The news and the markets

Dan Denning - Mon 16 Oct, 2006

...We continue to believe that the energy bull market is still in its infancy. The future will favour investors who buy into weakness in the oil and gas sectors...

 
 
- Russia has barred foreign oil companies from participating in the development of the mammoth Shtokman gas field in the Arctic.

- At least that is what Alexei Miller, chairman of Russian gas monopoly Gazprom, said last week. Gazprom has decided it will develop the Arctic field, 550km from Murmansk, by itself. "This field will be developed without offering foreign companies the right to its reserves," Miller said. "Gazprom will be the 100 percent owner."

- Whether the Russian's have the know-how to execute the project is another question. We recall a former US air-force pilot and Boeing Executive once telling us that the Russians can do more with less than any people on the Earth. We wouldn't put it past them.

- But the real significance of the announcement is that by excluding US oil companies Chevron and ConocoPhillips, Russia has decided to export future production from the giant field to Europe. Clearly, US oil companies no longer get "first dibs" on all of the world's new oil and gas discoveries.

- The Shtokman project also highlights two important trends. First, finding and developing conventional hydrocarbons like natural gas and oil is becoming much more difficult and expensive.

- You might be able to find lots of gas in the Arctic, but developing it is going to cost you. Second, energy producers are scrambling to replace their reserves and to keep global production steady at current levels.

- Global oil production appears to have hit a plateau at 85 million barrels per day. This confirms the peak oil theory that the production of the world's easily recoverable hydrocarbons has, in fact, peaked. So what comes next?

- That depends on how long the plateau is. We can chug along at this rate for awhile. Peak oil sceptics will take this relatively placid plateau as evidence that there is no oil problem.

- Prices will fall. Urgency will vanish. And then, one fine day, depletion will begin to hit the world's largest producing oil fields. You know, the oil fields that account for the bulk of the world's daily oil production.

- At the risk of repeating ourselves, we continue to believe that the energy bull market is still in its infancy. The future will favour investors who buy into weakness in the oil and gas sectors.

- In other news, is Kim Jong Il mad as a hatter or mad as a meat axe? The question interests us here at the Old Hat Factory, where the legacy of mercury-induced insanity seems to have produced a tolerance for eccentric behaviour. It doesn't matter if Kim Jong Il is insane, delusional, or a shrewd tyrant who chooses to dress in drab jump suits.

- What does matter is that the world's nuclear club may be adding a new and unwelcome member. Geopolitics is not our beat in this space. But money is. Does North Korea's bomb have investment consequences?

- So far, the markets have taken the bomb in its stride. This tepid response implies one of two possibilities: Either the market has no idea how to price the risk of a new, unpredictable nuclear power, and therefore needs more information, or, risk is so thoroughly hedgeable in this derivatives-empowered era that even the birth of a new-era of nuclear proliferation does not pose a threat to global capital flows.

- Our take? The devil is in the details. It is not the obvious big fall in an index that signals financial catastrophe. That would merely be a symptom. Catastrophe usually arrives in baby steps. For example, Bloomberg reports, "The risk of owning South Korean bonds surged.

- The price of credit-default swaps based on $10 million of South Korea's dollar denominated debt rose to $26,000 per year from $24,100 Sept. 6, according to data compiled by Bloomberg. It was the biggest increase in 16 months."

- These kinds of marginal changes in bond, currency, and derivative markets are exactly the type of thing that hedge fund managers never plan on. Their models relegate geopolitical events to the realm of "exogenous" events and assign them low statistical probabilities.

- This makes the models incredibly vulnerable when they come into contact with real life, like a sea kayaker who comes into contact with a typhoon that wasn't in the forecast.

- A sudden shift in capital flows, a rush out of South Korean bonds or the yen and into some other asset class or currency is the kind of thing which sets about a cascade of other changes in the inter-connected world of derivatives.

- But wait. Is it fair to hold fund managers accountable for events which they could not possibly predict? Of course not! But life is not fair. Models which fail to take into consideration human behaviour are bad models. Though it is hard to program human behaviour into a model, failing to do so can be financially disastrous.

- As Eric Beinhocker writes in The Origin of Wealth, "Real human beings have real behavioural regularities." One of those regularities is that entire nations go stark raving mad from time to time. The history of the 20th century is filled with examples. The world is full of hatters, and all of them are going mad.

- It would be nice to have a tidy mathematic model that accounts for the periodic irrationality of financial markets. But quantifying irrational behaviour is notoriously difficult.

- From a financial perspective the moral is simple: do not underestimate the unanticipated financial consequences of a geopolitical event that triggers a fiasco in the derivatives markets.

- Pricing risk is not the same kind of science as splitting the atom. Inexactitude in one is nearly as explosive as precision in the other.


Regards,

Dan Denning
for The Daily Reckoning