Financial Sense Storm Watch Update "There is No Plan B" by Jim Puplava 10/14/2005

“The oil crisis is very, very near. World War III has started.

It has already affected every single citizen of the Middle East.
Soon, it will spill over to affect every citizen of the world.”
Ali Samsam Bakhtiari, Vice President of the National Iranian Oil Company

The oil crisis has arrived in the United States. This summer’s storm season exposed the Achilles heel of the U.S. economy: OIL. We have reached what system analysts refer to as ”a single point of failure.” It is the one item that if it breaks down, it brings the entire system down with it. Like it or not the U.S. economy runs on oil—cheap oil—and we are running out of it. Oil powers our economy in manufacturing, transportation, and agriculture. Without it, our economy would cease to function. There is no other commodity other than water that can have such an effect on how and what we do. Oil is the lifeblood of our economy.

For three decades the energy infrastructure in the U.S. has been neglected and allowed to decay. Now those chickens are coming home to roost. Politicians can bluster and pontificate all they want, but this will not solve the predicament that we now find ourselves in. The plain fact is we are running out of oil and natural gas. Oil production in the U.S. peaked in 1970. Since then, the United States has not been able to supply its own oil needs. As a result of this failure, it lost control in its ability to influence the world price of oil. This has led to a loss of control over an important part of its economic destiny.

Today the U.S. economy is now totally dependent upon foreign sources of oil and natural gas. Our country has also moved to dependence on refined oil products such as gasoline, diesel and jet fuel due to a lack of refinery capacity; a problem that will only grow worse with time. Since reaching a peak in 1970 energy production has declined each and every decade. On land in the lower 48 states oil is tapped out. Production in the lower 48 is less than half of what it was in 1970. Production in the North Slope of Alaska peaked in 1988 at 2.017 million barrels per day (mbd).[1] Alaskan production is now down to less than half of that. Oil production on the North slopes is expected to have fallen 4% in 2004 and by another 1% this year.

Running out of oil and natural gas isn’t the only problem. Spare capacity is disappearing throughout the entire energy infrastructure. As shown below “Houston, we have a problem.” Everywhere you look there are either energy bottlenecks or constraints. What little spare capacity we had left was eliminated by Katrina and Rita.

CAPACITY CONSTRAINTS

Oil and gas wellhead
Refineries
Pipelines
Tankers
Drilling Rigs
Processing plants
Personnel

STORM DAMAGE

108 oil & gas producing platforms destroyed
53 major platforms heavily damaged- offline until 2006
342 offshore platforms still evacuated- assessing damage
12 refineries & 21 gas processing plants remain offline
As of last week, 90% of Gulf crude oil production is shut-in
72% of Gulf natural gas production remains offline

To say we are in a crisis is putting it mildly. The United States will find itself moving from one energy crisis to another in quick succession. In the near future, we will see oil and natural gas price spikes, brownouts, gas lines and eventual shortages. There is nothing, I repeat nothing, we can do to prevent these crises from erupting. It is already too late for that. Decades of neglect, inaction and political dithering is the culprit. Rome burns while our politicians fiddle.

For the optimists energy conservation will not stave off the day of reckoning. You can’t conserve what you don’t have. Boosting CAFÉ standards by 6.8 miles per gallon by 2015 would only trim US oil demand by 2.5%, or 610,000 barrels per day, according to the E.I.A. The U.S. imports about 12 million barrels of oil a day, representing about 58% of our total energy demand. That percentage is growing every year and you can now add refined oil products to that growing list of imports. And if you think things are going to get better just because prices have fallen recently--think again. What is occurring is just a reprieve before other energy storms arrive. Prof. Michael Economides, who predicted $65 oil in the summer of 2004, is now predicting $100 oil within a year. By December Economides believes we will see $20 natural gas and $5 diesel fuel by next summer. Economides laments that his predictions of $100 oil no longer impress. On September 15^th, in a speech at the Houston Petroleum Club, Matt Simmons talked about $200 oil by 2010. Simmons is so sure of his predictions that he’s willing to bet anyone $5,000 that he is right.

