Paradigm Shift


The energy conundrum discussed at this past weekend’s ASPO conference at Boston University was primarily directed at governments and the scientific and environmentalist communities. Let’s examine how this might affect the U.S. Economy and Financial Markets.

National Security

The U.S. Dollar is the world’s reserve currency, not least of which is because of the political security we enjoy. Yes we have a nasty and hotly contested election before us – but there will be no gunfire. Much of the world can’t say as much. With our trade and budget deficits our currency relies on our political hegemony. Can we maintain U.S. hegemony while increasing our reliance on foreign energy supplies? Not unless we are able to export enough to pay for our imports – we currently borrow $1 BILLION per day to finance our international energy purchases.

"The U.S. has only two percent of world oil reserves. We consume 25 percent of world oil production. We contribute eight percent of world oil production. That means we're pumping our reserves four times faster than the rest of the world. U.S. natural gas production has also peaked. The United States is now the world's largest importer of both oil and natural gas. From importing one third of the oil we use before the Arab Oil Embargo, the U.S. now imports about two thirds of the oil we use. Oil and natural gas production in Texas declined five percent in the first nine months of 2005. We're sliding down Hubbert's Peak.” And “We are just on the verge of not being able to feed the world. Tonight about one-fifth of the world will go to bed hungry." - Congressman Roscoe Bartlett on the U.S. House floor.

We continue to deplete our domestic reserves faster than the rest of the world depletes their respective domestic reserves.

The victors of WWII, the allies dominated by the U.S. and U.S.S.R. – these 2 countries were the largest oil producing countries in the world at the time. The vanquished? Germany and Japan - had no domestic oil supplies with which to prosecute the war. Can the U.S. maintain security while emptying its reserves? One thing is certain - countries barren of Oil do not have a great track record as superpowers.

Food Security

As I have related in recent posts, the world is experiencing flat to declining food production while at the same time its population is growing – so much so that world wide inventories of wheat and corn and rice (in terms of days of supply) are at multi decade lows, and the price of these commodities is at new highs. The questions are: Why is this happening? Is the trend continuing? It has been reported that if the next 2 crop years are as poor in yield as 2006 that the world will be in a full fledged food crisis. If true, and the data are compelling, we can expect a tremendous bout of inflation as the average American family spends much more on food than on gasoline, and a concomitant hike in short rates by certain central banks.

Worldwide wheat inventories are at 57 days of supply, corn is at 31 days of supply.

“To put the 57 days in historical perspective, the world price for wheat went up six-fold in 1973, the last time reserves were this low. Wheat prices ricocheted through the food supply chain in many ways, from higher prices for cereal and breads eaten directly by humans, to the cost for milk and meat produced from livestock fed a grain-based diet. If such a chain reaction happens this year, wheat could fetch $21 a bushel, again about six times its current price. It might fetch even more, given that there are two other pressing demands for grains that were not as forceful during the 1970s. Those happy days pre-dated modern fads such as using grains as a feedstock for ethanol, now touted as an alternative to petroleum fuels for cars, and pre-dated factory barns that bring grains to an animal’s stall, thereby eliminating farm workers who tended livestock while they grazed in fields on pasture grasses.” Wayne Roberts

For those of you old enough to remember the 1970’s, inflation, driven by food and energy, increased at the greatest rate in U.S. history. Inflation is a disaster for an economy, but if you play it right, it can make you rich, or at least negate its ill effects on you. Even if the markets crash and we must walk instead of ride, we still must make a living.

Financial Security

This may sound odd, but I think the best way to say what I have learned in my 2 decades- plus in the financial services business is this: You make money by not LOSING it. Think about it – how would your portfolio have done if you could go back in time and take out all the losers. Pretty good, huh? Well, we can’t. That’s why we diversify. Heck, if you were never wrong, diversification would be the last thing one would do. Here is where I am going. If energy becomes as constrained as the scientists presenting at the BU Peak Oil Conference suggest, then, without question, the upheaval in the markets will be stunning. I am precluded from making specific strategy recommendations in this forum but you can ask yourself, and research for yourself (or just call me): what assets held their values during times of turmoil? Plenty of examples of where to look. What still had value in post-war Germany and Japan and post-collapse of the Soviet Union. No, things will not be that bad here, of course, but the lessons are of value.

Maybe you think I am all wet and that there is plenty of Oil just waiting to be found in shallow deposits and good climate. Then why are we looking in 20,000 feet of water and 7000 feet of earth, 200 miles from shore? Why are we fighting over the North Shore so badly? Why are we even CONSIDERING a nuclear reactor in Alberta, Canada, to supply the necessary energy to convert the Tar Sands into a liquid. These are capitally intensive, expensive, and environmentally costly projects. If there were other projects available, I contend we would be doing them, instead. The circumstantial evidence is compelling. Between the price gains of recent years and the industries actions, I would vote to convict.

''You look at the globe and ask, 'Where are the big increments?' and there's hardly anything but Saudi Arabia. The kingdom and the Ghawar field are not the problem. That misses the whole point. The problem is that you go from 79 million barrels a day in 2002 to 82.5 in 2003 to 84.5 in 2004. You're leaping by two million to three million a year, and if you have to cover declines, that's another four to five million.'' In other words, if demand and depletion patterns continue, every year the world will need to open enough fields or wells to pump an additional six to eight million barrels a day -- at least two million new barrels a day to meet the rising demand and at least four million to compensate for the declining production of existing fields. ''That's like a whole new Saudi Arabia every couple of years… It can't be done indefinitely. It's not sustainable.” - Sadad al Husseini, recently retired head of exploration and production for Saudi Aramco

"Consider this simple math. If Ken Deffeyes (Professor of Geology, Princeton University) is correct that the world oil production peaked in December, 2005, then we will use--at our current rate of consumption--more than 10% of all remaining conventional crude + condensate reserves in the next four years." -Jeffrey J. Brown is a petroleum geologist in the Dallas, Texas area.

This story will unfold over the next decade – not next month. But markets discount the environment going forward – they do not look in the rearview mirror (if they did, those “technical analysts” would be a lot wealthier than they are). Being aware of this paradigm shift and up to date on the data will give you an edge. In any transaction there is a buyer and a seller, and only one of them gets to be right.

Greg Jeffers

Menatt (at) yahoo (dot) com