the coming oil back-draft

Back-draft: A situation when a fire that has absorbed
all available oxygen explodes suddenly when more
oxygen is re-introduced to the fire.
If you judge traders by their actions, you can see
the market is setting up for a big oil back draft. As
evidence, Bloomberg reports that, “Morgan Stanley
hired a super tanker to store crude oil in the Gulf of
Mexico, joining Citigroup Inc. and Royal Dutch Shell
Plc in trying to profit from higher prices later in the
year, two shipbrokers said.”
This is the “contango trade” where supply is
stockpiled offshore, and thus withheld from
refiners, allowing existing gasoline inventories to be
worked down. Then in six to twelve months time,
when crude prices have moved higher, you simply
park your ship at the terminal and cash in on the
difference between what you paid six months ago
(today) and the new market price.
By the way, it’s normal for the oil futures to be in
contango, where spot prices are lower than futures
prices. What’s less normal is the amount of oil being
stockpiled offshore. “Frontline Ltd., the world’s
biggest owner of super tankers, said Jan. 14 about
80 million barrels of crude oil are being stored in
tankers, the most in 20 years,” Bloomberg ads.

A Barbeque and the Coming “Swift and
Violent” Rise in Oil Prices
Last weekend I attended a 60th birthday barbeque.
While flipping chicken, I told an investment banker
friend I was on the lookout for good oil stocks. He
spat his beer all over our dinner and said I was crazy.
On the surface, my unsanitary friend has a point.
The oil price has plummeted, hitting $33 on the
Nymex in July. Demand for oil is falling too. The
Paris-based International Energy Agency recently
cited “the relentless worsening of global economic
conditions” as it reduced its global demand
expectations by one million barrels, to 85.3 million
barrels a day.
For the first time in decades, Japan, Europe, and
North America will all be in a recession at the
same time. Massive oil stockpiles are building up.
Norway’s Frontline, one of the world’s biggest tanker
owners, says they’re using 45 super-tankers as
“floating storage”. It now has over 80 million barrels
at sea – the highest in a quarter century.
You’d be nuts to be bullish on oil right now, right?
Well, no. All the of the above is masking something
rather sinister... an impending oil price ‘back-draft’...

