Growing Energy In Kansas

John Mauldin - Mon 18 Apr, 2005

"...Opec is beginning to like $50 oil...but as the price remains high, and Chinese demand increases, market forces will replace the worlds dependency on oil with other, cheaper fuels...and other sources of less expensive oil..."

Oil prices may temporarily spike to $80 a barrel during the next two years if there is a major supply disruption, said OPEC's Acting Secretary-General, Adnan Shihab-Eldin, last month. "I can stress that the probability that the price of a barrel of crude rises to $80 in the near future is a low probability," Shihab-Eldin told leading Kuwaiti daily al-Qabas in an interview in Vienna.

"However, I can't rule out the rise of a barrel of oil to $80 in the coming two years," he said. "But, if the price rises to this level for one reason or another (for example a shortage of supplies from a producer nation by one or two million barrels per day), it's not expected that this spike will last long."

Prices around $50 or $60 a barrel, if they continued for two years or more, would increase investment to expand supplies and curtail demand, pushing down prices in the end, he added. "This is an essential law of economics," Shihab-Eldin noted.

OPEC is becoming increasingly comfortable with $50 oil. Only a few years ago, the consensus was that $50 oil would reduce demand and create the potential for a worldwide recession. Since a global world recession would not be good for world demand, and thus oil prices, OPEC leaders targeted $22-$28 oil. They were not being nice. They simply wanted to make sure their customers would be financially sound enough to keep paying. This is somewhat like cocaine dealers being concerned about their customers in order to keep up their business.

Since $50 oil has not created a recession, there is no constraint upon OPEC to work to reduce prices from here. However, the fact is that OPEC can do little about bringing down oil prices even if they wanted to.

Here's how it used to work. During the 50s and 60s, America produced all the oil it could use and essentially controlled the price of oil. Much of US oil was then produced in Texas. The Texas Railroad Commission had (and still maintains) regulatory authority over the production of oil in Texas. They limited the production of oil so as to maintain a price that would allow oil companies to make a profit and thus continue to be able to pump oil.

In 1971, the Texas Railroad Commission allowed oil producers to go to full production, as demand had outstripped supply. That gave control of oil prices to OPEC and they moved to increase prices dramatically in 1973-74. Up until then, the TRC could raise or lower the price of by simply increasing or decreasing their production.

World oil demand is around 80 million barrels of oil a day. If you increased oil production by, say, 2 million barrels a day over world demand, within three to four months there would simply be too much oil sloshing around and no place to put it. Prices would drop, and if production did not also drop, the price of oil could go down dramatically.

The consensus view is that OPEC has maybe, possibly or potentially the ability to produce an extra 1 million barrels of oil a day. Given that much of the world's oil producing capacity is in politically unstable countries - the various tribes and factions in Nigeria are constantly threatening war with each other...Iran, Iraq and Saudi Arabia are not paragons of political stability...and then there is the madman that runs Venezuela - it is quite easy to imagine a disruption will affect far more oil production than this estimated 1 million barrels of oil a day.

World oil demand is currently surging far higher than normal rates. During 1991-1999, annual world oil demand growth was about one million barrels a day. In 2004, that spiked to an additional 2.5 million barrels per day. The Energy Information administration (EIA) in Washington estimates that world oil demand growth will be more than 2 million barrels per day for the next two years.

A third of that oil demand growth comes from China, which is no surprise, of course. The need for oil comes from two primary sources. First, China now has 20 million cars. That demand is only going to increase as estimates are that China will have between 120 million and 145 million cars in a mere 15 years from now. (China's air pollution is already among the worst in the world. It is going to get worse.)

Secondly, all the new industry in China creates a huge demand for electric power. Electricity is primarily produced by coal in China. The problem, however, is that there is simply not enough electric power production capacity, and thus much of Chinese industry has resorted to buying their own generators, most of which are powered by diesel fuel. Optimistically, this means that as China brings on more power plants, it is possible that the diesel generators will be replaced. This will more than be offset, though, by increased demand for oil brought about by new cars and an emerging middle-class lifestyle.

It is clear the demand for oil is only going to rise. And this is just China. When you factor in India and the rest of Asia, there is a real potential for global demand to out-produce near term potential supply. And any increase in demand-over-supply by 2 million barrels a day will ultimately mean much higher oil prices.

Now let's be clear that nobody really knows how high oil prices will go in the rest of this decade. Personally I think that a rise to $70 oil would start to negatively impact the US economy, and increase the likelihood of a recession. The US recession would affect the rest of the world negatively, and thus we should see a drop in the price of oil.

But as noted above, there are numerous unpleasant political possibilities. Some of the less stable oil-producing parts of the world could seriously, even if temporarily, spike the price of oil to $100. Anything is possible, but not everything is likely. While I do think we will see $100 oil in the coming decades, I would be surprised if we see it that high in this decade.

Ironically, in my opinion, $100 a barrel oil is the solution for high oil prices. Has anybody noticed that ethanol is selling for less than unleaded gas on the futures market? Today, unleaded gas on the futures market is $1.66. Ethanol June futures are "only" $1.21. In the future, it may be cheaper to run you car on environmentally friendly emission free ethanol. And yes, I know the US government, for one, subsidises ethanol. But a $0.45 differential is huge. Who would have thought that would be the case five years ago?

Dennis Gartman tells me the Athabasca Sand Tars in Canada is roughly three Saudi Arabias. They can now get oil out of the sand at a cost of roughly $11 a barrel. So in the future, instead of buying oil from OPEC, America will grow it in Kansas and mine it in Canada. Oil at $100 will force market solutions for other energy sources and whole new industries and technologies.

The Cassandras who predict that the world will run out of energy simply don't get it. Yes, we will eventually see oil production peak and then begin to fall. But it will not be a calamitous over the waterfalls type of event. It will simply be a gradual lessening of production.

That need for energy will be replaced by other energy sources. Such a change will be disruptive, but then most change usually is. That change will of course increase the number of potential opportunities for investors. This is a sector that I want to keep a close eye on.


Regards,

John Mauldin
for The Daily Reckoning