Investment 2005: Assessing the Petroleum Factor
If 2005 were a conventional economic environment, we could invest as we have in the past. Look for industry and market trends, check out the economic indicators, keep an eye on the politicians, and then – with this information in hand - evaluate individual stocks and bonds. But 2005 is not a conventional economic environment. The old rules of investing are useful, but they ignore an essential truth - petroleum has become a wild card.
Investing in 2005 is like walking across a minefield. The landscape may look benign, we may think we know what is happening to us, but then – boom! Investors are blindsided by an unfavorable political event, or a SNAFU in oil production, transportation, or refining. Consuming nations are threatened with a worldwide oil shortage that rattles the stock and bond markets.
So we have to look at the stock market in two ways. There is the conventional "everything goes right" approach, and the "what if" approach. Conventional stock market evaluation assumes we know that the past, however deviously, will tend to repeat itself. If everything "goes right" our economic environment follows old familiar conventions. By contrast, the "what if" approach adds the paranoia of the unexpected or unwanted surprise that promises to blast away all conventional thinking.
The "Everything Goes Right" Numbers.
We humans collectively produced just over 29.7 Bbl of oil in 2004. Of this amount, 5.2 Bbl (17.5% of the world's production) was extracted and refined in North America (United States, Canada and Mexico). We consumed 29.6 Bbl of oil during this period, and this left us with a little surplus at the end of the year. North American users accounted for 9.0 Bbl (30.4%) of world consumption. The big news was the sharp increase in Asia/Pacific oil consumption (including China and India) which grew at a rate of 6.8 percent. The price of light oil averaged $41.00 per barrel.
If geology, transportation and refining are the only challenges to production, the oil industry can plan on delivering 30.4 Bbl in 2005. Assuming projected economic growth rates are correct, users will consume about 30.2 Bbl in 2005. And again, assuming no disruptions to production, transportation and refining, and given the surplus currently in the "pipeline", we should have a narrow – but workable – margin of production over consumption. Asia/Pacific consumption is projected to increase by 4.1 percent. The price of light oil should drop to an average of $37.00 per barrel.
During 2004, the United States experienced an inflation rate of 2.7 percent, an unemployment rate of 5.4 percent, and a GDP growth of 6.6 percent (all in current dollars). Gasoline prices for all grades averaged about $2.00 per gallon.
Looking ahead to 2005, the United States can reasonably expect an inflation rate of 3.5 percent, an unemployment rate of 5.1 percent and an annual GDP growth of 6.7 percent (or about 3 percent in "real" inflation adjusted terms). Gasoline prices, for all grades, should average $1.84.
Unfortunately, 2005 Will Not be Perfect.
The ghosts of anxiety lurk around the corner. The "Everything Goes Right" forecast is based on the mathematics of an econometric model. Unfortunately, economic history – which provides the data for any model – is unable to account for the foreword dynamics of an ever changing global economy. Cultural forces (including those of politics and religion), resource depletion, population migration, consumer confidence, international cash flows, debt financing, and technological innovation are all examples of change that are difficult to quantify. They are, never-the-less, a very real part of our economic future. We thus have to make an evaluation of the individual elements of our model against these dynamics in order to interpret our economic forecast.
The American dollar will continue to decline against the currencies of its primary trading partners. Worries about America's load of government, corporate and consumer debt will increase.
The current account deficit will continue to grow. A weakening dollar will increase the price Americans pay for imported goods and services. Limits to world resource production will drive up the price of basic commodities. Wholesale prices have been increasing and this will continue into 2005.
Further disruption in the production, transportation and refining chain is highly likely, sending oil prices considerably higher until the fear of shortages subside. This will retard GDP growth, have a mild upward impact on inflation, and exacerbate unemployment problems. The bigger the disruption, the larger the economic impact. Oil shortages, real or perceived, could unleash recessionary forces on the economies of the industrialized nations.
The psychological pain and increasing costs of war will weigh heavily on the American economy in 2005. The Islamists have drawn a line of blood in the sands of Iraq. They have a clear objective: drive the infidel out of the Middle East. Western politicians are divided, spineless, and unprepared for the consequences. Further terrorist attacks are being planned against European and American targets. The potential economic impact of these events are a wild card we hope will stay in the deck.
