GREENBACKS GREASE OIL
By Eric J. Fry
Question: How is a dollar bill like a barrel of crude oil?
Answer: It isn't.
Significance of the answer: 1) Oil prices will rise; 2)
Merger and acquisition activity in the energy stock sector
will increase.
Dollar bills and crude oil are different...very, very
different.
For example, dollar bills, while easily combustible,
provide very little energy when burned. As such, they are
not an ideal fuel for heating homes or for powering
automobiles.
Crude oil, on the other hand, is a poor substitute for
dollar bills. Although crude may be a worthy competitor to
the U.S. dollar as a store of value, it is not widely
accepted in Madison Avenue boutiques. What's more, crude
oil makes a mess of wallets and purses, and it gums up ATM
machines when deposited.
Although the dissimilarities between dollars and oil are
numerous, one specific dissimilarity may be exerting a
powerful influence over the price of crude oil: dollars are
plentiful; oil is scarce.
Dollars are plentiful, of course, because they are so easy
to create. They fly off the printing presses at the U.S.
mint, billions at a time. But creating crude oil requires
several geologic eras – give or take a few billion years.
Because dollars are plentiful and crude oil is scarce,
large holders of the former have become increasingly
interested in exchanging them for the latter.
We suspect it is no mere coincidence that China, one of the
world's most conspicuous buyers of natural resource assets,
is also one the most vocal critics of the dollar's
reliability.
Last night, Fan Gang, director of the National Economic
Research Institute at the China Reform Foundation, shocked
a standing-room crowd at the World Economic Forum in Davos,
Switzerland, when he volunteered, "The U.S. dollar is no
longer – in our opinion is no longer – [seen] as a stable
currency, and is devaluating all the time, and that's
putting troubles all the time."
No doubt, China is but one of many nervous dollar holders
who may increasingly become eager oil buyers.
"The key to the oil price, we believe, lies not so much in
the ratio of reserves to production," observes James Grant,
editor of Grant's Interest Rate Observer, "but in the
position of the dollar in the global economy..."
"The dollar exchange rate is – ultimately – going down.
[Therefore], commodities denominated in dollars will, other
things being the same, tend to become more expensive in
dollar terms...
"Last summer, a Hoboken, N.J., money manager exactly
summarized the petro-monetary situation. 'Awash in a sea of
dollar debt,' wrote Jes Black to the editor of the
Financial Times, 'the world now finds itself in short
supply of tangible goods and the opportunity cost of not
transferring these paper dollar claims into hard assets is
too great. If and until the Fed shows it understands the
dilemma, too much money will fuel ever higher oil prices.'"
In other words, the bull market in crude oil is one part
monetary and one part geological – and the monetary part is
becoming increasingly important. Many large holders of
depreciating dollars want to spend them while their dollars
can still purchase something of value. Crude oil certainly
qualifies. Oil-producing companies with significant oil and
gas reserves would also qualify.
Clearly, the abundance of dollars, alone, would not be
sufficient to fuel a bull market in crude oil. Rather,
oil's relative scarcity is half the bull market equation.
"The oil industry now faces significant exploration
challenges," say Wood MacKenzie analysts, Matthieu
Castellani and Andrew Latham. "Overall oil discoveries from
new fields have replaced only 40% of production."
"The 1990s saw major advances in the opening of exploration
acreage to the international oil industry," the pair of
analysts explains. "Changing geo-politics and technology
were the principal drivers. Much of what became available –
like deep water – was previously undrilled or at least had
not been explored with modern techniques. Accordingly, the
oil companies...made very significant discoveries.
"But life is now getting harder for the explorer," say
Castellani and Latham. "There is no escaping the fact that
oil and gas are finite resources: the more that have been
found the less that remains to be found...Reserve
replacement is a critical issue. A super-major like BP
needs to add around 1.3 billion barrels of oil equivalent
(boe) each year – more than 100 million boe each month – to
sustain its position. Between them, western majors need to
find the equivalent of an Angola every 15 months or a UK
North Sea every 18 months just to stand still."
As we observed in the November 2, 2004 edition of the Rude
Awakening, "Mineral exploration, like a kind of cosmic
Easter egg hunt, becomes increasingly difficult the longer
the hunt proceeds. Today, most of the world's oil explorers
are finding that the best chocolate eggs are long gone. The
only goodies remaining are a few stray jellybeans and some
candy wrappers. So the big oil companies are turning their
attention, instead, to the candy store known as Wall Street
to satisfy their permanent craving for new reserves."
To illustrate the diminishing returns of energy
exploration, we presented the chart below, courtesy of Wood
Mackenzie, illustrating that the commercial value of oil
and gas discovered by the 10 largest energy groups over the
last three years was well below the sums spent to find
them. In 2003, for example, the top 10 oil groups spent
about $8 billion hunting for oil, but only found about $4
billion worth of the stuff.
