The Trade of the Century
Erik Townsend: This week on the Financial Sense Newshour, Jim Puplava is pleased to welcome Erik Townsend, a successful private investor living in Hong Kong. Jim and Erik discuss the case for peak oil arriving sooner than later, and the investment opportunity this presents to the educated and nimble investor.
- Jim Puplava: Energy: The Defining Issue - October 2010
- Erik Townsend: Peak Oil Investing - November 2010
- Spread Backwardation Annotated (image chart 2247x1024 pixels)
Peak Oil Reports & Resources
- UK Peak Oil Taskforce Report - February 2010
- Kuwait University Study - Forecasting World Crude Oil Production - February 2010
- The Joe Report - US Military - February 2010- the peak oil assertions are buried deep inside (see p.29), and certainly not underlined in the summary.
- Oxford (Smith School) Study- The Status of Conventional Oil Reserves - Hype or cause for concern? - March 2010
- Chatham House - LLoyds of London White Paper - Sustainable Energy Security - June 2010
- German Military Report (leaked) on Peak Oil - Der Spiegel Online - September 2010
- New Zealand Parliament - The Next Oil Shock? - October 2010
- IEA World Energy Outlook 2010- Presentation to the press - November 9, 2010 - London
- Chris Martenson's Analysis of the recent IEA report - November 23, 2010
- Oil demand growth reverts Brent to backwardation - Reuters - December 3, 2010
Jim Puplava:Welcome everyone to the Financial Sense year-end special review and as I mentioned last week and as we mentioned in the first hour we're going to be doing a special program as our year-end special. We're going to be talking about topics that we think are going to have a major impact in the future. Rather than sit back and look at the year that just has passed by us, and say okay this was a key event, this was a key event, this is where the market is, we're gonna do something different, and we're gonna talk about things that are gonna occur in our belief in the future.
And joining me in this hour is Erik Townsend. He's a private investor out of Hong Kong and in this hour we are going to talk about something that we call the perfect trade. And Erik, just to give us a little background for our listeners, why don't you just give us just a brief background on your own background and why the two of us are talking about peak oil today.
Erik Townsend: Sure. First of all Jim thanks for having me on the program. It's a pleasure to be here. I was a, uh, entrepreneur in the software business; technologist and entrepreneur, and sold a company in 1998 and I was 33 at the time, so I was really too young to be retired. I tried to do that and needed to have some kind of intellectual stimulus and really found that reinventing myself as a private investor and running my own assets as a full-time job, was the most fulfilling thing than I could've ever asked for. It's a lot more fun and more interesting than running a software company was.
The reason that we got together on this particular call is I think we're looking at just an incredible trading opportunity and the reason I say that: if you think about what's a good trade? Well a good trade is when you're right about something, when you get the fundamentals right and you understand what the bet is that you're making and you make it intelligently. But a really incredible trade is when the market has it dead wrong and therefore the market is mis-pricing assets and you have an opportunity to get something at a steal of a price.
Now an example of that would be something like the very famous story of John Paulson and Paolo Pellegrini, who was his cohort, who did the incredible trade at CDS [credit default swaps]. They saw that CDS was really junk paper and the rest of the market was saying. "no no no, this stuff is Triple-A rated. This is really great. These bonds they have these fancy things called CDOs [collateralized debt obligations]. These really smart people do this financial engineering and it's all wonderful." And they were saying, "No, this is liar loans. This paper is backed by lies. This has to come falling apart."
And I think what we're seeing in the market now, as we'll get into, is this concept of variant perception where what goes on in the market is very different than the picture that you and I see with regard to peak oil.
Jim Puplava:And as we get into what we're calling trade of the century I think Erik it's very important that we give our listeners some background because there's two perceptions that one can walk away when we get into the perfect trade. Either Jim and Erik are wrong about peak oil, therefore the market is right, or the market is wrong and Jim and Erik are right about peak oil, so I think as maybe a set up to what we called the trade of the century is that we need to get into a background in terms of our peak oil story and why we think this is real in why this is setting up or providing the fundamental backdrop for this trade of the century. *
Erik Townsend: I couldn't agree more Jim. I think that the amount of news that we've had this year about peak oil is staggering, just going through the headlines I think would be very helpful for the listeners. But you've been studying this peak oil thing for a decade now so what in your mind are the key things that people need to understand about the problem?
Jim Puplava:You know, I'm a sailor, you're a sailor, Erik. So I tend to use weather analogies but I really think we are heading into another perfect energy storm. And it's made up of three components in my opinion.
- First of all is rising demand and I don't need to share with our listeners and especially Erik in your neck of the woods where you're living in Hong Kong, rising energy demand that's coming from China, that's become the second-largest economy in the globe, India and also rising demand coming from OPEC, so we're seeing a new element of demand come in to the marketplace that we didn't even think about 10, 15, 20 years ago.
If you thought about energy demand you always thought about what was going on in the US economy. Today a more important development is the developing world and especially China. So the first part of the perfect storm is rising demand.
- The second element is what I call tighter supply. But we've seen a number reports beginning with the IEA's 2008 World Energy Outlook they came out and said, Guess what, "We've looked at 800 of the world's largest oil fields that account for most of our energy and the depletion rates are running much higher than we thought possible."
A second element is ever since 1968 decade by decade we are discovering fewer or making fewer discoveries and the discoveries we're making are becoming smaller and smaller.
Another element is restricted access. The Obama Administration, for example, recently just by executive order have ruled out offshore drilling for the next five years. So there's restricted access.
- And then another element under tighter supply is the energy industry is under-investing. So the second element or the second storm front is tighter supply, the first one is rising demand, and then the third one is called infrastructure decay. The late Matt Simmons used to talk about this rather frequently—whether you're looking at drilling rigs, whether you're looking at the work force within the energy industry—it's aging. Steel rusts...the platforms, the drilling rigs, the pipelines, the whole infrastructure itself is decaying and that is, I think, the three elements that are going to form what I call the perfect energy storm.
Erik Townsend: OK, Jim, so if you were to summarize peak oil, what would you tell us just to net it down for the listeners?
Jim Puplava:If you want to take a look at where we are right now, Erik, I think you could summarize it by number of key points:
World oil production is at or near maximum production currently.