Consumers, businesses, and government seem vexed at today’s rising energy prices. Yet we did not get here overnight. It has been a long process that has been building for decades. The current crisis is attributable to a combination of a growing demand for oil from growing economies, Asian industrialization, and declining supplies. Oil discovery peaked in the 1960s and since 1985 we have failed to replace the oil we consume each year. A bear market in energy gave us lower prices, which encouraged consumption at the same time it discouraged investment. Finally a combination of tight environmental restrictions and NIMBY (not-in-my-back-yard) and BANANA (build absolutely nothing, any time, near anybody) brought opposition to exploration and drilling, the building of refineries, pipelines, power plants and refineries. A look at the different aspects of our crisis in oil should illuminate the future problems we face.

Crude Oil Production
The crisis we now find ourselves in goes back decades as the gap widened between demand and sources of supply upon which the world has come to rely. As shown in the table below global oil demand has increased in every decade since the first oil crisis in the mid-'70s.

As the table above illustrates, demand increased each decade and then accelerated in the mid-'90s as a result of the technology boom and the industrialization of China and India. While demand was growing the rate of increase in oil production began to slow during the early '80s. According to many oil experts, production appears to be approaching a well-defined limit in the not too distant future.

Oil discoveries peaked in the 1960s and most of the oil we consume today comes from giant Middle Eastern oil fields that were discovered and put into production over 40 years ago. Most of the world’s key oil producers have already experienced peak oil. According to Richard Duncan, director of the Institute on Energy & Man, 25 out of the top 45 oil producers are past their peak. These 45 producers account for 98.7% of the world’s oil production. Another study done by Washington energy consultants, PFC Energy, found that 33 out of the 48 major oil-producing countries have either peaked or plateaued.[2] Moreover many of today’s large oil producers such as Russia and Mexico have failed to replace their production over the last decade. Mexico’s oil production is expected to peak this year with the peaking of its largest oil field, Cantarell. Even worse, we find Saudi Arabia may also be close to peaking as Matt Simmons posits in his book “Twilight in the Desert.”

The Oil and Gas Journal estimates that the United States has about 21.9 billion barrels of proven oil reserves as of January 1, 2005. The bulk of these reserves (80%) are concentrated in only four states, Texas (22%), Louisiana (22%), Alaska (20%), and California (18%). As of 2003, top producing areas of the U.S. include the Gulf of Mexico (1.6 mbd), Texas onshore (1.1 mbd), Alaska’s North Slope (. 949 mbd), California (.683 mbd ) , and Louisiana onshore (.244 mbd). Hurricanes represent a clear and present danger to the U.S. because nearly half of our oil and gas production and refinery capacity is located along the Gulf of Mexico. We saw examples of this last year with Ivan where 7 platforms were destroyed and 6 incurred major storm damage. Over 150 platforms and 10,000 miles of pipeline were struck by Ivan’s fury. This year hurricanes Katrina and Rita were far more damaging as noted earlier. Paul Hornell with Barclay’s Capital Inc., London, said, “The supply-side deficits in US oil product market remain cavernous, with demand effects dwarfed by the size of the product gaps.” In his October 5^th report Hornell stated: “The cumulative loss of crude oil output due to Katrina and Rita is now close to 50 million bbl and is likely ultimately to extend beyond 100 million bbl. We now expect the cumulative level of forgone refinery output to close in on 200 million bbl, with the cumulative reduction in gasoline output alone now expected to stretch towards 100 million bbl.”[3]

Hornell points out that all of this is occurring at the same time that US crude oil production is at it lowest level in 60 years. Moreover, the greater part of the storm’s disruption hasn’t been fully reflected in the energy supply data.

In summary US crude oil production has been in a multi-decade decline. US production began a steep decline after the price collapse of the mid-1980s. Production leveled off during the mid-1990s, and began falling again after the sharp price declines of that decade. By 2003 production had fallen to around 7.8 million barrels per day, of which 5.7 million barrels was crude oil. The average production is a little over 5.5 million barrels a day by the end of 2004.[4]

The net result of falling production and growing demand is that the US has had to increasingly rely on energy imports. According to the Energy Department total net oil (crude and products) imports amounted to 11.8 million barrels a day during the January-October 2004. This represents 58% of total US demand. Of this amount 2.4 mbd comes from the Persian Gulf (1.5 mbd from Saudi Arabia), 1.3 mbd comes from Venezuela, 1.1 mbd comes from Nigeria. These areas remain politically unstable and could be subject to supply disruptions at any time. For now the only energy policy the US has is based on carrier battle groups.

