than that,” wrote Gywnne Dyer in an article syndicated to several newspapers. “World oil output is nearing 90 million barrels a day now, but it is never going to reach 100 million barrels a day. ‘Peak oil’ may be just a few years away, or it may be right now. (You will never know until after the fact, since it is the point at which global oil production goes into gradual but irreversible decline.)” After assessing the fi elds producing more than 10,000 bpd, Cambridge Energy Research Associates (CERA) concluded that overall output was declining at a rate of 4.5 percent per year. “This is much lower than the 7 to 8 percent average rate that is generally assumed in the industry,” noted Carl Mortished, writing in The Australian.

So while, for example, Mike Bahorich, Apache’s director of exploration and production technology, points out in World Energy (Vol. 10, No. 4) that we have 4 trillion barrels of recoverable oil in the ground, our ability to produce the barrels in volume per day is coming to its peak. Some other important statements are contained in the article. Currently 43 percent of the global supply is provided from 15 percent of the planet’s reserves. This is an equation that simply does not bode well for increasing our daily supply.

Rocky Road Ahead

This paints a picture of a rocky road leading into the future. As China and the United States reach a saturation point where each is using more than 130 million quads of energy, we quickly see that the transportation portion of this, particularly in the United States, is unsustainable. Remember, 96 percent of our transportation runs on petroleum-based products. We can see that as demand moves signifi cantly over supply, the economies that are colliding will pay a premium for the hydrocarbons being produced. The shipments of oil that would otherwise have arrived in the United States will be diverted to other growing economies willing to pay a premium for that delivery. In addition, those economies lack the strings we like to attach to our trading partners. China has very little need to ask other countries to observe the rights of their citizens or to share oil revenue with the common man.

China is already making deals to secure supply from countries with whom the United States is not even speaking. For instance, Iran now supplies 13 percent of China’s crude oil. Iraq, which is aiming to increase its production to 3 million bpd this year, signed a $65 million contract with China last year to buy three oil tankers. And China’s massive investment in the genocidal Sudan is well documented. The government of China is actively trying to secure a supply of oil to meet its needs on a go-forward basis.

Meanwhile, the United States remains the third-largest producer of oil and gas, taking our place behind Saudi Arabia and Russia. As our other partners Nigeria, Mexico and Canada all begin to make decisions on where to sell their hydrocarbons, the domestic producers of oil and gas and the companies holding significant reserves become the most important companies in our economy. Another factor affecting resources available to the United States is the domestic use of these hydrocarbons within the suppliers’ burgeoning economies. The Gulf of Mexico is America’s most productive region for producing hydrocarbons, but it is very hard to escape the decline rate. As a straight-line average, our production of oil has been declining by 1.25 percent annually, and our production of natural gas has remained fl at for the last 10 years. Interestingly, others around the world have begun to recognize the importance of the Gulf of Mexico even as the United States considers it a shallow stepchild. Petrobras recently set up shop in the Gulf, drilling with a vengeance. StatoilHydro moved in as well. In the proven locations along the Gulf of Mexico shelf, the players have transitioned to small, nimble operators called independents. Knowing that we need to continue to produce these areas, these independents have become increasingly important to our economic future. Assuming a fl at-line increase of demand based on population growth, we will continue to increase our demand by 2.25 percent per year. With the United States government squarely focused on the subprime mortgage problem and trying to increase renewable sources of fuel, the policymakers are not focused on some crucial statistics:

In the lofty future, we see an economy that is not hydrocarbon-based. In 2000 George W. Bush pointed us toward the hydrogen economy, which all too quickly evolved into an alternatives culture based on corn-based ethanol. At the same time he proclaimed Mexico and Canada our natural gas partners of choice and developed an energy policy based on their increased production.

Hindsight is always 20-20, but it is obvious that the hydrogen economy is not here to save us either now or in the foreseeable future. 

Natural gas demand in the United States continues to be stable, and the predicted liquefi ed natural gas (LNG) imports have not materialized. In fact, LNG shipments will be headed for the United Kingdom and Japan at premium rates before they will come to our own lower 48 states. It seems the only way to quench this ever-increasing demand is to force our economy into an economic downturn. How much of an effect this can have on demand remains to be seen, but it appears obvious that markets around the world are reacting to this prediction. It is worth remembering that oil is currently trading above $90, and Raymond James is predicting this price will hold for 2008. “We believe that the market’s negative response correlating a slowing U.S. economy with ugly energy fundamentals is simply wrong,” noted his Raymond James Energy Stat of the Week in late January. “To begin with, our oil supply/demand model already incorporates a U.S. recession, as well as a significant increase in OPEC production. Simply put, the U.S. economy must slow due to limited oil supplies.”

 What Does All This Mean? 

If you are an independent operating in the Gulf of Mexico, this means you have a guaranteed market for the foreseeable future. If you are a public company, it means you present an excellent opportunity for investors to take advantage of continued demand.

As the international market for oil and natural gas continues to stabilize and other economies compete for oil that would otherwise have been earmarked for the United States, the need for domestic production increases significantly.

Companies sitting on reserves of oil and natural gas in the Gulf of Mexico will be insulated from any price decreases because global supply will not be available to fi ll our needs at a lower price. As prices increase and supply goes to competing economies, we may even see other areas reopen for drilling in the United States.

This vision may appear far-fetched, but a recent look at a study done by the California Energy Institute suggests otherwise. From 1978 to 2001 the population of California was polled regularly on their willingness to allow offshore drilling. Most of us in the industry would have called a public mandate to drill “highly unlikely” at best.

But surprise: In 1981 the number was over 50 percent. In 1998 the number was less than 20 percent, and by 2001 it had leaped to approximately 45 percent. As best the researcher could tell, the rise was directly related to the price of gasoline. 

Well, gasoline prices in the United States are at an all-time high. Internationally, we are receiving no sympathy from economies that already pay twice what we pay for the same commodity. So it rests with United States to fi gure a way out of this mess. You could also imagine that, if given the choice, our independents would rather deal with the U.S. government and produce domestically than chase reserves in the far-fl ung nations of the world.

Relying on our government to put policies in place to check this high-priced environment is one thing we can count on not happening, so here’s the bottom line: Holding hydrocarbon reserves in the United States is a good bet on a go-forward basis.

The savvy economist, investor, politician and consumer ought to be encouraging as much development as possible. However, with policies like the renewable fuel standard and corn-based ethanol, restrictions on drilling sites, and emissions standards that prohibit diesel cars, we cannot foresee anything that brings those prices down. Bring on those 35-miles-pergallon cars!

© 2008 Richard Loomis & Susan Salter
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