Second, when the decline begins, were going to start seeing shortages. They'll begin to develop and they'll increase each year until some form of mitigation kicks in; either conservation, new forms of energy, maybe, uh, gasification, liquid fuels, who knows what that's gonna be, but there's a number of issues out there that we could probably address at another time.
As the shortages begin, we're going to see oil prices will begin to escalate just very much in the same way that we saw this happen in 2005 and 2008, between that period of time, and it's going to produce economic damage. It's definitely gonna harm economies. You know a lot of people talk about how the worldwide recession that we experienced between 2008 and 2009 was all due to the credit crisis. I would say that's only part of it. I think part of the reason that we went into recession was triple-digit oil prices.
But like anything else when there is a problem there's always opportunities and that's what we're gonna get to later on in this broadcast.
Erik Townsend: you know Jim, to me 2010 was the year of peak oil because I've been following this for several years as you have. But 2010 was just an inundated year in terms of the data that came out starting in February. Maybe what we should do is not review of all the information that we've received this year.
Jim Puplava:Yeah, that's the thing that I find most astounding about this topic and it first alerted me in August of 2009. There was a study that came out called, "Global Oil Depletion," and it was by the UK energy research center and it was verifying, Erik, the IEA study that came out in 2008.
Well then beginning in February we had that peak oil task force. They came out with a major study called, "The Oil Crunch," which was the second report they published. Unfortunately their first report came out with the IEA's report back in 2008 and, of course, in November of 2008 nobody was paying attention to oil. Oil prices were going down. We were worried about whether the credit system was going to hold up.
In February of this year the United States joint force command, the "JOE Report" came out and they said by 2015 we could be facing 10 million barrels a day shortfall in oil production.
Again in February the University of Kuwait came out with a major study forecasting world crude oil production and they were confirming the UK task force, by the middle of the next decade we were to be in trouble. And I thought. "Wow!" Just back to back three studies in a single month. But then we go further.
In the month of March we had a report come out from Oxford University and they did a study on the status of conventional world oil reserves.
June of this year, Chatham House and Lloyd's of London came out with a report called, "Sustainable Energy Security," where they're telling people, "Look, if you have a viable business model, you're a major corporation, and energy is a large component of your cost structure, you'd better rethink your energy structure or you may not survive in the decades ahead."
August, the German military came out and they called a drastic oil crisis, and then in September, we had the Parliament of New Zealand.
So it out here we had private industry, here we had the US military, the German military, Oxford University, Kuwait University, Parliament, government entities all coming out, Erik, saying the very same thing. And we talked about it.
And then once again the last thing they came out was November recently is the IEA World Energy Report, where they all but admitted that conventional peak oil peaked in the year 2006, although many of us believe it was May of 2005, and more importantly when they're talking about the year 2020 and 2030, and this is something you and I going to get to a later on, but as you look out into the future, they always had these demand forecasts: "OK, you're gonna have 'X' amount of barrels of demand coming from China, the developing world, the OECD countries. By 2020 demand will be 'X.' By 2030 demand will be 'X.'" And they always had the supply. Supply was always equaled the demand. But if you look at where the sources of oil are coming from, there was a big plug number called "yet to be discovered oil.'' And that figure has gotten larger and even the IEA itself when you look at their future oil projections, that forecast is becoming down rather dramatically, and you read the IEA report. Didn't that astound you when took a look at, because here's an organization that saying, "those numbers [aren't] going to be what we thought they were."
Erik Townsend: Well it absolutely astonished me not only for the reasons you said but also IEA, has kinda little bit of a reputation for being too conservative for trying to paint a rosier picture than there really is about the situation perhaps trying not to panic people.
Chris Martinson wrote an excellent piece right after the IEA came out, which actually goes through not just this IEA report but the last one and the one before that and the one before that and the one before that. And what does is he has a graph that actually compares what they said in each of their reports. And they keep quietly revising their numbers downward in terms of what they think we're actually going to see in production and then they keep increasing the size of that "plug number." So they keep trying to make it look like everything is flat, but the "plug number," which fills the gap between reality and what the world, you know, the reality of what we can produce and what we actually need keeps getting bigger. I sent you a link to that I think we can get it up with your producers for the background information on the show.
Jim Puplava:Yeah, various, very astutely pointing out year-by-year how these numbers are coming down, which brings me to the next thing that ah I want to set up here. And that is: we've heard all kinds of people that believe in peak oil from the oil guys to the analysts to the geologists to the consulting agencies and what I find rather remarkable is you've got all of these kind of projections when peak oil will occur. And guys like oilman T. Boone Pickens, former Shell geologist who worked with M. King Hubbard, Ken Deffeyes, the late San San Bakteri, head of the Iranian national oil company—they all believed that conventional oil would peak around 2005. And since May of 2005 we have yet to beat those numbers. I think it was 74.3 million barrels a day and we're now on the 73.
Then you have a group of people: the late Matt Simmons, Colin Campbell, Chris Skrebowski from Petroleum Review, the head of the University of China, Stat Oil geologists and they're coalescing around the 2010–2011 period, and it's amazing, Erik, as you and I are speaking on this Thursday, we've got oil prices that are close to $88 a barrel, $89 a barrel.
And then you get into the sort of that 2011 to 2015 period, where you have guys like Charlie Maxwell, senior energy analyst at Wheaton & Co., Merrill Lynch, Sadad al Husseini, retired Saudi Arabia executive, Christophe de Margerie, head of CEO or CEO of Total, and Wood MacKenzie.
And then there's a whole group I call the "Cornucopian," and we need to talk about it because not everybody believes in peak oil. And that's Daniel Yergin's group CERA, Cambridge Energy Research Associates, the US Energy Information Agency, the IEA and Exxon/Mobil. And so they don't believe we have a problem 'til after 2030.
So it's amazing in addition to all these studies and the headlines that you and I are talking about, the majority of people believe that somewhere in this next decade, whether it's this year or it's gonna be next year on the way to 2015 is when we start running into trouble and I think it is no surprise that we're looking at $88 oil on the day you and I are speaking.