Refining Capacity and Downstream Processing
The United States has experienced a steep decline in refining capacity between 1981 and the mid-1990s. The number of refineries fell from 324 in 1981 to 149 in 2003. This steep decline in refining capacity resulted from the removal of price controls and allocations, which kept many marginal refineries in business. Many of the early refineries that shut down had little downstream processing capability and were economically viable as long they received subsidies under Federal price controls. In addition to the removal of price controls, a bear market in energy and narrow refinery margins produced low rates of return on capital. Average returns on capital were not much more than 5.5% during this period. Other factors included environmental constraints that imposed major capital expenditures and legal suits which only added to costs. The net result of all of these factors is that refinery margins—the difference between the cost of input and the price of output—have squeezed profit margins at the same time that operating costs and the need for additional investment to meet environmental mandates has grown.

The net result of this combination of negative factors of poor returns on capital, environmental constraints, and narrow profit margins is that no new refineries have been built in the US in nearly 30 years. The industry consolidated and refinery capacity shrank from 18.6 mbd to 15.7 mbd by the end of the '80s. Since then existing refineries have increased capacity by 28% from 1990-98. As of September of last year capacity grew to 16.9 mbd.

Growing Demand and Stricter Guidelines
While refinery capacity in the US has shrunk over the last two decades gasoline, consumption has risen by 45 percent. The US Energy Information Agency is forecasting annual growth of 1.8% for motor gasoline, 3.1 % for jet fuel, and 1.5% growth for distillates.

Demand for refined petroleum and natural gas products is projected to continue to grow. However, these refined products are going to get more expensive due to environmental regulations. Robert Bryce at World Energy Monthly is forecasting that $5 diesel fuel is coming soon. “The surging cost of diesel over the next 12 to 18 months will be caused by new regulations, capacity constraints throughout the midstream and downstream, and soaring demand.”[5] According to Bryce beginning next June, American refiners will have to reduce the amount of sulfur in their diesel from 500 parts per million (ppm) to 15 ppm. In addition beginning in January of next year refiners must also reduce sulfur in gasoline from 90 ppm to 30 ppm.[6] This is the biggest change to motor-fuels since leaded gasoline was phased out three decades ago.

Bryce is predicting major disruptions in the ultra-low sulfur diesel (ULSD) market as a result of these new EPA mandates. The mandates add additional blends of gasoline to the already myriad blends required by different state, city, and federal environmental regulations. Now refineries will have to make up to 50 different blends of gasoline. These different blends will require special segregation in storage and shipping. Segregation of the different fuels will require more tanks and special pipes since they can’t mix different environmental blends of gasoline. That means more costs for refineries, which translates into higher costs for consumers.

All of this takes place next year when the US energy industry will still be making needed repairs to our damaged energy infrastructure as a result of the last two years of storms. Moreover, the US now imports over 1.1 million barrels of gasoline a day to meet demand. In the case of ULSD it is doubtful whether foreign refiners like Venezuela will make the added EPA changes to their refinery mix. US EPA standards are far stricter than those of Western Europe, Asia, or Latin America. Refiners could decide to ship their diesel outside the US in order to avoid the heavy costs of compliance. At the same time foreign exporters could refuse to comply with US EPA standards. Therefore the US may not be able to rely on foreign imports to meet its growing demands. Meanwhile demand will continue to grow for diesel fuel as many US and foreign car manufacturers are adding diesel engines to their product line due to better fuel efficiencies. What we have here is the classic case of the wrong policy at the wrong time. If you’re upset over $3 gasoline, you better buy some Zantac, because $4 and $5 gasoline is not too far away.

In a recent speech Saudi Arabia’s Foreign Minister Saud al-Faisal warned that the world energy crisis has reached a “very dangerous” situation, with lack of refinery capacity a major cause. He said that Saudi Arabia, the top exporter of oil is the only country left with spare capacity to produce oil. “The basic problem of the current energy crisis… is that current refineries are incapable of meeting demand on oil products, shortages in storage capacity and restrictions imposed on the oil industry thus paralyzing it from building more refineries…Not a single refinery was built in the United States in the last three decades, while the difference in standard requirements on oil products from one state to the other inside the United States, particularly due to environmental concerns, has greatly deteriorated the energy crisis, he said."[7]

So where does all of this leave us? I believe we are in the first stage of a developing crisis that will lead to further and even larger crises down the road, if not war. The first crisis, which we now find ourselves in, is related to the approaching peak and decline of non-OPEC oil production. This predicament is behind much of today’s high oil prices. Other factors include the combination of growing demand, driven mainly by China and the United States, and restricted output from Iraq.

