Wall Street History

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Wall Street History

02/03/2006

Energy Review, Part II

In his “State of the Union” address, President Bush did what
every president since Richard Nixon has; call for America to
reduce its dependence on Middle East oil. This didn’t go over
well in the Middle East, particularly in Saudi Arabia where the
kingdom feels like it’s done its part to keep production up at
existing levels rather than cave to hardliners in OPEC such as
Iran and Venezuela who seek production cuts. But that’s a tale
for “Week in Review.”

As a follow-up to some of the information I supplied on the
energy sector last time, the Wall Street Journal, via the Energy
Information Administration, had a good table the other day on
the top ten foreign suppliers of crude oil to the U.S.

The following nations account for about 50% of U.S.
consumption. Overall, the U.S. imports 60-65% of its oil (12.5-
13 million barrels of oil per day) out of total consumption of
20.5-21.0 mmbd.

1. Canada .supplies the U.S. with 2.1 mmbd
2. Mexico 1.6
3. Saudi Arabia 1.5
4. Venezuela 1.5
5. Nigeria 1.1
6. Iraq .0.534
7. Algeria 0.483
8. Angola 0.468
9. Russia 0.410
10. UK .0.400

So you can see why disruptions in hot spots such as Nigeria and,
potentially, Venezuela, can shake things up and force the U.S. to
make up the difference elsewhere.

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Switching gears, former secretary of defense, secretary of
energy, and director of central intelligence, James Schlesinger,
recently wrote a piece for the Winter 2005/06 issue of The
National Interest.

Titled “Thinking Seriously About Energy and Oil’s Future,” it’s
a good outline of the current predicament facing all consumers of
crude.

Schlesinger addressed the run-up in prices. There are both
substantial cyclical elements as well as “contradictions” at work.

“For several decades, there has been spare capacity in both oil
production and refining. Volatile prices for oil and low margins
in refining have discouraged investment. The International
Energy Agency, which expresses confidence in the adequacy of
oil reserves, urges substantially increased investment in new
production capacity and has recently warned that, in the absence
of such investment, oil prices will increase sharply. Such an
increase in investment clearly would be desirable, but it is more
easily said than done.

“In the preceding period of low activity, both the personnel and
the physical capacity in the oil service industry have diminished
- and it will take time to recruit and train personnel, to restore
capacity and to produce equipment. It is interesting to note that
the capacity of OPEC itself has shrunk in this last quarter-
century from 38 million barrels per day to 31 mmbd. The bulk
of the shrinkage occurred in Iran, Iraq and Libya, which have
been the targets of both U.S. and international sanctions.”

With increasing demand from China, India and the U.S.,
production levels are an increasing concern.

“Three additional points should be kept in mind. First, crude oil
production capacity has not been wholly exhausted. The
minister of petroleum of Saudi Arabia, Ali Naimi, points to the
unutilized 1.5 mmbd in his country and states that he stands
ready to serve additional buyers.”

But this extra capacity is largely unusable by U.S. and other
refiners, it being of the heavy, sour crude that Saudi Arabia could
bring onto the market in an emergency. [Valero Energy is one
refiner that can process it easily and this is one of the many
reasons why that company in particular has been rocking and
rolling the past few years. That is NOT a stock recommendation,
however. I don’t do that here.]

Schlesinger continues:

“Second, it is the international oil companies (IOCs) that have
lots of cash. Their inclination has been to invest in new
production capacity, counting only on prices being in the range
of $20 to $30 per barrel – and not necessarily expecting the
current high prices to be sustained. But while the IOCs have the
cash, it is basically the national oil companies (NOCs) that have
the reserves.”

For the most part, the NOCs aren’t allowing the IOCs to take
equity stakes, though there are signs this is beginning to change.

“Third, when gasoline prices are rising, public anger rises at least
correspondingly. Public anger immediately draws the attention
of politicians – and here in the United States it elicits a special
type of political syndrome: wishful thinking.”

Such as on talk of energy independence.

In the 1950s and 1960s, “oil production and consumption more
than doubled in each decade. Annual growth rates in
consumption of 8, 9 or 10 percent were typical.”

But no one expects a doubling of production in the future. Most
forecasts are for 50%, max, over the next two decades. In other
words, increased production will not be able to meet rising
demand.

The biggest problem in terms of crude production is the simple
fact there have been only a handful of big discoveries since 1975.
Recently, Kuwait Oil Company said its Burgan field, the world’s
second-largest, is now past its peak production. News like this
plays into the hands of the Hubbert’s Curve enthusiasts.

M. King Hubbert was a geologist who years ago forecast that
production in the United States would level off around 1970 and
he was dead on. Dissenters, though, have in Schlesinger’s words
“a deep (and touching) faith in the market mechanism – and a
belief that over time market forces can adequately cope with any
limits on oil supply. In the extreme, some economists have
regarded oil supplies as almost inexhaustible.”

Personally, I’m in Schlesinger’s camp. The former secretary
concludes, “(The transition) away from conventional oil as the
principal source of energy for raising the living standards of the
world’s population will be the greatest challenge this country
and the world will face – outside of war. The longer we delay,
the greater will be the subsequent trauma. For this country, with
its 4 percent of the world’s population, using 25 percent of the
world’s oil, it will be especially severe .

“Both people and nations find it hard to deal with the inevitable.
Even though it was long recognized that a Category 4 or
Category 5 hurricane would inevitably strike New Orleans, a city
substantially below sea level, Hurricane Katrina reminds us that
political systems do not allocate much effort to dealing with
distant threats – even when those threats have a probability of
100 percent.

“We should heed a lesson from ancient Rome. In the towns of
Pompeii and Herculaneum, scant attention was paid to that
neighboring volcano, Vesuvius, smoking so near to them. It had
always been there. Till then, it had caused little harm. The
possibility of more terrible consequences was ignored – until
those communities were buried in ten feet of ash.”

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Wall Street History returns next week.

Brian Trumbore

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