Erik Townsend: Oh I think it's no surprise at all and, you know, it's interesting because EIA as you said has supposedly come across as a skeptic of all this, but I'm looking at a chart right now and I think we'll get this to your producers so we can get it out to your subscribers as well. It's a chart from the EIA and what it shows is this wonderful rosy as categories of where energy needs are going to be met, and there's this big wedge that starts opening up at about 2013 or so and it gets bigger and bigger towards 2030. And the category is called "unidentified projects," and I guess it just makes me think I'd like to go into a bank, Jim, and say, "Well look, I'd like a 100 foot yacht and a Lear jet, so I want to borrow $10 million and I'm going to pay you back using money from an unidentified job that I don't have." You know, what's an unidentified project?
Jim Puplava:Yeah, or unidentified profits from a trade you're gonna make or something.
Erik Townsend: EIA's own charts are showing that there's a huge gap there and it's the plug number that you're talking about.
Jim Puplava:You know to me...and I will come back to the year 2005, because 2005, Erik, was the turning point and I think a tipping point for oil. Several things happened. First of all that was the year the Robert Hirsch and Roger Bezdek issued a report. They were hired by the US government to study peak oil and the issued a report called, "Peaking of World Oil Production: Impacts, Mitigation..." In May of the same year Matt Simmons wrote, Twilight in the Desert the Coming Saudi Oil Shock. And in May of that very same year conventional oil peaked at 74.3 million barrels a day. And right after these three events in June government leaders, private industry, heads of state, former energy officials, CIA people got together and they put together a simulated program called, "Oil Shock, Oil Crisis and Simulation." And then in August and September of 2005 we were hit by the hurricanes Katrina and Rita and we saw what happened.
Erik Townsend: So of the various reports that you've outlined...I think that knowing that down to three different scenarios that we might expect over the next decade. Why don't we review those?
Jim Puplava:Yeah, the first one is production.
- Oil production is at a maximum capacity and we're at the point where no new oil fields can be found. In other words we're not going to find another Gharwar, another Cantarell, another North Slope, another North Sea, that's the first scenario.
- The second scenario is production is at or near maximum capacity but there are some large easily accessible fields that will be brought on stream. This is sort of like the Sara, the EIA and maybe the IEA scenario that you hear about, that is very common. That you hear, "Oh, we don't have to worry quite yet. We've got time." So that's scenario number two.
- The third scenario is, yes, there are new large oil discoveries to make. But there not going to be easily accessible and they're going to be difficult to extract from. So think about for example, the Tupi fields are those large oil discoveries in deep water off the shores of Brazil.
So those are the three scenarios. The second one is the maybe-you-know-we-don't-have-to-worry-yet scenario. The first one is no we've got a problem and that problem is in a developing get worse as we proceed into this decade. And the third one is we still have a problem. Yeah we're still going to be finding this stuff but we don't have the technology and current prices aren't going to support these kind of discoveries until oil prices get in the triple digits that can pay for this kind of production.
Erik Townsend: So of those three scenarios, the second one is the only one that doesn't paint a picture for much much higher oil prices. And if I understood you correctly, Jim, what you're saying is that there's all these great big, large fields that we're going to find. But the oil companies aren't finding them now they're going out and drilling in deep water in their ignoring these opportunities? I mean, it just doesn't make sense to me.
Jim Puplava:Yeah, I mean why wouldn't you, if you could sell oil at $100 a barrel or even $90 a barrel, why wouldn't you go out and start making as many these discoveries, ramping up your drilling budget, your exploration budget? Because if you can sell oil $90 a barrel, if there's all this oil out there, why wouldn't you? And we just haven't seen that.
And that brings up something that's very, very important and that was were the study done by Oxford University really struck me, because we have all this confusion between production, which is a flow rate issue, and oil reserves. And as you and I know, Erik, in the 80s OPEC doubled their oil reserves overnight in a three-year period without announcing any major discoveries. So Oxford University, their Smith School of International Studies, did an analysis of all the worlds oil reserves. They took a look at the Oil and Gas Journal, the world oil outlook, the IEA, the BP Statistical Review, and did an independent review. And the gist of it is they took existing oil reserves and downgraded them by 34%.
Now that's scary because the Oil and Gas Journal believes we have 1.4 trillion barrels left. World Oil thinks we are 1.2 . The IEA believes we have 1.2, and the BP Statistical Review. And here's the thing that this was something the late Matt Simmons used always remark on when I am on the program is that the way these reserves are done is they issue surveys to international oil companies and to national oil companies, and they go, "Why don't you tell us what your reserves are?" And they sent him back and they said, "Oh, our reserves are 'X' amount." And then it gets compiled and you see it come out in programs like the IEA and the BP Statistical Review with absolutely no audit whatsoever. It would be, Erik, like I don't know, you're a creditor and I keep telling you, "Well I have this big bank deposit. Can I see the bank deposit and audit it?" "No just trust me. This what the number is." And that's what Oxford University did in downgrading oil reserves by 34% that's a scary fact.
Erik Townsend: Well, that's scary to start with, Jim, but the other thing I think that we should explain here is that the mechanism that OPEC uses in order to allocate among the member countries, these quota systems that they use. The way they do that is that the quota is apportioned according to each country's reserves. What that means is that each country has a strong financial incentive to overstate their reserves. And they don't allow anybody to audit it. Pretty strong financial incentive to lie. What am I gonna do?
Jim Puplava:Yeah and it also makes the rest of the world dependent and it's kind of like the Alfred E. Newman approach to our energy problem, because we don't have a plan B right now.
And what people really don't understand I think is if you take a look at how we get our oil production today, you get the oil production from existing wells. These are wells that have been operating in production for a number years.
You also have new additions that are coming online each year. This is maybe a discovery that was made a decade ago and is now coming online. So it's bringing on new sources of oil, and then you have to subtract the depletion. The loss of the existing wells that you lose each year, and that equals current production.
So if we're going to meet all these future production forecast that you're seeing the EIA, IEA, and even though the folks at Sara...it all gets to this category we're going to show this graph and that gets that plug number, Erik, that you were talking about earlier, future yet-undiscovered-reserves.