The inability of non-OPEC production to meet incremental demand after its projected peak after 2010 precipitates the second crisis when OPEC spare capacity runs out. As non-OPEC production declines, OPEC capacity will have to increase just to stay even, much less to increase supply. The third crisis arrives when OPEC production peaks. Many expect this to occur in the next decade. Of the eleven members of OPEC, several have already reached their peak—Indonesia, Iran, Kuwait, Nigeria, Iraq, and Venezuela. As mentioned earlier global oil discoveries replaced only half of the oil produced last year. We stopped replacing the oil we consume each year in 1985. We have been running energy deficits since then. This tells me that the second stage of the energy crisis could soon be upon us.

The US now finds itself in an eerie parallel to the energy crises of the 1970s. In viewing the past crises I find similar parallels and list them as follows:

The US has now left itself vulnerably exposed on the energy front. We are more dependent today than we were during the crises of 1973 and 1979. Oil production in the US has fallen each decade, falling 40% since its peak in 1970. As a result of this decline imports now represent 60% of our energy needs. Even more worrisome is that even if we could import all the oil we need we wouldn’t have the refinery capacity to process it. As demand has increased we now have to import more of our refined energy products due to capacity constraints. The ability to import refined gasoline will be limited by the new environmental standards ,which are unlikely to be adopted by foreign refineries.

What we in the United States have yet to deal with is the fact that the era of high energy and mineral abundance is gone. Whether we will be able to maintain our present standard of living is questionable. At present we are financing that living standard with borrowed money, most of it from overseas. This presents a problem. According to Dr. Walter Youngquist, in order to maintain our standard of living, each person in the US requires 20 tons of mineral resources each year.[8] Since our ability to produce these resources diminishes each year, we have to rely on imports to provide them. This in turn impacts our balance of payments. This cannot go on forever. The US may reach a point where foreigners are no longer willing to accept dollars in payment or if they do they may demand higher rates of return. As Youngquist states, “It is a clear statement that the oil industry is no longer centered in the United States as it was for nearly 100 years. The significance of this is that oil resources, so vital to American industry and the national economy and way of life, are now chiefly in foreign hands. The oil companies may be American, but they are subject to the rules, regulations, taxes, politics, and whims of foreign governments. That was a vastly different situation from before 1970 when the United States was still self sufficient in oil.”[9]

Given the crisis that the U.S. now finds itself in you would think the nation would be mobilizing and moving forward to solve its problems. Instead politicians and the media are still playing the blame game focusing on irrelevant issues which distract from the problem at hand. In the words of General Honore at a press conference at a time of an approaching emergency (Hurricane Rita) he responded to a reporters irrelevant question by answering, “You are stuck on stupid, I’m not going to answer that question.” [view statement] This is where we still find ourselves today. We’re still stuck on stupid. With 12 refineries and 21 gas processing plants still out of commission, 90% of our Gulf oil production shut in, 72% of our natural gas production offline, 503 oil platforms destroyed, heavily damaged, or abandoned, energy imports soaring, and a rapid decline in non-OPEC oil production it would be time to be putting “Plan B” into effect. Instead our politicians dither. Last week the House of Representatives narrowly approved an energy bill aimed at encouraging construction of new refineries. With close to 50% of the US refinery capacity concentrated in the Gulf States in the direct path of hurricanes, supporters said the recent storms demonstrated that the country needed more refineries, including new ones outside the hurricane belt. The bill passed 212-210. Not one Democrat voted for the bill and several Republicans broke rank in opposing it. The prospects of the bill passing in the Senate are uncertain. Maybe another hurricane season is needed to convince our fiddlers. Not having built a refinery in over 30 years one might think it would be time to add capacity, especially given the fact that gasoline consumption has increased by 45% since the last time one was built in this country.

