Weekly Musings 5-01-11 from oftwominds.com
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For those who are new to the Musings: they are basically a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books.
This week's topic: Oil "Head-Fake" Update
Correspondent Russ J. (and other readers) were kind enough to send me the link to investing legend Jeremy Grantham's latest newsletter, which summarized Peak Everything's unsustainability and eventual impact on the global economy.
It is well worth the time, even if you are already well-informed about Peak Oil and the limits to exponential growth.
One section caught my attention, as it paralleled my own expectations of a new high in oil prices followed by a "head-fake" crash as global recession severely erodes demand.
This is a "head-fake" because it won't mean oil is abundant or that peak Oil is false; it simply means oil exporters will be pumping every barrel they can to maximize their income even as demand plummets. Since oil is priced on the margin, an oversupply of a mere 1 million barrels a day will have an outsized effect on price, just as a 1 MBD shortfall will drive price up very quickly.
I first predicted the oil "head-fake" in May, 2008, when oil was $123/barrel. I suggested oil would reach $150/barrel and then drop sharply, and then climb again as Peak Oil took hold. Oil topped out at $147/barrel and then fell all the way down to $34 a barrel in January 2009.
I now see oil repeating this "head-fake" in a series of stairstep moves up of higher highs and higher lows. Grantham outlined just such a possibility, suggesting that when China's overheated economy cools (when, not if), likely in 2011, then oil could fall to the lower standard deviation channel around the mid-$40s/barrel.
In Grantham's view, this head-fake will provide savvy investors with a once-in-a-lifetime chance (well, a second chance) to load up on oil assets before they resume their next ascent to the $200/barrel level and possibly beyond. As global supply falls, then the next rise in global demand will find no matching increase in supply, and price will skyrocket.
I was mocked in the blogosphere for depicting a potential price of $1,000 a barrel for oil once the supply-demand imbalance became acute. The reason for the scorn, of course, is that all sorts of other energy options such as gasifying coal and natural gas, solar-powered hydrogen, etc. etc. all because attractive options when oil is $250/barrel, never mind $500 or $1,000 a barrel.
But this kind of thinking completely ignores the enormous investment of capital and time required to bring any alternatives online in quantities anywhere close to replacing oil.
The Germans gasified coal in World War II, so the technology already exists--the Fischer-Tropsch process. But the scale that would be required to replace gasoline from oil is staggering.
Here is a quick rundown of the statistics:
Americans consume about 345 million gallons of gasoline a day.
A single gasification plant can make 133 million gallons of gasoline a year from 1.5 million tons of coal.
So 950 such plants would be needed to produce the gasoline burned in one year (135 billion gallons, or about 13 million barrels a day).
That would require 1,420 million tons of additional coal or equivalent feedstock.
Let's say we're going to replace oil-derived gasoline with switchgrass, biofuels, natural gas and hydrogen-powered fuel cells, with solar cells supplying the electricity to break water into hydrogen and oxygen. The scale required is simply too vast to be built in time to start replacing oil. Right now, alternative energy sources provide about 3% of total energy consumption in the U.S., and most of that is hydropower from large dams.
To dig up and transport another billion tons of coal, or assemble enough solar arrays to create millions of cubic feet of hydrogen daily, to manufacture (or modify) the transport fleet (200 milion vehicles total) to use natural gas or hydrogen--these are projects which simply cannot be completed in time to forstall a gap between demand for oil and oil supply.
The oil and transport infrastructure took 100 years to build; even a "crash program" would be lucky to replace 10% of the oil supply consumed by the U.S. in 5 years.
So if a large gap opens between demand for oil and supply, price could easily double from previous highs in a matter of months. If we know anything about the price of oil,it is extremely sensitive to marginal demand and supply. In 2008 it went from $75 to nearly $150/barrel and then fell below $40/barrel that same year.
If it takes years to construct the facilities needed to replace even 10% of this vast ocean of gasoline and jet fuel derived from oil, then what happens between the few months that oil doubles and alternatives come online years later?
The world isn't "running out of oil," as we all know; the problem is that the easy-to-access oil is gone and the costs of pumping the hard-to-get stuff are high. And production has peaked around 85 million barrels a day--a number that just barely meets demand.
The take-away for investors is straightforward: when oil plummets in the next head-fake, have some cash on the sidelines to invest in oil. We've already seen oil quadruple from its early-2009 lows--and we've only just started to experience supply disruptions from political turmoil.
Yes, some alternatives will undoubtedly be great investments, too, but they are linked to oil prices and thus are just as volatile as oil. Navigating a highly dynamic and volatile environment will require a new investment worldview.
As for timing: many observers see China's credit/real estate bubble popping this year as the Chinese government has no choice but to tighten lending and credit creation as inflation takes hold and crimps the lower income citizenry's ability to survive. Once China's economy rolls over, then that will provide the first domino in a global recession that will once again cut demand for oil significantly and quickly.
Other links of interest:
From Left Field:
This week's quote:
"Honesty is the first chapter in the book of wisdom." - Thomas Jefferson
CHS note: no wonder wisdom is in such supply in the U.S. at this point in history; so is institutional/financial/political honesty.
Thanks for reading--
charles