And the remarkable thing that I find through all of this is that oil discoveries peaked in the 1960s. They peaked in terms of the number of new discoveries that were made, and they also peaked in terms of the size of these discoveries. And what most people may not realize is almost 20% or I think it's 25% of our oil comes from 20 oil fields, discoveries that were made 40 and 50 years ago. Discoveries like Ghawar and other fields that oil fields overtime is going to deplete. And the unfortunate thing is Ghawar, which is the largest oilfield ever discovered, it produced roughly 50% of oil production for Saudi Arabia. We have never found another Ghawar. We have not found another North Sea. We haven't found another North Slope, nor have we found let's say another Cantarell, which may be the closest thing that we have found the largest these and the largest discovery to date, and yet we still don't know what it's in a turnout to be and what will be in terms of its flow rate and what possible take to bring it and what technology will be required is the oilfield made by Petrobras off the coast of Brazil.
Erik Townsend: So to summarize all this, the lower 48 United States peaked in 1970 just about 40 years after the peak of US discoveries. It's now 40 years after the peak of global discoveries and we're seeing what appears to have been a May of 2005 peak in production, and we're expected to believe that somehow something magical is about to happen, and we're going to find a bunch of new fields that we haven't found, despite the fact that there's been very little capital expenditure in the industry in the last five years and very little capital expenditure is allocated for new projects over the next five years. It just doesn't add up, Jim.
Jim Puplava:No, it doesn't add up and if you take the lower level of the IEA's world depletion rate. And let's just say it's 4 1/2% to 6%. In 10 years were going to need, if we're going to reach the number that they think the world's going to need to grow their economies which is somewhere around 100 and 112 million barrels a day. At a four and a half percent decline rate, we're going to have to find, Erik, 75 million barrels of new capacity or in other words in the next 10 years we're going to have to find eight new Saudi Arabias. And I can tell you that's not happening. I mean if you take a look at oil production in the top 10 oil companies in the world, both international and national oil companies there's only three of them that are international in production is down with the exception of a few markets. And, yes, people are talking about deep offshore but, Erik, you need over $70 oil to make deep offshore profitable. And, yes, Canadian tar sands has a lot of oil in it, but you know you need $80-$95 oil to make that profitable. So where's all this undiscovered oil? And that's the plug number that you talk to anybody that says, "Do not worry. There is all this oil out there that we're going to make a discovery." Why we haven't done that in 40 years why people think will do it in the next 40 is beyond me.
Erik Townsend: The thing that just blows my mind about this, Jim, is the way the market is pricing this because if you look at the term structure of the crude oil market, it's not indicating that there's a problem at all. If anything the market is indicating that were going to have excess supply in the next five years.
Jim Puplava:Yeah, I want to this as we get into the trade, but I think what we need to do is set up, Erik, what I call the crisis window. Because it's what we're calling the trade of the century is what is going to provide us with that opportunity or that window of time. I would hearken this....it would be like John Paulson gone back to the year 2005 and 2006 looking at the credit market and building up his short position.
But I want add one more element before we get to be a trade of the century, and here's another element that is not being recognized in that is in the 70s the world operated under a fixed exchange contract system. So if you were Exon and you were buying oil from Saudi Arabia you had a ten year fixed contract with Saudi Arabia with some maybe price escalation clauses in it, and everything was done on a fixed-rate basis it was because of that that OPEC was able to embargo the US. And as a result of that embargo the US began to look for other sources of oil to compete with OPEC, other secure supplies and instead of fixed contracts they began to move this new oil into the spot market and into the futures market and we created this virtual oil pool. And that's basically been the environment that we have operated in from the 80s and 90s and pretty much throughout this decade. But that market is reversing itself.
Number one: you have countries like China and Russia that are going back to the fixed contract system. So when China invest $25 billion in Russia to get 300,000 barrels of production, and that's 300,000 barrels that have been taken out of the virtual oil pool. When China goes to Venezuela and buys three or 400,000 barrels. When they go to Iran, when they go to Africa, and likewise with India and other countries, the virtual oil pool for the OECD countries is shrinking every single year is more these national states like China and other countries begin to tie up with long dated contracts with oil, taking that oil off the market.
And this provides the other element that comes in here, is OPEC itself, because they are building two new petrochemical complexes in Saudi Arabia. The Saudis are saying: why should we just sell our oil why don't we make all the money we can from oil on all the refined products, gasoline, petrochemicals, diesel fuel, and jet fuel? So OPEC itself, which subsidizes oil to its citizens, I mean if you're a Saudi citizen or a citizen of Iran your unaware that the price of oil is in the world market say close to $90 a barrel, because you're probably buying gasoline at the pump at $.40 because it's subsidized. And so not only are they subsidizing their own population, but they are now building businesses like petrochemical complexes that are consuming more and more of their own product line.
And this sets up the trade of the century because if you look at the UK task force and all of these reports that Erik and I have been talking about that have come up since beginning of the year. They talk about this crisis window from 2010 to 2015. Erik, you trade in the futures market a lot more than I do, but before we get to the trade of the century, take us back to 2008. Because in 2008 we saw oil prices hit $147 a barrel in July of that year and then just begin to plummet, so that when we got to the spring of 2009 in the spot market versus the futures market the price oil came down to $32 a barrel. Because you know at that time I went into the futures market and bought oil but what I was paying for in the futures market wasn't anywhere close to what I was saying in the spot market. So why don't you explain for listeners, you spend a lot more time in the futures market, what was going on and the consequences of that because a lot of people saw oil dropped to 32 and they said, "See, it was speculators. There's no peak oil."
Erik Townsend: Sure. Well let's start by explaining a little bit of terminology in the futures market, because in a lot of investors are not familiar with it.
Let's suppose, Jim, that you want to buy some oil. You know you're the buyer, I'm the seller. And you tell me that you want to buy oil for delivery right now, or next month. Well, there's a price for that and the price that contract has been back and forth and the same kind of bid-ask system that stocks are bought and sold with. But if you wanted to buy crude oil for delivery next year well that's a different price and that is also bid back and forth between buyers and sellers. The difference between the price that you pay now and the price that you would pay for later delivery is called either "contango" or "backwardation."
And I don't know who makes up this terminology contango sounds to me like a ballroom dancing of your dance the contango? But what the word contango means is simply that the cost of oil is higher if you get later and lower if you get sooner delivery.