Adding new refineries is only one aspect of ”Plan B.” We need to seriously look at our whole energy infrastructure in transportation, our energy power plants, the electrical power grid and alternative sources of energy. Does it make sense to be building natural gas power plants, if US and Canadian natural gas production is in decline and we’re unwilling to allow natural gas exploration or LNG terminals to be built? We need to be exploring new technologies for developing coal into gasoline as well as sources of electricity. Rethinking nuclear power is another option that should be explored along with wind and solar. With non-OPEC oil production close to peaking the clock is ticking with not a minute, hour, or day to waste. God help us, if Matt Simmons is right. In that case, we move quickly to the second and third stage crisis in energy. And if that happens, then it is war.

We should also be rethinking the transportation of goods in this country. The cost of trucking goods coast-to-coast will be too expensive and impractical as oil prices escalate. The movement of goods by rail and boats is far more energy-efficient. This means it is time to rebuild our rail system which is a shadow of its former self. Our transport sector relies on oil for 97% of its energy needs. It also accounts for 68% of our oil consumption.[10] Alternative forms of transportation such as mass transit in our larger cities and more fuel efficient cars—hybrids and diesel—should also be explored. And to ameliorate the bottlenecks in gasoline we need to agree on only a few varieties of environmental grade gasoline. Do we really need 50 different varieties of gasoline? Does every major city or state need its own version of environmentally clean gasoline? Can’t the experts agree on one formula? A Heinz-57 approach to our environmental needs is not only costly and inefficient, it is also insane.

As Matt Simmons points out in his book “Twilight in the Desert”, the purpose of “Plan B” is to buy time until “Plan C” where a new source of energy is developed or invented. “Plan B’ is essentially a series of bridges that buys us time in the period of transition to a new form of energy. It means doing everything that works. We know that wind and solar work as do coal and nuclear. But none of these sources of energy is a silver bullet. The problem regarding oil is there is no energy replacement on the horizon that can replace it. Creating new forms of energy is no easy task. We’ve only done it twice in the last 1,000 years. Coal replaced firewood and oil replaced coal. As the price of oil and natural gas inexorably rise all other forms of energy become more competitive. Finding a new source of energy to replace fossil fuels may be the most daunting task ever to face mankind but it needs to be done. Otherwise it will be forced upon us. Once the world arrives at peak oil, rationing and conservation will become the norm. This is why “Plan C” is critical. Getting to “Plan C” involves accelerating R&D efforts which should begin immediately and that means today.

Today’s high energy prices are a warning to mankind. They can be ignored in the hope that the problem goes away or they can be faced head-on by acknowledging that they exist. As I was penning the final words to this Storm Update I was made aware of an article published on the web called “Oil Shockwave.” On June 23, 2005, a group of nine former White House cabinet and senior national security officials gathered to simulate a future energy crisis. Their task was to advise an American president on options in dealing with a major oil crisis over a seven-month period. The key findings of this group were as follows:

Rather than review Oil ShockWave in this Storm Watch Update, here is a direct link to the Energy Commission's presentation. The point is that high level personnel in government and in the private sector are thinking about these things. This summer's storms is a case in point. They demonstrated just how vulnerable we really are. These officials met on June 5^th, oblivious of this summers hurricane patterns, but cognizant enough of our own vulnerabilities to supply side disruptions.

While their study deals with different geopolitical scenarios from political unrest in Nigeria (a key oil supplier to the U.S. ) to a terrorist attack on Saudi oil facilities this report only scratches at the surface of our vulnerabilities. Other key tipping points would include the following:

What the world faces is growing competition over increasingly scarce oil and other natural resources like water and minerals. The reality of this scarcity is just beginning to be understood. The race is on to secure these limited resources. No one understands this better than the Chinese. A booming domestic economy, rising exports, rapid urbanization, and a growing domestic appetite for automobiles is driving China’s foreign policy. State-owned companies are scouring the globe, buying resource companies in North and South America, securing exploration and supply agreements with states that produce oil and gas, while at the same time courting these same governments through investment and the building of goodwill. Like the US, China is attempting to secure access to foreign resources, the cornerstone of its economic growth. This growth is totally dependent on foreign resources, a fact that makes China insecure and vulnerable.