If the American housing market experiences a substantial dislocation (i.e. tank), then the market for mortgage debt will implode, sending the value of Mortgage Backed Securities downward. International lenders are already wary of America's capital and consumer debt. Any dislocation in any debt market could easily spread into treasury, public and corporate bonds. The ensuing chain reaction will trigger debt instrument defaults. If this scenario happens, the entire global banking system will be under an enormous financial stress.
Let's evaluate the odds. Further deterioration in the dollar: 100%. But we don't know how far it will slide, or if it will recover. Higher inflation: 100%. But we don't know how high it will go before the end of 2005. Oil disruptions: 100%. But we don't know if there will be sufficient damage to cause oil shortages or how long these shortages will last. War and terrorism: 100%. But it is difficult to assess their impact on the economy. Debt crisis: 70%. If all goes well in 2005, there will be no debt crisis. But in order for this to happen, everything else has to work. No economic or political screw-ups to shake investor confidence.
The net impact of these scenarios does not bode well for the American economy. Under the best of circumstances, the decline of the dollar, higher prices for goods and services, and a loss of confidence in American debt will send inflation well over 3.5 percent. The American Federal reserve will be forced to raise interest rates. Unemployment will exceed 5 percent. GDP growth will be less than 6.7 percent (in current dollars). World stock and bond markets will bobble like a cork.
Oil in 2005
Although short term oil shortages are probable in 2005, they will not be caused by a depletion of oil resources. In 2003, seven new large scale oil projects were brought on line and another 9 projects were added in 2004. In 2005, up to 18 new projects will come on line. New drilling projects in Saudi Arabia promise to increase that nations capacity to more than 10 million Bl per day by the end of 2005. Assuming relative peace in Iraq, that nation's capacity should increase by 1.7 million Bl per day by 2006.
Our conclusion. Producers will have the capacity to ship enough oil to cover growing world demand in 2005. Weather or not they will be able to get it to the consumer is another matter.
Oil Beyond 2005
Unfortunately, we humans are running out of new large scale drilling projects. We might see 11 new projects in 2006 and another 3 projects in 2007. That makes 2007 a pivotal year. At this point (or perhaps we should say – by that year), existing worldwide well production will be dropping faster than new capacity is coming on-line. A study published by Petroleum Review points out that about a third of the world's oil production is currently coming from mature oil fields that have a projected production decline of four percent per year. Global production from existing wells is therefore contracting at a rate of over 1 million Bl per day every year. We should also note that approximately 70 percent of the world's oil now comes from basins that were discovered and drilled over 25 years ago. Although there will be enough capacity to satisfy demand in 2006, the excess of capacity over consumption will begin to shrink. A study by Exxon-Mobile shows that non-OPEC crude and condensate production will plateau by 2010 and begin to decline by 2017. Any new increase in oil production will have to come from Natural Gas Liquids, tar sands and shales, OPEC condensate, and OPEC oil wells.
Will the discovery of new large scale oil projects save us? In 2000, there were 16 discoveries of 500 million Bl of oil, in 2001 there were 8 large scale discoveries, and in 2002 there were 3 such discoveries. In 2003 there were no large scale discoveries of oil. Furthermore, the rate of depletion has exceeded the rate of discovery since the 1980s. We consume more than 2 barrels of oil for every one found in a new discovery.
Going forward, higher oil prices and recessionary economic activity will put a downward pressure on consumer demand. The Best Case scenario described in my book "Oil, Jihad and Destiny" assumes no disruptions occur from cultural conflict and a relatively modest annual increase in Middle Eastern production. In this scenario, reduced demand delays peak oil production until 2021. However, the Production Crisis described in "Oil, Jihad and Destiny" makes – according to most of my peers – a more realistic assessment of world oil production. Peak oil production occurs much sooner.
That said, we should be aware that any qualified economic scenario will show that production, transportation and refining disruptions will cause transient oil shortages long before we humans have reached the theoretical peak of oil production.
And it's all downhill from there.
Ronald R. Cooke is the author of "Oil, Jihad and Destiny", which provides an assessment of world oil production, characterizes the economic devastation of oil depletion and suggests solutions to the emerging energy crisis. It is available for purchase at BookSurge.