And that was the case at record levels back in 2008. So when you saw the selloff from $147 a barrel down to $32 a barrel, some people were saying, "Oh okay, is was just speculation. You know the real price was only $32." I think that's actually misleading because in my opinion the price of oil never really sold off to $32. What we had was a short-term clearance sale or because of the sudden crash in the economy the pipelines are full and the oil has to go someplace because there's no storage for it. So in the very short term the price was bid all the way down to $32. But on that very same day that it hit a bottom of $32, if you wanted to buy oil that was delivered six months later that I was gonna cost you $65. So we had a record contango meaning that the differential between the right now price in the later price blew out to an astronomical proportion. And that actually inspired a lot of traders at the time to start playing those spreads.
Jim Puplava:And let's talk about what happened during that period of time, because that was when I first entered into the futures market and I think I was buying oil at 66 bucks, even though the spot price was around 32. And because [of] that contango, the difference between the spot market in oil delivered into the future, I was buying oil in March and the December contracts were around $66. And so it was almost double the amount of the spot price. That's when a lot of traders began to say, "Wait a minute. If I can take delivery in the current market at such low prices. I'll just hold it in solid later on in a higher price."
And let's talk about the tanker trade in this floating inventory that developed as a result of this trade.
Erik Townsend: Sure. What happened there is because the contango had blown out to astronomical proportion, a lot of smart hedge funds said, "Well, wait a minute. If we charter a ship and we fill it up with oil and we buy it at $32, and we just anchored the ship and let it sit in the Gulf of Mexico someplace. We can come back six months later and we can lock in a price right now, so that we know we have no market risk. We'll lock in a price of $66. We're buying the oil for $32. We're going to double our money in six months." And they did exactly that.
Ever since then there's been a large amount of what's known as floating supply. And that use of the word floating is in the literal sense, floating in ships on the ocean. So the important thing to understand about what happened then, Jim, is that the market was assuming that prices were going to go way up in the future because everybody knew that that $32 price was not reality. That was a situation that was created by forced unwinding of speculative contracts in the futures market, the credit crunch, the lack of capital that everybody had. But everybody knew that in the long run prices were to go up much higher. And if you believe the peak oil story as you and I do, you can certainly understand why later prices should be higher.
So let's move to today. Now let's suppose that you told me you want to buy oil. You're the buyer. I'm the seller. And you want me to deliver oil to you one year from today, December of 2011. Well if I look at my screen as we talk here the price for that is $91.60 per barrel. So it could cost you 91.60 a barrel to get oil next year. Now suppose that you were to tell me that you wanted to lock in the price not for next year, but for five years out, all the way in December of 2015. Well, presumably if you expect that there's gonna be inflation between now and then, peak oil is coming. For crying out loud IEA just a couple of weeks ago all but outright admitted that the peak has already occurred. So you would expect a much, much higher number, a much higher price for 2015 oil wouldn't you? Wouldn't that make sense?
Jim Puplava:Sure, because if supply was to be in short demand and they're running printing presses which means that the value of our currency was going to be worth less. You know it was just like we've seen in other commodities this year. I'm looking at a screen, cotton prices are up 94%, wheat prices are up 52. I would expect that if I was looking out let's say December 2015, I'd be paying over a hundred dollars a barrel.
Erik Townsend: Well, and if you were to look six months ago at the market, that's exactly what you were seeing. Because right now it's $91.60 for the 2011 oil and there was a $10 contango in the market six months ago so you would've paid $101.60. Well, you know what the price is today, Jim? It's $90.26. It's actually a dollar and a half less to buy the 2015 oil than to buy the 2011 oil. Now that is called backwardation, because the price structure is turned around backwards, so that the later dated contracts are actually selling at a discount to the nearer term contracts. So what the market is telling us is that oil is the stay expensive to the end of 2011, but then it's going to get cheaper after that. The price is gonna come back down.
Now when this first happened it was December 3 that the market lapsed into backwardation. That was what I called you and said, "Jim, we've got to talk! 'cause this is just crazy!" I couldn't believe it was happening. So I did little to research and sure enough, Barclay's Capital did a report about a week earlier that correctly predicted that this was gonna happen.
But it's very interesting. I sent you link that I'm sure we can get up on the site of a Yahoo finance description of this Barclay's report. And basically what they're saying is that there's suddenly this tightness in the market that nobody understands. Well of course you and I understand why this tightness in the market,we've reached peak production, and that the economy is starting to recover, and we can't produce enough oil to meet demand. That's the reason for doing this.
What the consensus view seems to be is, well, OPEC doesn't like quantitative easing. They're kind of concerned about the dollar being deluded. So they're going to hold out little bit longer before they increase their quotas, make more oil available, then everything returned to normal and will be hunky-dory again. Prices will come back down and we'll all live happily ever after.
So the market is discounting this idea that there will be a short-term squeeze on supply, but it's all to get better in about a year or so. Now that is directly at odds with everything that you and I know about peak oil. And that's to me why it's so reminiscent of the subprime trade where people are saying, "No, no. These things are all triple-A rated by the rating agencies and they're always right and besides it's backed by the collateral of housing and housing prices always go up." Well, yeah, if you believe that that then it makes sense, but if you know better, it doesn't make sense. And I think we're looking at the exact same thing with what's happened in the crude oil market.
Jim Puplava:Yeah, and I've heard even one other explanation on one of the cable channels were they talked about this very thing, backwardation. Well, it is because they're expecting a double dip. The economy will get weak.
So you've got two explanations out there: one the economy weakens therefore, less demand for oil.
Or two: OPEC, once it gets over a hundred dollars a barrel, well they're going to crank up the oil production and they're to be of the pump out all the oil, which would bring the price of oil down. And you and I will be happy and we'll be back to three dollar gasoline at the pump.
The only problem with all of this, and this is surprising, is between 2005 when the price of oil hit 50 bucks and then went all the way up to $147 a barrel, not only was conventional oil production unable to increase, but OPEC did not increase his own production. So if they couldn't increase it when oil went from $50 to $147, Erik, why do you think the market believes that when it goes to a hundred they're going to be able to increase it?