"We believe that exploration cannot continue to be the main
growth engine for the majors as it has in the past,"
Castellani and Latham conclude. "The majors will have to
find new ways to explore or find other ways to grow."
Acquisition, rather than exploration, seems to be one of
the most plausible means of "growing" reserves. And a few
oil companies are beginning to figure this out.
Late last year, Noble Energy offered $3 billion to buy
Denver-based Patina Oil, one of the four major purchases in
2004 of an energy company with significant Rocky Mountain
natural-gas assets.
Yesterday, Cimarex Energy Co. continued the trend by
agreeing to purchase Magnum Hunter Resources Inc. for about
$1.5 billion in stock.
But Western oil companies do not have the marketplace to
themselves. Increasingly, they are brushing shoulders with
buyers from the East. As oil companies in the West jockey
to replace reserves, oil companies from the East are
stepping up their efforts to secure future supplies. The
more these two buyers bump into each other, the more
frenzied the shopping is likely to become.
Since 1990, according to a paper by Philip K. Verleger Jr.,
senior fellow of the Institute for International Economics,
oil demand in China and India has soared 7% a year. Over
those same 14 years, world demand has grown by only 1.3% a
year – INCLUDING the demand growth in China and India.
Therefore, as Asian demand continues to boom, securing
future supplies becomes an increasingly vital economic
imperative. The Chinese oil companies seem to have gotten
the message, as they crisscross the globe to ink joint
ventures and takeovers in the energy sector.
"[Foreign] state-owned oil companies that don't answer to
shareholders appear willing to pay premiums for oil and
natural gas they desperately need to meet long-term
demand," Barron's reports. "Chinese companies are
outbidding their western counterparts or access to new
reserves in places like Venezuela and Russia. Recently,
China National Offshore Oil was reported to be interested
in Unocal, which has significant Asian reserves."
As merger and acquisition activity intensifies in the oil
patch, the values of nearly all mid-sized oil and gas
companies should appreciate. Some will be acquired and some
will merely begin to reflect the values an acquirer might
pay. Barron's suggests Occidental Petroleum and Anandarko
Petroleum as potential takeover targets. Outstanding
Investments editor Kevin Kerr has also recommended a few
select mid-sized oil companies that could catch the eye of
an oil-hungry suitor.
"This may go down as the year of the shopping junket for
energy companies flush with cash from high oil prices,"
Barron's concludes. "Now investors need to figure out what
will be in the shopping bag."
Maybe so, but we wouldn't advise trying to guess the next
mid-sized oil company to catch the bouquet. Rather, we'd
suggest seeking solid companies and riding the powerful
trends already in place: a crude oil bull market, enhanced
by a U.S. dollar bear market.
-------------------------
Did You Notice...?
By Eric J. Fry
Is the crude oil market fast approaching a geologic
"tipping point?" David Goodstein thinks so. Goodstein, a
vice provost and a chaired professor at the California
Institute of Technology, believes that the world is running
out of oil. He says so in his new book, 'Out of Gas: The
End of the Age of Oil.'
"Goodstein's new idea (new, at least, to us)," James Grant
reports, "is that the moment of truth will come not on the
day when production ends, but rather on the day that it
slows. That is, the real bull market in energy begins when
a declining rate of production crosses a rising rate of
consumption. 'That means,' Goldstein explains, 'the crisis
will come when we've used roughly half the oil that nature
made for us.'"
"The Goodstein thesis is both less radical and more radical
than it first appears," Grant continues. "Over the 1995-
2003 span, total additions to the known supply of oil
(technically, energy "liquids") outstripped global
production, according to a report from HIS Energy, a Denver
oil and gas research and consulting service. Of course, as
HIS readily acknowledged, oil is a finite resource. Mankind
started with 2,285 billion barrels, it says. We have
prod! uced 1,020 barrels. The remaining resources of 1,265
billion barrels imply global liquids depletion of 44.6% at
end-2003. In other words, humanity is 5.4 percentage points
away from the Goodstein halfway mark."
Flash Update! The world has consumed about 30 billion more
barrels of oil since the end of 2003. Therefore, the
world's remaining crude oil birthright has slipped to about
1,235 billion barrels. In other words, humanity is now only
5.1 percentage points away from the Goodstein halfway mark.
Based on current consumption trends, planet earth should
arrive at the halfway mark sometime around New Year's Eve
2007.
[Ed. Note: Ubiquitous commodity trader, Kevin Kerr, is in
the news again. He was commenting on a new 3-month high for
gasoline, and was quoted by MarketWatch. "We are not seeing
any build in supplies and this is going to turn into a
major problem as winter fades and we head into peak driving
season," said the editor of Resource Trader Alert.
"The market needs to see big buildups in the fuel, but it's
seeing exactly the opposite for now," he said. "The shift
of focus is going to be on unleaded."
AI