one that could make the credit crunch look like a
tea party. As quoted in Dan’s front-page article,
Goldman Sachs analyst Jeffrey Currie is calling for a
“swift and violent” rise in oil prices this year.
He is not along. The just-established Industry
Taskforce on Peak Oil and Energy Security puts it
this way: “We’re in danger of repeating the shock
we had from the financial crisis, where governments
failed to see the mother of all crises coming...”
Low Oil Prices Pave the Way for Certain
Scarcity
“Finish the top part of the well. Then plug it up...”
Right now there’s a bloodbath in the oil industry.
Lower oil prices have delayed new projects and
forced companies to drastically slash exploration
budgets. The ones working on difficult and marginal
resources – with the highest costs – simply get
priced out. They shut down rigs, cut down staff and
cut back on their expansion plans.
This is quite the irony. Low oil prices are accelerating
the rate of depletion in the world’s large oil fields.
As prices decline, people get comfortable resuming
normal driving habits. At the same time, the oil
price crash is causing the oil industry to dramatically
roll back its exploration and production plans for the
next five years.
Take oil service provider Senergy. The company
has been developing a US$19m oil well for Stratic
Energy. Recently they were told “to finish the top
part of the well, plug it up and walk away”. This is
not an isolated case.
Schlumberger and Halliburton, the world’s No. 1
and No. 2 oilfield service firms, said they are both
taking a hatchet to their workforce. Schlumberger
has already axed 1,000 jobs, while Halliburton is
axing an “undisclosed” number of positions.
Smaller drillers and exploration companies are
downsizing massively or postponing projects.
Nabors Drilling have fired 150. Canadian oil and
gas supplies company Tenaris Prudential has just
temporarily laid off 400 workers. French oil company
Total’s CEO recently warned that at even $60 oil, “a
lot of new projects would be delayed.”
Greg Kuipers of Calgary mining junior Black Sea
Oil and Gas says he’s already made redundant 20%
of his work-force, and cut the pay of the rest. He
reckons 200 other Canadian mining juniors are in
the same position. “A good portion of engineers in
downtown Calgary are going to be worried about
their jobs. I would say about 20 per cent of them will
probably get laid off,” he said.
Russia’s largest oil company Rosneft has postponed
the opening of its giant Vankor oil field. That’s 135
million tons of oil that won’t reach the market. The plummeting oil price is expected to cost oil and gas
state Texas a massive 110,000 jobs in the next six
months alone.
It’s not just private companies cutting back, either.
Fall of the Petrol States
The handful of countries that rode oil prices to
record profits and increased geopolitical profiles are
now doing it tough. Russia has 20% of its GDP in
oil-related industries. Finance Minister Alexei Kudrin
said in Hong King this month that Russian economic
growth may slow to 0% in 2009, compared with 6%
in 2008. That’s quite a slide.
According to Venezuelan Energy and Oil Minister
Rafael Ramirez, oil prices need to rise to about $70
a barrel to sustain investments in fields and avoid
shortages. Venezuelan strong-man Hugo Chavez
has quietly begun inviting Western oil companies
back into the Orinoco Basin. Without their expertise
and capital, Venezuelan oil production faces serious
decline.
And Mexico, the struggle between the drug cartels
and the Federal government could be bad news
for the Federales, considering that over 50% of
Mexico’s budget comes from revenues generated
by state-run oil company PEMEX.
PEMEX has underinvested in production capacity
and exploration and faces declining production from
its largest field (Cantarell). What’s more, a recent
report issued by the United States Joint Forces
Command suggests Mexico could face a, “rapid
and sudden collapse.”
So what, you might say? This is just part of the
natural economic cycle, right? You get recessions.
Companies and countries cut back. People lose
jobs.
But here’s the problem. A recession doesn’t change
the fact that 86% of the world’s energy is derived
from fossil fuels. Once this recession is over – and it
will end eventually – demand for oil will start soaring
again.
The trouble is, aging fields that are in depletion,
particularly the giant oil fields. Big exporters are
consuming more, but will most likely produce less
oil at the same time. If they consume more and
produce less the fact is unavoidable: exporters
will export less oil in the coming years. All this will
happen over the next few years, by which time I
expect demand growth in China and India to have
resumed.
That means the production shortfall from
somewhere. What we need – urgently – is MORE
investment in finding and drilling for oil, not less.
For this reason, I’m picking an oil ‘back-draft’, where
the price explodes when high demand is suddenly re-introduced. Look at the fundamentals.
A Twenty-Five Percent Export Decline in the
Next Six Years
Take a look at the chart below. It shows the
expected decline in world oil exports, given both
declining production and increased demand in
oil export countries. It is not a pretty sight if, like
Australia, you’re a nation that relies on foreign
oil for all your domestic crude oil and refined
transportation fuels.
Historically, the countries that produced a lot of oil
– Saudi Arabia, United Arab Emirates, Iran, Mexico,
Venezuela – haven’t used much of the stuff. That’s
changing – fast. As these countries have moved
into the 21st century, so have their oil needs. In fact,
net oil exports from the world’s top 20 exporting
countries have been trending downwards since mid-
2005.
These producers have seen the writing on the wall.
They figure in a world of peak oil, it may just be a
good idea to hold onto your reserves instead of sell
them.
A recent independent study produced a ‘middle
case’ scenario in – one in which exports from
the world’s top five oil exporters decline by
6.2% by 2015. That’s a decline equivalent
to one quarter of the world’s internationally
traded oil over the next six years.
Now match that to this chart to the right...
Australia’s domestic oil production peaked
back in 2000. It will never recover. We are
already 50% dependent on oil imports. As you
can see in the chart above, we’re going to be
TWO-THIRDS dependent by 2015.
Just to make this clear for you...
In the next six years, there will be 25% LESS oil on the export market. But Australia’s dependence
on foreign oil will INCREASE from half to two-thirds.
So in an environment where people are clinging
onto every drop of crude, Australia will need to
shop around for more of the stuff!
Of course, Australia will not be alone. A whole
bunch of countries will be frantically chasing
diminished oil supplies. In fact the smartest and
most powerful are already doing it...
Discount Shopping and Oil Hoarding
For some nations (and investors)
this month’s low oil prices are the
best chance this year to load up on
oil and oil related assets while they
are still cheap. For example, China
has already started hoarding crude.
Zhang Guobao, vice chairman of the
National Development and Reform
Commission, says China will now move
forward with “phase two” of building
strategic reserve facilities.
State media reported that around
7.3 million barrels of oil had been
delivered to the Huangdao facility,
China’s third strategic reserve, in
November, with more stockpiling
planned in December and January.
It’s simple really. If you think something
is going to be scarce and expensive
in the future, you buy it now – when it’s relatively
abundant and cheap. As an investor, you can say the
same regarding certain oil stocks. But only ones that
you think will make it through the current downturn.
This will be one of our key areas of focus in the
coming year.
Let’s not forget – bubbles tend to overshoot on
the way down. Take a look at oil futures. A barrel
of crude can be bought for around $35 today. But
looking at the oil futures market, a one-year contract
prices oil near $60 a barrel – 71% higher than today.
Anyway you look at it; the price of oil must go up eventually. I believe a ‘back-draft’ affect – where
investment in future supply won’t have been made
to meet demand – will send it to triple digits, and
fairly fast.
So what should you be doing about it now? Unlike
past bear markets in energy, there are a lot of oil
and gas companies sitting on good projects, with
healthy balance sheets. But their prices are now
50% or even 70% lower than a year ago. Among
these companies, I’d target outfits that are most
likely will benefit from a fast, frantic rush to increase
oil supply when the cycle turns bullish.