Erik Townsend: It blows my mind. You know I contacted Charlie Maxwell, who's is an extremely well respected oil analyst, and he said he was as surprised as I was by this backwardation. He wasn't expecting it and he pointed out something else that I thought was very interesting. He said, look he understands peak oil, but even if you don't understand peak oil, if you just look at the CapEx [capital expenditure] that's been spent in the last five years, and the CapEx that's been dedicated to the next five years. There isn't enough expenditure to support increased production. Even if there was no peak oil problem you haven't spent the money that you have to on the rigs and the equipment necessary to produce more oil.
Jim Puplava:You know, it's amazing because I think last night (I stopped counting after 100 books), I just read Ken Deffeyes last book and it's called When Oil Peaked. It's currently out and I highly recommend people pick up a copy, because he brings up something that I think adds some relevance to what Charlie just said. And that was in the 1980s, slowly, but then gradually building up steam, the major oil companies began to cut back on their R&D departments. I mean why go out and invent new ways and more efficient ways of trying to go out and find more oil, when there wasn't a lot more oil to go out and find? And this certainly lines up factually with the number of discoveries and the size of discoveries they we're making. So the R&D department at major oil companies began to be slashed. The exploration budgets began to be slashed. And this gets back to the original IEA report that came out in 2008, when they said, "Look! Unless we spend equal the equivalent of $350-$360 billion a year, both national oil companies and international oil companies...we need to spend this equivalent every single year or we're going to be in trouble by mid-decade."
Well, if you're an oil company you don't have access to fields. In the last couple weeks Obama just took off shore drilling off limits and if you don't have any other places where you can find large deposits, why would you be spending this extra money? So this gets back to what not only Ken Deffeyes has talked about in his new book, When Oil Peaked, but also gets back to the comments that Charlie Maxwell said that, "Look at, when current production that we're experiencing right now, depletion rates and what oil companies should be investing, both national and international, it's simply not there." So it's another confirmation.
Erik Townsend: No, I think you're exactly right. You know the more that we see backwardation in the crude oil market, the more of a buying opportunity I think it is, because not only does that mean that for people who are trading the actual commodity you're getting a bargain on the long-dated contracts, but it also means that the market which is pricing equities and other investments is assuming that that forecast accurately predicts what prices are going to be in the future, and that means that oil-producing equities, oil service companies, NLPs, all the very different investment vehicles, I think are probably underpriced in this market.
The other thing that it's important to understand about floating supply Jim, when you have all this floating supply, and there was quite a bit of it because of the contango that existed until recently in the market. Well when the market shifts back into backwardation, there's no profit for the people that are operating those trades anymore. So what they do is they take that floating supply off of the ships and sell it into the market, and that temporarily floods the market with all of that floating supply coming into the market.
So I think that what we're seeing, you saw on the big run up from about $80.50 on the front month about a month ago all the way up to $91 or so and then it just kind leveled off, and we been a little bit range-bound for the last week or so. I think what you're seeing is a temporary effect where that floating supply is starting to come back into the market, and it's going to prevent a big up move price for a short period, but eventually I think you'll see a resumption of an upward trend in crude prices.
Jim Puplava:And so as we take a look at this market, Erik, there's either two things going on here: Either you and I are right about peak oil and this is presenting a unique opportunity in time, kinda like a once again going back to the analogy of the subprime crisis between 2005 in 2006, where the markets were telling everybody all this stuff was AAA rated, but guys like Paulson were saying, "No don't buy that," and they began to accumulate positions that would short against that. So as we take a look at the information that we've been talking about in this interview and as we now go forward, okay with all these facts we're going to have to boil this down to how do I make money on this?
Erik Townsend: Well I think that there's several opportunities, Jim, and it's important for the listeners to understand too that what happened then I think will happen again now, which is the market just is not see the impact of peak oil, and I think that there's room for this backwardation trend to continue. So, I think that the underpricing of assets could continue and therefore I would encourage people to think of this as a long-term trade, not something that they would do it as a short-term trade. Because it may take a while for the market around and I should qualify too, I am not a registered investment advisor and I can tell you what I'm doing but I do not intend to give investment advice to anyone else.
But as far as where the opportunities that I see in my own trading operation here, you got several ways to play this: You can play the equities, you can play the companies that operate in the crude market or in the refining companies or anything else, or you can play the commodities themselves. And I think it's important to differentiate the two.
It's much easier to play the equities. You buy stock. You got shares. You hang onto it. You don't have to worry about the complexities of commodity markets. I think that there's potentially a little bit of downside there, which is that we all know the price of crude oil is going to go up as it becomes more scarce. Now you would naturally assume that that means the oil companies will be profitable. I don't know if that's necessarily going to be true throughout the entire crisis, because I think this thing is going to be really, really, really bad for the world and I think that governments are going to be tempted to impose price controls, to impose windfall profit taxes, to potentially nationalize assets. There may be resource wars where oil companies' assets get destroyed as a result of military action. So if an oil field gets blown up by a bombing and everything that's there is destroyed, while the price of oil goes up, because it's even more scarce, but the profitability of the company that just had all of its assets destroyed, maybe doesn't do as well. So I don't think that equities are a bad play, but I think that people should understand the risk inherent to the possibility that various factors could cause the oil companies not to be profitable to the extent that the commodity itself sees and increase in price.
Jim Puplava:And you know something we now just remind our listeners. And Erik, you remember in 2005 when the price of oil shot from $50 to over $70 a barrel with Katrina and Rita, the Congressional hearings were they dragged all the oil company executives before Congress and called them raping the American public. There was talk about special taxes and we did that in the 70s, when the price of oil went from a couple bucks to $40 a barrel. We had a windfall profits tax and the same thing happened in 2008, where they had another investigation when the price of oil to $147 a barrel, and you had all these investigations and there was talk about slapping another windfall profits tax on these companies. You remember Exxon made $40 billion. They had sales of almost half a trillion dollars, and so they were looking at the profit not as a percentage of sales but the numbers themselves, and that indeed is a risk. And we all know that governments can become rapacious and especially our own government now which is in desperate in need of new tax revenues.
Erik Townsend: Absolutely and that's the reason that just my choice, my style, is to approach this market through the commodity primarily as opposed to the equities.
