Option Investor

Thank You Iran

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Iran's new hostage crisis and their belligerence in the press has produced another week of gains in oil prices. Should they suddenly decide to release the hostages the price would plummet but probably only temporarily. The dice have been cast and it appears we are racing into an armed conflict between the US and Iran. Another carrier battle group is headed for the Persian Gulf and occupancy at UAE hotels has climbed past 90% due mostly to US military support personnel. Patriot missile batteries have appeared in Bahrain and American civilians are being told to leave the region. I can't conceive of a scenario where Iran backs down and loses face in the region. They would rather go out as martyrs than sit down and debate rationally.

With gasoline inventories low and refinery problems rampant and hurricane season only eight weeks away the Iran problem could not have come at a better time for prices. Considering the jump of nearly $10 from the recent lows their hostage escapade has produced an additional benefit of nearly $35 million per day in additional oil revenues. All they have to do now is keep their oil fields from being cut off from the outside world to collect that money.

On our side of the pond the refiners are printing money with the volatility in oil prices and gas prices nearing $3. The only challenge on our side is to keep drivers driving and not have them succumb to sticker shock at the pump. Consumer sentiment fell unexpectedly in late March and the price of gas was given as the primary reason.

I have decided there is an idiot born every minute and quite a few of those born 40-50 years ago were on CNBC this week. Two in particular were claiming that oil was the perfect short for the next 20 years. I kid you not that is exactly what they were suggesting. One was targeting $20-$30 again within four years. This came in the same week that the GAO released its Peak Oil report saying that Peak Oil was inevitable and nobody was doing anything about it.

The Peak Oil report was unremarkable in its lack of a consensus of opinion and remarkable in its vagueness. A form of the word "uncertain" was used 87 times and the word "could" was used 84 times. Typical bureaucratic cover your butt mentality. Read it here

A few highlights for your reading pleasure:
I paraphrased some for length. (My comments in italics)

Ethanol may be technically feasible but it is more expensive than gasoline (gets 25% less mileage as well) and will require costly investments in infrastructure before it can become widely used as fuel. Even at maximum effort key alternative technologies including ethanol could only displace 4% of annual gasoline consumption by 2015. (Gasoline consumption is expected to rise 8% by 2015 so alternative fuels are a net loss) In such circumstances, an imminent peak and sharp decline in oil production could cause a worldwide recession.

According to a 2005 report prepared for DOE, without timely preparation, a reduction in world oil production could cause transportation fuel shortages that would translate into significant economic hardship. (Duh!)

Most studies estimate that oil production will peak sometime between now and 2040. The timing of the peak depends on multiple uncertain factors including how much oil remains in the ground, how much can be extracted even at great cost and future oil demand. (Great, you spent millions of taxpayer dollars and this is the answer you provide. Any Option Investor reader could do better than that!)

According to the IEA, most countries outside OPEC have reached their peak in conventional oil production or will do so in the near future. 60% of the remaining global oil reserves are in politically unstable countries. (No argument here)

Some experts believe OPEC estimates of proven reserves to be inflated. For example, IEA reports that reserve estimates in Kuwait were unchanged from 1991 to 2002 even though Kuwait produced 8 billion bbls during that period and did not make any new discoveries. The potential unreliability of OPEC's self reported data is particularly problematic with respect to predicting a peak because OPEC holds most of the worlds current estimated reserves. According to the Oil and Gas Journal estimates in Jan-2006, of the estimated 1.1 trillion barrels of proven reserves worldwide, about 80% are located in OPEC countries. (Claimed reserves, not proven)

It is also difficult to project the timing of a peak in oil production because technological, cost and environmental challenges make it unclear how much oil can ultimately be recovered from proven reserves, hard to reach locations and non-conventional sources.

The timing of peak oil is also difficult to estimate because new sources of oil could be increasingly more remote and costly to exploit including offshore production in deepwater and ultra deep water. (They go on to elaborate that 2.2 mbpd "could" be extracted from ultra-deepwater in the Gulf by 2016 BUT production challenges at those depths may make production unfeasible. Yes, the oil is probably there but we can't get it for any reasonable price.)

Worldwide oil sands production was 1.6 mbpd in 2005 mostly from Alberta Canada. Production is projected to climb to 3.5 mbpd by 2030. (Not even enough to offset the depletion rate in the US and Mexico over just the next 5 years) However, raising production to this level presents significant environmental challenges. Production would use very large amounts of natural gas (already in decline) which generates large amounts of greenhouse gases when burned. In addition large-scale production of ol sands requires significant quantities of water, typically produce equal quantities of contaminated water and alter the natural landscape. These challenges may ultimately limit production from this resource EVEN IF SUSTAINED HIGH OIL PRICES MAKE PRODUCTION PROFITABLE! (I have been warning that this would come to pass.)

In many countries with proven reserves, oil production could be shut down or curtailed by wars, strikes and other political events. If these events occurred repeatedly on in many different locations a peak in production may result even though proven reserves may still exist. Using a measure of political risk that assesses the likelihood that these events may take place over the next 5 years we found that four countries, Iran, Iraq, Nigeria and Venezuela, that have proven reserves of more than 10 billion bbls also face high levels of political risk. Those four countries contain nearly one-third of worldwide oil reserves. The possibility of a drop in production is very strong. In addition the loss of technical expertise due to political unrest in these countries and others is degrading the amount of oil that can be produced and ultimately recovered.

