Sunday, October 28, 2007

My friends know cool stuff: Matt Stone

Today we turn to an interview with Matt Stone, a friend and fellow columnist from when we were at the University of Arizona. I wanted to get his opinion because he's turning into an energy expert, especially with regards to international security. He has a good bio of himself here, at his excellent site The Global Buzz.


What variables will most likely influence oil prices going forward?

Like any commodity market, oil prices are determined first and foremost by supply and demand. It's stunning to see how often people forget that basic tenet of economics, assuming instead that prices are dictated by greedy oil executives (implausible) or Middle Eastern dictators (somewhat implausible). Today's market is primarily fueled by growth in demand, hardly price gouging by international oil companies (IOCs) like ExxonMobil, BP or Royal Dutch Shell or production quotas from OPEC, which are consistently violated by the cartel members.

On the demand side, growth in demand from the developing world, most notably China and India, is sure to provide long-term upward pressure on the price of oil. Moreover, domestic subsidies for petrol consumption in oil-producing countries are taking increasingly more oil off the global market. Most analysts expect Iran to be a net oil importer by 2012 and the introduction of petrol rationing by the Iranian president this past year is an indication that the regime fears the loss of the export-revenue flow. In the developed world, the United States continually fails to show leadership on climate change, first by not signing the Kyoto Protocol or at least negotiating a better treaty, more recently by failing to increase gas-mileage standards for domestic vehicles. While the political momentum on this issue may change in the States in 2008, it is taking an unacceptable amount of time to do so and American energy demand continues to grow. Frankly, the world market is not about to see an aggregate reduction in demand for hydrocarbons anytime soon, no matter how much nuclear power, ethanol, hydrogen fuel-cells or renewable energy is pushed by opportunistic politicians as the next energy panacea.

On the supply side, things are a bit more promising. High oil prices have pushed oil companies, including national oil companies (NOCs) like Brazil's Petrobras, to invest in new technological innovation. Deep-sea exploration and production looks better and better – though not from an environmentalist's standpoint – and new deposits may be found soon. Companies are developing new techniques to exploit the tar sands of Canada and Venezuela, which collectively contain more oil than all of Saudi Arabia. There is certainly enough oil to satiate demand in the long-term, but it will require prices to go even higher before production becomes profitable for these unconventional sources. Nevertheless, short-term disruptions of supply could throw the oil market into a crisis every now and then (more below).

Now to prices: How much of a price premium is built in for geopolitical risk? How do you see potential events affecting the oil price?

Geopolitical risk is never far from the minds of oil traders or the companies that produce hydrocarbons. We have been transitioning in the past decade or so into a new bout of hydrocarbon nationalism, wherein national oil companies (NOCs) gain majority equity stakes in a variety of projects at the expense of the IOCs, who are desperate at this point for access to acreage (note the massive amounts of cash IOCs are sitting on; they have nothing to invest it in). While the NOCs are increasingly technically competent, they are still less effective at optimally exploiting resources than the IOCs, meaning more oil gets locked in the ground due to ham-fisted production efforts. This has especially been the case in Russia, where state-controlled Gazprom and Rosneft still can't quite produce oil and gas as effectively as the private oil companies operating there, and yet the Kremlin seeks to push out those private companies to create large state-controlled national champions.

In this environment of increasing resource nationalism (in Russia, Kazakhstan, Bolivia, Venezuela, Chad, Ecuador, even Peru), we have to take into account the threat of isolated attacks on energy infrastructure as we have observed with MEND in the Niger delta, Ogaden rebels in Ethiopia (interestingly, against oil exploration and development by a Chinese oil company) and even al-Qaeda in Saudi Arabia in 2005. The right attack in the right place – say the Ras Tanura oil terminal of Saudi or the Baku-Tbilisi-Ceyhan (BTC) oil pipeline by Kurdish guerillas in Turkey – could immediately reinvigorate the "fear premium" in the oil market, even if the actual barrels of oil taken off the world market is small. But, as is normal in economics, we have to think on the margin, and even a small amount of barrels off the market can have huge effects, especially those of the psychological variety.

Thus, right now, I do believe the price premium for geopolitical risk or the "fear premium" is on the order of $5-10 per barrel, a bit lower than in the past few years. One headline-making attack, however, and that premium could rocket up to $20-25 per barrel in a matter of minutes. Supply is constrained, demand is growing, and taking marginal amount of barrels off the market will have serious price and psychological effects.

The money question: if you were a betting man, where would you place your money on where oil prices will be 1, 5, 10, and 25 years from now?

Oil prices are notoriously impossible to predict. The 1998 price collapse was not widely predicted, nor was the run-up in prices since 2004. Instead, analysts tend to notice the trends that are pushing prices in whichever direction only after the prices start moving in that direction. Thus, I will hazard a guess, but don't bet on me, in the same way that I won't put my money where my mouth is on this topic.

One to five years from now, prices will likely go up. By my estimation, technological innovation in oil-producing technology and other forms of energy (ethanol, hydrogen, nuclear, etc.) will not offset for the growth in demand from the economies in Asia. Even if the Chinese or Indian economies overheat, which is increasingly likely in India, demand growth will most certainly continue, though at a reduced rate.

Ten years from now and 25 years from now are much harder to predict because we may start transitioning away from petroleum-based economies by that time. Substitutes for oil, including natural gas, will become increasingly available and scalable. I would personally put my money on natural gas as a long-term substitute to oil for a number of reasons: (1) it's cleaner-burning than oil, which pleases the environmentalist in all of us; (2) the costs of liquification technology, which allow the natural gas market to go global as opposed to the present disjointed regional markets, are decreasing rapidly; and (3) it already has a track record for being marketable, which most current energy fads do not. On the negative side, natural gas reserves are concentrated primarily in Russia, Iran, Qatar and Algeria (not exactly the developed world's best friends) and the substance is incredibly flammable, meaning that a terrorist attack on a liquefied natural gas plant or tanker could be absolutely devastating for the surrounding areas – and the entire market for natural gas.

Thus, 10 to 25 years from now, the price of oil may be significantly lower as our economies transition to other forms of energy – or significantly higher if we do not do so.

How should a stock investor act with regard to energy stocks?

Since NOCs are taking more and more of the world's energy reserves, it might be a safe bet to invest in them, but know what you're getting into. Brazil's Petrobras continues to evolve into a world-class company whereas Venezuela's PDVSA or Russia's Gazprom are bloated bureaucracies aimed at increasing the prestige of the state rather than maximizing return to their shareholders.

Instead of the NOCs, it might be smart investing in the service companies that provide technical expertise to oil companies. Companies like Schlumberger or Halliburton will be increasingly called upon to provide the technology and know-how for NOCs.

Investing in the IOCs has historically been a good bet, but the nature of the market is now changing fundamentally. The IOCs must adapt to a new reality where they play second fiddle to the NOCs, taking on less than majority stakes in projects, acting more like the service companies that they are not. Investing in an IOC means you expect the IOC to "book" new reserves quarterly, the share price being based on such figures. Most IOCs are not "booking" new reserves at a rate that merits significant investment. Instead, IOCs need to decouple their share price from the amount of oil reserves on their books by diversifying into a whole new range of energy technologies. If you believe the company is truly responding to the changing market and diversifying, BP would be a buy recommendation and ExxonMobil would be a sell.

In other areas of energy, investing in nuclear power producers like GE or Areva might be smart. The uranium mining sector is currently booming and should continue to do so over the next few years, especially if the United States goes forward with new nuclear power plant construction.

And like I said before, I do believe natural gas has the best chance as a growth sector over the next decade, even more so than nuclear.

6 Comments:

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