Jim Puplava:Okay so the first way that you can profit from this trade we mention, and maybe the more conservative one, would be go in to the equity market, you buy Exxon, you buy I don't know, a Devon, you by an international oil company, national oil companies, CNOOK, Petrobras, but you own stock in a company that owns oil, probably a conservative way to do it. Let's also talk about commodity ETFs. Now, up until recently, Erik, the second way to invest would be to own let's say a commodity ETF if you didn't want to go in the futures market. Let's talk about why that didn't work in the past but it may work now.
Erik Townsend: Well it may work better now, but I'm not sure it's a good long-term play.
The problem was that the contango that existed in the market, where the future price was constantly higher than the spot price. What that resulted in was as these ETFs rolled their positions over each month, and they were generally not very smart about the way that they did it. They would just buy the front month. The end of the month they would roll it over to the next month. Well, what happened is that each month they're losing a little bit of value to contango, because the next forward month costs a little bit more than the month that they just sold. So the more contango that exists in the market, the less efficient those are, and it creates what's called a tracking error, which means that an ETF that's designed to follow crude oil prices doesn't really track crude oil prices correctly. It tracks crude oil prices minus this loss that keeps occurring from the contango that exists each month.
Now if the market goes into backwardation and stays in backwardation, the opposite becomes true. You're not losing anything and in theory or maybe even gaining something as a result of backwardation, as the contracts roll over from month to month, and that's what the ETF is actually investing in. So a couple of problems though: I think the big move in crude oil prices will happen when the markets recognize, "Holy cow, peak oil is real! This is actually not of bunch of tin foil hat stuff. This is a real phenomenon and it's going to dramatically change the world." Well, that's when the market will go back into a steep contango. So just as you're getting to the point where the market is about to turn up and really make the big gains, that's when those commodity ETFs are going to become inefficient again.
The other problem is that even though there is long-term backwardation in the market now...the 2015 costs less than 2011...it's still true though that the January of 2011 costs less than the December of 2011. So we still have contango from right now up to the end of 2011 and the backwardation starts after the December 2011 contract, where the oil gets cheaper as you go further out. So the ETFs that are rolling all over every month are still going to be victims of this contango problem for the next several months. If they do get into a backwardation situation, I don't think it will last for the life of this trading opportunity. So for that reason I still think that even though backwardation kind of cancels out the problems that have plagued these ETFs, I think they're going to run into them again just at the worst possible moment.
Jim Puplava:So we've talked about two ways to play this. The first would be oil companies. We talked about the opportunities and the risk involved. The second would be a commodity ETF. Let's talk about the third and fourth way to play this, which would be futures and options on futures, which is the area that you and I are operating in.
Erik Townsend: Yeah, and I think, you know, before we do that, we should probably throw out a disclaimer here, which is if you've heard, you know for retail investors who might have heard that dealing in options can be like playing with fire if you don't really know what you're doing, trading futures is like playing with dynamite... (Laughter) ...or C4.
Jim Puplava:You know, Erik I think it's very important at this time as we talk about the four ways that we've been talking how an individual could take advantage of this unique opportunity. I think it's also important to mention at this time that this is a long-term investment. There are a number of things that could go wrong in the short term. We could get a double-dip recession. China could tighten its economy and slow it down as it did dramatically in 2008 where its demand for energy would decline. There are a number of things out there that are at risk out there, and I think it's very important to point out that you have to look at this as a long-term investment, a long-term trend, that there's going to be some bumps along the way. It's not going to work out perfect[lu], even when Paulson and Andrew Lahde started laying in their trades. In 2006 they were losing money for the entire year. They did not start to make money until the Bear-Stearns crisis hit around the spring of 2007, when their trades began to go positive. Up until then, thank goodness, they were well-capitalized, because those trades were losing money.
Erik Townsend: That's absolutely right, Jim. What my comment would be...I do think the price of oil could double from here, but it won't be if it gets cut in half first, and people really do need to think about planning how they're going to hedge or ride out the downside that could exist in the oil market before we eventually get the big move up as a result of peak oil.
I think that we can explain how these markets work as a matter of interest to people. I know that you do have some institutional listeners as well as some very sophisticated private investors listening, people who are futures traders and know all about this stuff. That's great for them, but if you don't fall into that category, for heaven's sake, work with a qualified broker and advisor who can give you sound advice on how to manage risk, because these are instruments that are really the turf of the professionals and its very easy to hurt yourself with them.
Getting into the futures market is fairly complex because you have to choose a contract that you're going to invest in. To just buy naked long positions say in 2015 futures, you can buy that contract, as I said earlier, for $91.50. The thing is that a futures contract, unlike an option, has an unlimited downside. If you use leverage to buy a whole bunch of contracts and take advantage of the leverage opportunity that's available in the futures markets, and the price of oil sells down as say a result of say a double dip or tightening in China more likely, that might cause demand destruction between now and when that crisis window is fully realized, you could lose your shirt and then some. So you really wouldn't want to be in the naked long futures position.
There are more complex hedged futures positions that are probably beyond the scope of what we're prepared to talk about on the show today. But there is a way to play this that's a little bit safer and that is to use call options on long-dated futures. So just to give you an idea of some prices are, I'm going to pull my screen up here and look at the calls on long-dated futures options. So if you wanted to buy calls on the December 2015 contract at the money, meaning that you, that the price of oil right now is about $90, you want the $90 call on 2015. That's going to cost you about $16.29. So what that really is telling you is that if you make that investment, you buy calls for $16.29 a barrel, the price has to go up by at least $16.29 now and 2015, in order for you to break even. Your maximum loss is that $16.29 a barrel and of course each contract in the futures market is 1,000 barrels. So the minimum investment will be $16,290 to buy one option contract. If the price of crude oil by 2015 has not gone up by at least $16.29 a barrel, so that would be about $106 a barrel, you're going to lose what you paid on the option. And you're going to have nothing left. If the price is considerably higher than $106 by the 2015 rolls around, you're going to make whatever profit there is between $106 and whatever the actual price of oil is. That gives you a way to play the longer-term futures contracts, so you don't have this role over of contango every month.