According to our analysis, 85% of the worlds proven oil reserves are in countries with medium-to-high investment risk or where foreign investment is prohibited. Over one third of the worlds proven reserves lie in only five countries - China, Iran, Iraq, Nigeria and Venezuela - all of which have a high likelihood of seeing a worsening of the investment climate.

Only three international companies, Exxon, Shell and BP, rank in the top ten companies based on production. No international companies rank in the top 10 according to reserves. Only national oil companies rank in that metric.

The IEA projects production declines from ALL non-OPEC countries by 2010. (Without significant additional OPEC production by 2010 the world will peak.)

The IEA expects global oil demand to reach 118 mbpd from the current 86 mbpd by 2030. (Unfortunately that means we have to add the equivalent production of FOUR new Saudi Arabian sized countries at 9 mbpd each in order to meet that demand. IT IS NOT GOING TO HAPPEN! The oil simply does not exist at those flow rates.)

This is the most amazing statement in the entire report:

Factors that create uncertainty about the timing of the peak also create the uncertainty about the rate of production decline after the peak. The IEA estimates this decline will be between 5% and 11% annually. Another methodology employed by the EIA assumes the rate of decline will actually be faster than the rise in production before the peak. The rate of decline after a peak is an important consideration because a decline that is more abrupt will likely have more adverse economic consequences than a decline that is less abrupt. (This is the first time I have seen hard numbers from the IEA and EIA about the depletion rate. They normally say 1-2% or ignore it altogether. A 5-11% decline rate is actually realistic and highly probable. At today's production rate of 86 mbpd that equates to nearly 7 mbpd (8% average). That means every year in the future we have to add 7 mbpd just to stay even. That is nearly the entire production of Saudi Arabia each year. I have warned about this repeatedly and now even the IEA has admitted the problem. Can you imagine a peak next year and then a 7 mbpd shortfall to follow? That is 7 supertankers of oil every day, 365 days a year. Where would prices be then?)

In the United States alternative transportation technologies have limited potential to mitigate the consequences of a peak and decline in oil production. If the peak and decline in oil production occurs before these technologies are advanced enough to substantially offset the decline the consequences could be severe. The seven alternative fuels and advanced vehicle technologies we examined will take time and significant challenges will have to be overcome. These technologies include ethanol, biodiesel, biomass gas-to-liquid, coal gas-to-liquid, natural gas vehicles, advanced vehicle technologies (??) and hydrogen fuel cell vehicles. (How many of those do you think will be ready by 2010? ZERO!!)

Because development and widespread adoption of these technologies to replace oil will take time and effort an imminent peak and sharp decline in production could have severe consequences. The technologies we examined currently account for less than 1% of consumption and could only achieve a 4% equivalent by 2015. If a peak and decline occurs before 2015 competition among consumers for increasingly scarce oil resources would cause oil prices to sharply increase. Ultimately, consequences of a peak and permanent decline in oil production could be even more prolonged and severe than those of past oil shocks. Because the decline would be neither temporary nor reversible the effects would continue until alternative transportation technologies to displace oil became available in sufficient quantities at comparable costs. Furthermore, because oil supplies would decline even more year by year after a peak the amount of replacement technologies would have to also increase year by year.

Federal agencies do not have a coordinated strategy to address peak oil issues. Federal agencies have many programs and activities related to peak oil issues but peak oil is not the main focus of these efforts. (In other words, if peak oil appears over the next several years it will be a monstrous debacle.)

Report Conclusion:

The prospect of a peak in oil production presents problems of global proportions whose consequences will depend critically in our preparedness. The consequences would be "MOST DIRE" if a peak occurred soon, without warnings, and were followed by a sharp decline in oil production because alternative energy sources, particularly for transportation, are not yet available in large quantities. Such a peak would require sharp reductions in oil consumption and the competition for increasingly scarce energy would drive up prices possibly to unprecedented levels causing severe economic damage. While these consequences would be felt globally, the United States, as the largest consumer of oil and one of the nations most dependent on oil for transportation, may be especially vulnerable among the industrialized nations of the world. (In other words, the bigger we are the harder we will fall.)

The committee warned that peak oil could come at any time and consequences would be severe. Because they also said it could come as late as 2040 it will be ignored. It is always easier to put off until tomorrow an unpleasant task you don't want to face today.

This is not the same report as we are expecting from the National Petroleum Council to be completed in June. That one may be a tad more detailed as to a target date.

We saw more consolidation in the oil patch last week with US Steel (X) buying Lone Star Technology (LSS) for $2.1 billion. This will make the combined company the largest North American producer of tubular steel. That was a 39% premium to the $48.45 closing price on LSS before the announcement.

For the rest of the oil sector the highly volatile oil prices produced some volatility in the stock prices with profit taking hitting some pretty hard on Friday. It is just a symptom of the current market and we will have to live with it until a longer term trend appears. Today everybody is thinking we should see some profit taking before the next rally but without a hostage release by Iran it would be short and new highs are still ahead.

Jim Brown

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