Its insatiable appetite is giving various governments concern, especially the United States and Japan. Like China both countries are dependent on foreign oil, a fact that makes all parties uncomfortable. David Zweig and Bi Jianhai writing in Foreign Affairs describe this delicate balance. “While China struggles to manage its growing pains, the United States, as the world’s hegemon, must somehow make room for the rising giant; otherwise, war will become a serious possibility. According to the power transition theory, to maintain its dominance, a hegemon will be tempted to declare war on its challengers while it still has a power advantage. Thus, easing the way for the United States and China—and other states—to find a new equilibrium will require careful management, especially of their mutual perceptions.”[11] Similar rivalries in the past forced Britain into an arms race with Germany that eventually led to war. Likewise, US foreign policy initiatives designed to check Japan’s imperial ambitions by cutting off access to oil led to conflict with Japan. History shows us that resolving these competitive conflicts is not done easily. More often than not, the need for resources has led to war.

China’s success on the trade front and its ability to use its economic weight in securing trade deals is making the US uncomfortable. China has made major inroads into America’s backyard. It has secured oil deals with Venezuela, made agreements to develop Canada’s natural gas, oil sands and uranium deposits, gained access to minerals in Brazil, and formed oil agreements with Iran, Sudan, and Myanmar.

The next big test according to Zweig and Jianhai will be if China decides to flex its economic muscles by expanding its military influence. While many nations are disposed favorably to Chinese trade, they are increasingly uncomfortable with China developing military power. Meanwhile, China believes it must protect its trade routes. It is expanding its navy, giving it the flexibility of both defensive and offensive positioning. It is helping Pakistan build a port at Gwadar. It is also upgrading a military airstrip in the South China Sea, monitoring stations in Myanmar and it is negotiating naval facilities in Bangladesh.[12] China’s military power is growing and Washington has taken notice. So far its expansion has been friendly and out of necessity to protect trade. Interested parties hope it remains that way.

Whatever way this friendly competition resolves itself the world—and especially the United States—must acknowledge the impact of China’s energy needs. Its voracious demand for energy will only get bigger as its economy continues to develop and expand. After the United States, China has become the second largest consumer and importer of oil. In 2004 it accounted for 31% of global energy growth. Politicians, economists, and analysts will have to get use to a new variable in the international oil markets, a variable that will impact demand, supply, and prices—named China. You can throw the old energy models out the window. They are no longer relevant.

The ideas expressed in this update may startle and stun but they are real. The US now finds itself facing the first of many energy crises to come. We should have been working on “Plan B” years ago. While a few experts admit we have problems, Washington (especially Congress) and the mainstream media are caught up in denial and the blame game. In the words of General Honore, they are still “stuck on stupid.” Politicians love to point figures at everyone but themselves. In trying to assess blame they avoid dealing with the issues at hand. There are three basic reasons that we have crises:

this failure and avoidance is why we find ourselves stuck in a crisis. Many of the issues ofnew sources of energy, declining refinery capacity, and bottlenecks in the electrical grid system have been evident for decades. It seems it takes a crisis to bring them to the forefront. Let’s hope we can get beyond “stupid”, it could mean the difference between peace and war.

There are many today that feel oil prices are heading back to $40 a barrel. I’m not one of them. Oil prices are more likely to see $100 a barrel before we see $40. There are others that believe oil stocks are overvalued. I don’t agree. Oil stocks are still cheap and the recent pullback only makes them cheaper. As shown in the three P/E graphs below, after peaking in 1999, P/E multiples have fallen and are at an all-time low. Even though many energy stocks have doubled or tripled in price they still remain undervalued. This is because earnings have grown at a far faster pace than stock prices. Many energy companies like ExxonMobil, Chevron-Texaco, and Apache have seen their earnings triple or quadruple while their stock prices have only doubled. Price earnings multiples in the energy sector are close to the bottom of their historical range. This means they could have ample room for expansion. Finally, there are quite a few experts that believe the energy bull market is over. I disagree. We’re a long way from the final inning. We are going to need more oil and natural gas as demand continues to outstrip supply. We are going to need more alternative energy sources as non-OPEC oil production peaks. Finding and developing new energy sources takes time as does building infrastructure. The first energy train left the station long ago. The second train is about to embark. All aboard!

For those not familiar with the peak oil argument or its political ramifications, please see two earlier articles that I wrote in 2002: PowerShift: Money, Oil and War and Hubbert's Peak.

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	Storm Watch Update THERE IS NO PLAN "B" by Jim Puplava www.financialsense.com October 14, 2005