But you are paying a pretty significant premium for that optionality. $16.29 is a pretty significant move, but it's also over a five-year period. So just to put this all in context, Jim, what I'm seeing is a market that clearly does not recognize peak oil as reality. So one of two things is true: Either you and I are wrong and peak oil is not the big threat, the looming of impact on the markets that we think it is, and if that's true, we've got it wrong, the market has it right, and it would be foolish to make a speculative investment in something that's not gonna really come true. The other possibility is that we do have it right. The 100 authors that you've interviewed in the last several years have it right. The five or six reports that came out this year have it right and peak oil is real. If peak oil is real this market is not pricing it in, and that creates a buying opportunity that I think is absolutely fantastic.
Jim Puplava:Yeah, because you really are what I call the perfect trade and we're calling this the trade of the century, is the dynamic of this kind of environment where the fundamentals tell you something's wrong here, something's mis-priced, going back to, for example, the credit crisis back in 2005, when we were issuing all this junk paper and we were telling the world it was all AAA-rated. And there were people like Andrew Lahde of Lahde Capital. There are people like John Paulson that took a look at that and said, "No I don't buy that. Our research says that this is junk," and they started to build up positions. So that's the opportunity that I think provides, that's how fortunes are made. John Paulson is now a billionaire today as result of it and it's amazing he's moved into the gold sector as well.
So we've talked about this opportunity and we are going to list the eight or nine links to, some of these reports are free the UK task force, the Lloyd's of London report, the New Zealand Parliament report, so we're going to list the links. There eight of them up there that you can do your own homework. So don't just listen to Jim and Erik and say, "Okay, these guys, you know what maybe they're talking their own book here." Do your doing your own research and we're going to have those eight links. I am also going to have a link to a presentation that I gave at a resource conference and Erik you have a bunch of material and articles that we're going to put up there as well. So don't just listen to this broadcast and say, "Oh, this sounds like a great idea." Do your homework. Understand the most important thing that you need to understand the fundamental backdrop for this story, and whether you believe it and understand it, and therefore you can make a better informed decision.
We've also been talking about four ways to play this. We talked about stocks, we talked about a commodity ETF, and we talked about futures and options on futures. So there's four possible outcomes for this. And if you were choosing outcome number three, which is the futures market, or outcome number four, the options on the futures market, please get good investment advice. The futures market is not for the, let's say, novice investor. This is where the pros operate, this is where big money moves, and this is where if you don't know what you're doing, you can loose a lot of money. And so therefore are four ways to play it.
And Erik as we close, if our listeners, I just want to point out, you will be speaking, because we have a lot of European listeners, you will be speaking in April at the ASPO conference in Brussels, in Belgium. And so, you also have a website, so if people would like to follow some of the things that you're doing or the articles that you write, why don't you give out your website if you would.
Erik Townsend: Sure. It's www.eriktownsend.com. And unlike most of your authors that you interview, I don't really have anything to sell so the website is pretty primitive, there's not much there, but hopefully your listeners will find it interesting.
Jim Puplava:Yeah, and a final comment. It's amazing that I have not seen, you know we invest a lot in the energy area, but there is no pure peak oil fund at this time. There's been people that have talked about it, there's been orientation with that theme in mind, but there's none so far that I'm aware of.
Erik Townsend: (Laughs) I am acutely aware of that problem, Jim. I've actually been looking at launching an investment vehicle like that but at the moment nothing is registered and licensed, and I'm not prepared to talk about it publicly.
Jim Puplava:All right. Well we've been speaking with Erik Townsend. He's a private investor located in Hong Kong, and if you would like to follow Erik, you can go to his website at "www.eriktownsend.com." Erik's been my guest. Erik, thanks for joining us on the program.
Erik Townsend: It's my pleasure, Jim.
John Loeffler:This is our last full-blown show for the year. For the next couple of weeks we are presenting programs that we ran earlier in the year, based on what you people said you wanted to hear so we need to start by wishing everyone a Merry Christmas because we won't have a chance to do that before then and we hope that you have good time and a very prosperous and happy new year. Best bad news in town on the Financial Sense News Hour. And anything of interest over the next two weeks and then on into the new year?
Jim Puplava:Well coming up or the remainder of the year we do have two new book interviews. Next week Vitaliy Katsenelson will be my special guest. He's authored a new book called, The Little Book of Sideway Markets: How to Make Money in Markets that Go Nowhere. And then also on December 29, Quint Tatro will be joining me on the program called, Trade the Trader: Know Your Competition and Find Your Edge for Profitable Trading.
And here's something that we are going to be doing. We put a poll up for our listeners and we said alright, "Tell us your favorite program to run." And I was really surprised at how this turned out. Some of the things that I thought were important, weren't even mentioned. And there are some that were not important were. So here's we're going to do.
On the 25th, we're going to rerun an interview I did with Bob Prechter in June of this year. That was the most popular request by all of you. We'll also be running on the 25th, this is Christmas Week, Michael Newton, The Path to Tyranny. Also G. Edward Griffin, and then also in the third hour we're going to be running an Interview I did with James Dynes in July of this year. And an interview with Robert Hirsch on how we got into this energy mess. And then finally on New Year's Day, our guest will be Nicole Foss. It's a 37 minute Interview that I did in the middle of October that we talked about response to Peak Oil and deflation. Richard Russell. Also an interview I did with George Karahalios. And then Adam Ferguson and Colin Campbell. So we have a lot of great reruns. If you missed those shows from earlier in the Year in addition to two new book Interviews.
So on behalf of John Loeffler and myself, we want to wish you the best of a holiday season. Have a Merry Christmas, a Happy Hanukkah, a happy Kwanza, John have I left anything out of there?
John Loeffler:I usually just sum it up by saying, "Have a Happy Hannukwanzmas."
Jim Puplava:(Laughs) Okay, on behalf of John Loeffler and myself, have a Happy Hann...what was that again?
Jim Puplava:A Hannukwanzmas. (Laughter) And I hope the new year finds you healthy, prosperous and well.
*This belief constitutes Jim's personal opinion and should not be considered investment advice. Investors should always consult with their financial advisor before making investment decisions, and should make decisions that are suitable for their risk tolerance, age, net worth, and other factors.